Exchange Chapter 31 Niklas Jakobsson Click to add notes

Introduction So far we have discussed partial equilibrium, that is the market for a single good General equilibrium analysis study the interaction of several markets 2007

The Edgeworth box Competitive markets Two consumers and two goods Pure exchange (no production) 2007

The Edgeworth box - Trade Person A is better off than at the initial endowment at all the bundles above her indifference curve through the initial endowment Same is true for person B Both are better off where these regions intersect Trade to the point M Doing the same analysis from point M we see that no more trade occurs This imply pareto efficiency since the region where A is made better off is disjoint from the region where B is made better off. 2007

The Edgeworth box – Pareto efficiency Pareto efficiency: there is no way to make some individual better off without making someone else worse off If the two curves cross there is a possibility of mutually advantageous trade so the point cannot be pareto efficient (excluding border solutions The contract curve illustrates all pareto efficient allocations It goes from A’s origin to B’s origin and the shape depend on the indifference curves 2007

The Edgeworth box – Welfare theorems A competitive equilibrium will exist if each individuals demand function is continuous (convex preferences) or if every consumer is small relative to the size of the market The first theorem of welfare economics: the equilibrium in a set of competitive markets is pareto efficient The second theorem of welfare economics: if all agents have convex preferences there will always be a set of prices such that each pareto efficient allocation is a market equilibrium for an appropriate assignment of endowments 2007

First theorem of welfare economics This result is generalizable to much more complex models The theorem has grand implications for the way to allocate recourses The theorem follows from: Agents only care about their own consumption Agents behave competitively Agents are small relative to the size of the market 2007

First theorem of welfare economics A private market with each agent maximizing her own utility will result in pareto efficiency That is, a competitive market ensures pareto efficiency A competitive market economizes on the information that agents need to posess; only price information is needed 2007

Second theorem of welfare economics Every pareto efficient allocation can be achieved as a competitive equilibrium Thus, the problems of distribution and efficiency (allocation) can be separated As long as the taxes are based on the value of the consumer’s endowment of goods there will be no loss in efficiency When taxes depend on the choices that a consumer makes inefficiency result Practical problem: how to tax the initial endowment? The endowment is potential labour. Lump sum tax. 2007

Second theorem of welfare economics Prices should be used to reflect scarcity, not to distribute Lump-sum transfers of wealth should be used to adjust distribution Do not redistribute through the price mechanism! 2007

Critique “The assumptions of perfect competition are not even remotely related to much of the world in which we live…” -Richard Lipsey 2007

Informal justification of markets? The market system is self-organizing and coordinates economic decisions better than any known alternative – not optimally This is done relatively efficient by producing prices that are influenced by (not determined) relative scarcity A market economy with institutional underpinnings tend to decentralize power and cause less corruption than more centralized systems Markets are conductive in growth by encouraging competition of ideas and opportunities 2007

Summary General equilibrium Edgeworth bow The welfare theorems Implications 2007

One minute paper What is the most important thing you learned today? What is the muddiest point still remaining at the conclusion of today’s class? 2007