1. Chapter Twenty-Nine Exchange

2. u Two consumers, A and B. u Their endowments of goods 1 and 2 are u E.g. u The total quantities available and units of good 1 units of good 2. and are

3. Exchange u Edgeworth and Bowley devised a diagram, called an Edgeworth box, to show all possible allocations of the available quantities of goods 1 and 2 between the two consumers.

4. Starting an Edgeworth Box

5. Width =

6. Starting an Edgeworth Box Width = Height =

7. Starting an Edgeworth Box Width = Height = The dimensions of the box are the quantities available of the goods.

8. Feasible Allocations u What allocations of the 8 units of good 1 and the 6 units of good 2 are feasible? u How can all of the feasible allocations be depicted by the Edgeworth box diagram?

9. Feasible Allocations u What allocations of the 8 units of good 1 and the 6 units of good 2 are feasible? u How can all of the feasible allocations be depicted by the Edgeworth box diagram? u One feasible allocation is the before- trade allocation; i.e. the endowment allocation.

10. Width = Height = The endowment allocation is and The Endowment Allocation

11. Width = Height = The Endowment Allocation

12. OAOA OBOB 6 8

13. OAOA OBOB 6 8 4 6

14. OAOA OBOB 6 8 4 6 2 2

15. OAOA OBOB 6 8 4 6 2 2 The endowment allocation The Endowment Allocation

16. More generally, … The Endowment Allocation

17. OAOA OBOB The endowment allocation

18. Other Feasible Allocations u denotes an allocation to consumer A. u denotes an allocation to consumer B. u An allocation is feasible if and only if and

19. Feasible Reallocations OAOA OBOB

20. OAOA OBOB

21. u All points in the box, including the boundary, represent feasible allocations of the combined endowments.

22. Feasible Reallocations u All points in the box, including the boundary, represent feasible allocations of the combined endowments. u Which allocations will be blocked by one or both consumers? u Which allocations make both consumers better off?

23. Adding Preferences to the Box OAOA For consumer A.

24. Adding Preferences to the Box More preferred For consumer A. OAOA

25. Adding Preferences to the Box For consumer B. OBOB

26. Adding Preferences to the Box More preferred For consumer B. OBOB

27. Adding Preferences to the Box More preferred For consumer B. OBOB

28. Adding Preferences to the Box OAOA For consumer A.

29. Adding Preferences to the Box OAOA OBOB

30. Edgeworth’s Box OAOA OBOB

31. Pareto-Improvement u An allocation of the endowment that improves the welfare of a consumer without reducing the welfare of another is a Pareto-improving allocation. u Where are the Pareto-improving allocations?

32. Edgeworth’s Box OAOA OBOB

33. Pareto-Improvements OAOA OBOB The set of Pareto- improving allocations

34. Pareto-Improvements u Since each consumer can refuse to trade, the only possible outcomes from exchange are Pareto-improving allocations. u But which particular Pareto- improving allocation will be the outcome of trade?

35. Pareto-Improvements OAOA OBOB The set of Pareto- improving reallocations

36. Pareto-Improvements

38. Trade improves both A’s and B’s welfares. This is a Pareto-improvement over the endowment allocation.

39. Pareto-Improvements New mutual gains-to-trade region is the set of all further Pareto- improving reallocations. Trade improves both A’s and B’s welfares. This is a Pareto-improvement over the endowment allocation.

40. Pareto-Improvements Further trade cannot improve both A and B’s welfares.

41. Pareto-Optimality Better for consumer B Better for consumer A

42. Pareto-Optimality A is strictly better off but B is strictly worse off

43. Pareto-Optimality A is strictly better off but B is strictly worse off B is strictly better off but A is strictly worse off

44. Pareto-Optimality A is strictly better off but B is strictly worse off B is strictly better off but A is strictly worse off Both A and B are worse off

45. Pareto-Optimality A is strictly better off but B is strictly worse off B is strictly better off but A is strictly worse off Both A and B are worse off

46. Pareto-Optimality The allocation is Pareto-optimal since the only way one consumer’s welfare can be increased is to decrease the welfare of the other consumer.

47. Pareto-Optimality The allocation is Pareto-optimal since the only way one consumer’s welfare can be increased is to decrease the welfare of the other consumer. An allocation where convex indifference curves are “only just back-to-back” is Pareto-optimal.

48. Pareto-Optimality u Where are all of the Pareto-optimal allocations of the endowment?

49. Pareto-Optimality OAOA OBOB

50. OAOA OBOB All the allocations marked by a are Pareto-optimal.

51. Pareto-Optimality u The contract curve is the set of all Pareto-optimal allocations.

52. Pareto-Optimality OAOA OBOB All the allocations marked by a are Pareto-optimal. The contract curve

53. Pareto-Optimality u But to which of the many allocations on the contract curve will consumers trade? u That depends upon how trade is conducted. u In perfectly competitive markets? By one-on-one bargaining?

54. The Core OAOA OBOB The set of Pareto- improving reallocations

55. The Core OAOA OBOB

56. OAOA OBOB Pareto-optimal trades blocked by B Pareto-optimal trades blocked by A

57. The Core OAOA OBOB Pareto-optimal trades not blocked by A or B

58. The Core OAOA OBOB Pareto-optimal trades not blocked by A or B are the core.

59. The Core u The core is the set of all Pareto- optimal allocations that are welfare- improving for both consumers relative to their own endowments. u Rational trade should achieve a core allocation.

