EC 201 Lent Term Week 1

General Competitive Equilibrium

General Competitive Equilibrium

How do competitive markets aggregate consumer and producer choices into equilibrium prices and quantities? How does activity on one competitive market affect activity on another? For example, how do our conclusions about the effects of taxing a single-market economy carry over to twomarket economies? What properties do competitive equilibria have? For 2 example, when are competitive markets efcient?

Example
In 2007, UK government increased excise duty on bottle of wine (paid by seller) by 4p whilst keeping tax on spirits constant What should happen to wine and spirits prices? Partial equilibrium analysis analyses each market in isolation. It predicts: no change in spirits price because tax on spirits unchanged; wine price increases from p to p

pwine

New Supply Old Supply Demand qwine

p p
3

4p

General-Equilibrium Effects
Because wine and spirits are substitutes, when tax increase causes wine price to rise to p, demand for spirits rises, increasing the market price of spirits Because spirits market price increases, demand for wine increases (again since wine and spirits substitutes), causing its market price to rise to p>p

pwine p p

New Supply 4p Old Supply New Demand Old Demand qwine

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Where Does it End?

Now that the price of wine is p, demand for spirits rises, causing its price to rise, increasing demand for wine and causing its price to rise to p>p>p. And so on and so forth By analysing equilibrium in the two markets simultaneously, general equilibrium allows economists to account for the interplay between different markets, solving for equilibrium prices in the two markets

Exchange Economies
The simplest economy to analyse is one where people merely exchange goods that they already own

Our market model of exchange economies provides a simplied representation of markets from the London Stock Exchange to international trade to village bazaars to allocating courses to students at Harvard Business School Like all models, it is too simple to incorporate all the important features of these or other trading environments.Yet it provides important insights into economic behaviour
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Overview
In an exchange economy, each consumer begins with
an endowment of the various different goods in the economy

She trades her goods endowment for the best She consumes her allocation The end
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allocation that she can afford given that endowment and market prices

Formal Description of Exchange Economy N2 Different Consumers (Traders) L2 Different Goods in Economy Consumer i endowed with amount e 0 of Good 1,
1

e2i0 of Good 2, etc. We mostly use two goods in this course Consumer i has utility function ui
NB We use superscripts for people and subscripts for goods We also use ei to refer to the vector of Consumer is endowment of goods, i.e. ei=(e1i,e2i)
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Exchange Economies without Externalities

Absent production (rms), the N consumers simply
exchange (trade) their endowments of the L goods in the economy

(Until further notice), we assume that each

consumer cares only about her own private consumption; when Consumer i consumes the bundle of goods (x1i,x2i), her utility ui depends solely upon (x1i,x2i): ui(x1i,x2i). (In particular, Person is utility does not depend upon Person js consumption, nor does Person i care about money except insofar as it allows her to consume more, e.g.,9there is no saving)

 Consumers budget sets depend on xed market

prices for the L goods in the economy, p1,p2,...0 vector: p=(p1,p2,...)

Competitive Budget Sets

We write p (without subscript) to mean the price Each consumer faces the same, xed market prices!
That is, consumers take market prices as given and do not enjoy quantity discounts or other forms of non-linear prices, nor can they bargain over or otherwise affect prices

Budget sets also depend upon endowments Different consumers may have different
endowments!
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Describing Budget Sets

Consumer i can afford to consume any bundle of
goods (x1i,x2i)0 such that p1x1i+p2x2ip1e1i+p2e2i
Cost of bundle (x1i,x2i) at market pricesValue of endowment (e1i,e2i) at market prices

We can think of this as consumer rst selling all her

endowment at market prices and using the money she raises to buy consumption goods (e.g., poultry farmer sells all chickens at market price before buying a consumption bundle consisting of chickens and goats)
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Goods-Endowment Budget Set

Good 2 e2i+(p1/p2)e1i e 2i ei Goods endowment Budget Set

Slope = -p1/p2 Good 1 e1i e1i+(p2/p1)e2i As usual, you can work out intercepts on two axes by calculating how much of each good the consumer can afford when she buys12only that good

Features of Budget Set

Budget set depends upon the relative prices p /p
1 2

but

not upon the absolute prices p1 and p2

Each consumers budget set passes through her goods

endowment: regardless of what it is, the consumer can always afford to consume her endowment. She can does this either by selling endowment and buying it back (as prices being xed and common to all consumers means that buying price = selling price) or simply by not trading at all
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Money as Unit of Account

In economy without money as such, we use money

simply as a unit of account

Prices in general equilibrium are really relative prices,

how much one good costs in terms of another

For example, consider economy with only two goods,

chickens and goats. Suppose that each chicken costs k goats. Someone endowed with c chickens and g goats has an endowment with value of g+kc goats. Alternatively, that same endowment is worth g/k+c chickens. Whether prices are quoted in chicken or goat units does not affect economic behaviour
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 In consumer theory, Consumer is uncompensated