60. The Core u But which core allocation? u Again, that depends upon the manner in which trade is conducted.

61. Trade in Competitive Markets u Consider trade in perfectly competitive markets. u Each consumer is a price-taker trying to maximize her own utility given p 1, p 2 and her own endowment. That is,...

62. Trade in Competitive Markets OAOA For consumer A.

63. Trade in Competitive Markets u So given p 1 and p 2, consumer A’s net demands for commodities 1 and 2 are and

64. Trade in Competitive Markets u And, similarly, for consumer B …

65. Trade in Competitive Markets For consumer B. OBOB

66. Trade in Competitive Markets u So given p 1 and p 2, consumer B’s net demands for commodities 1 and 2 are and

67. Trade in Competitive Markets u A general equilibrium occurs when prices p 1 and p 2 cause both the markets for commodities 1 and 2 to clear; i.e. and

68. Trade in Competitive Markets OAOA OBOB

69. OAOA OBOB Can this PO allocation be achieved?

70. Trade in Competitive Markets OAOA OBOB Budget constraint for consumer A

71. Trade in Competitive Markets OAOA OBOB Budget constraint for consumer A

72. Trade in Competitive Markets OAOA OBOB Budget constraint for consumer B

73. Trade in Competitive Markets OAOA OBOB Budget constraint for consumer B

74. Trade in Competitive Markets OAOA OBOB But

75. Trade in Competitive Markets OAOA OBOB and

76. Trade in Competitive Markets u So at the given prices p 1 and p 2 there is an – excess supply of commodity 1 – excess demand for commodity 2. u Neither market clears so the prices p 1 and p 2 do not cause a general equilibrium.

77. Trade in Competitive Markets OAOA OBOB So this PO allocation cannot be achieved by competitive trading.

78. Trade in Competitive Markets OAOA OBOB Which PO allocations can be achieved by competitive trading?

79. Trade in Competitive Markets u Since there is an excess demand for commodity 2, p 2 will rise. u Since there is an excess supply of commodity 1, p 1 will fall. u The slope of the budget constraints is - p 1 /p 2 so the budget constraints will pivot about the endowment point and become less steep.

80. Trade in Competitive Markets OAOA OBOB Which PO allocations can be achieved by competitive trading?

81. Trade in Competitive Markets OAOA OBOB Which PO allocations can be achieved by competitive trading?

82. Trade in Competitive Markets OAOA OBOB Which PO allocations can be achieved by competitive trading?

83. Trade in Competitive Markets OAOA OBOB Budget constraint for consumer A

84. Trade in Competitive Markets OAOA OBOB Budget constraint for consumer A

85. Trade in Competitive Markets OAOA OBOB Budget constraint for consumer B

86. Trade in Competitive Markets OAOA OBOB Budget constraint for consumer B

87. Trade in Competitive Markets OAOA OBOB So

88. Trade in Competitive Markets OAOA OBOB and

89. Trade in Competitive Markets u At the new prices p 1 and p 2 both markets clear; there is a general equilibrium. u Trading in competitive markets achieves a particular Pareto-optimal allocation of the endowments. u This is an example of the First Fundamental Theorem of Welfare Economics.

90. First Fundamental Theorem of Welfare Economics u Given that consumers’ preferences are well-behaved, trading in perfectly competitive markets implements a Pareto-optimal allocation of the economy’s endowment.

91. Second Fundamental Theorem of Welfare Economics u The First Theorem is followed by a second that states that any Pareto- optimal allocation (i.e. any point on the contract curve) can be achieved by trading in competitive markets provided that endowments are first appropriately rearranged amongst the consumers.

92. u Given that consumers’ preferences are well-behaved, for any Pareto- optimal allocation there are prices and an allocation of the total endowment that makes the Pareto- optimal allocation implementable by trading in competitive markets. Second Fundamental Theorem of Welfare Economics

93. Second Fundamental Theorem OAOA OBOB The contract curve

94. Second Fundamental Theorem OAOA OBOB

95. OAOA OBOB Implemented by competitive trading from the endowment .

96. Second Fundamental Theorem OAOA OBOB Can this allocation be implemented by competitive trading from  ?

97. Second Fundamental Theorem OAOA OBOB Can this allocation be implemented by competitive trading from  ? No.

98. Second Fundamental Theorem OAOA OBOB But this allocation is implemented by competitive trading from .

99. Walras’ Law u Walras’ Law is an identity; i.e. a statement that is true for any positive prices (p 1,p 2 ), whether these are equilibrium prices or not.

100. Walras’ Law u Every consumer’s preferences are well-behaved so, for any positive prices (p 1,p 2 ), each consumer spends all of his budget. u For consumer A: For consumer B:

101. Walras’ Law Summing gives

102. Walras’ Law Rearranged, That is,...

103. Walras’ Law This says that the summed market value of excess demands is zero for any positive prices p 1 and p 2 -- this is Walras’ Law.

104. Implications of Walras’ Law Suppose the market for commodity A is in equilibrium; that is, Then implies

105. Implications of Walras’ Law So one implication of Walras’ Law for a two-commodity exchange economy is that if one market is in equilibrium then the other market must also be in equilibrium.

106. Implications of Walras’ Law What if, for some positive prices p 1 and p 2, there is an excess quantity supplied of commodity 1? That is, Then implies

107. Implications of Walras’ Law So a second implication of Walras’ Law for a two-commodity exchange economy is that an excess supply in one market implies an excess demand in the other market.