Uncompensated Demand

demand (x1i(p1,p2;mi), x2i(p1,p2;mi)) maximises her utility ui(x1,x2) subject to budget constraint dened by prices (p1,p2) and wealth mi: (x1i(p1,p2;mi), x2i(p1,p2;mi)) solves max ui(x1,x2) subject to (s.t.) p1x1+p2x2 mi demand (x1i(p1,p2;e1i, e2i), x2i(p1,p2;e1i, e2i)) maximises utility ui(x1,x2) subject to budget constraint dened by prices (p1,p2) and goods endowment ei: (x1i(p1,p2;e1i, e2i), x2i(p1,p2;e1i, e2i)) solves max ui(x1,x2) s.t. p1x1+p2x2 p1e1i+p2e2i
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In exchange economy, consumers uncompensated

Demand with Goods Endowment

Good 2 Indifference curves

x2i(p;ei) e 2i

ei

Budget Set Slope = -p1/p2

x1i(p;ei) e1i

Good 1

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Excess Demand

We call xji(p;ei)-eji Consumer is excess demand for good j=1,2, the difference between what she consumes and her endowment If xji(p;ei)-eji >0, then Consumer i is a net consumer of Good j If xji(p;ei)-eji <0, then Consumer i is a net supplier of Good j

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Excess Demand with Goods Endowment

Good 2 is Excess Demand Good 2 x2i(p;ei) e2i is Excess Supply Good 1 ei Slope = -p1/p2 x1i(p;ei) e1i Good 1

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Change in Utility from Price Change

Good 2 ei

e2i

old prices new prices

Good 1 e1i When i supplies Good 1, she benets when its price rises: at new prices she can afford old bundle (and hence utility) and may be able to afford 19 a bundle with higher utility

Change in Utility from Price Change

Good 2 ei new prices old prices

e2i

Good 1 e1i When i supplies Good 1, she may even benet when its price falls if that leads her to supply Good 2 instead
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Change in Utility from Price Change

Good 2 ei new prices old prices

e2i

Good 1 e1i However, the more usual case is that the utility of a supplier of Good 1 falls when its price falls
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Effect of Price Change on Demand with Goods Endowment Notice that with a goods endowment, demand for a
good can rise when its price rises even when it is a normal good (unlike consumer theory with money endowment, where only inferior goods can be Giffen) normal, yet when the price of Good 1 rises, the consumer consumes more of it. The reason is that a supplier of Good 1 becomes wealthier when its price rises, so the income effect works in the opposite direction than you are accustomed
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In our rst example of a price change, both goods are

 The market excess demand for good j=1,2 at prices p is

the sum of all N consumers excess demands for that good: i=1,2,...,N(xji(p;ei)-eji) When i=1,2,...,N(xji(p;ei)-eji)>0, then there is excess demand for Good j at prices p When i=1,2,...,N(xji(p;ei)-eji)<0, then there is excess supply of Good j at prices p When i=1,2,...,N(xji(p;ei)-eji)=0, there is neither excess demand nor supply for good j; the market for good j clears
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Market Excess Demand

Trading in Exchange Economy

In an exchange economy, Consumer i begins by
owning her endowment and ends by owning an allocation yi=(y1i,y2i)0 that species the (non-negative) quantity that she consumes of each of the goods (y11,y21; y12,y22;...;y1N,y2N) species each consumers consumption of each good

An allocation for all N consumers in the economy

NB Consumer is demand (x1i(p;ei), x2i(p;ei)) is a function of prices and endowment, whereas her allocation (y1i,y2i) is a constant!
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(1834-1910) A General Competitive (or Walrasian) Equilibrium consists of a price vector p= (p1,p2) and allocation (y11,y21; y12,y22;...;y1N,y2N) satisfying the following properties: 1. Utility Maximisation: Each consumer i maximises utility within her budget set as dened by the price vector p and her endowment ei by choosing (y1i,y2i); that is, (y1i,y2i)=(x1i(p;ei), x2i(p;ei)) 2. Market Clearing: given the price vector p, supply equals demand: i=1,2,...,N(x1i(p;ei)-e1i)= i=1,2,...,N(x2i(p;ei)-e2i) =0
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General Competitive Equilibrium Leon Walras

In a general competitive equilibrium of an exchange economy

1. Each consumer consumes the bundle of goods within her budget set (as dened by her endowment and equilibrium prices) that gives her the most utility 2. Market supply (total endowment) of each good equals market demand at equilibrium prices. (Strictly speaking, we merely need to require that the supply of each good be at least as large as its demand: in a general competitive equilibrium, there may be some good whose supply exceeds its demand.You may safely ignore this possibility.)
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Equilibrium
Last term you analysed Nash Equilibrium in
games: in a Nash Equilibrium, no player can improve her payoff given how other players behave. In that sense, behaviour is stable consumer can increase her utility given her endowment and market prices
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In a general competitive equilibrium, no

 Like game theory, general-equilibrium theory

Equilibrium Reasoning

primarily addresses the question of which combinations of allocations and prices constitute general competitive equilibrium and which do not; it typically does not address how the economy reaches a general competitive equilibrium yourself whether a particular allocation-price combination is a general equilibrium rather than how it came to be so

As general-equilibrium theorists, you should ask

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Market Model
Our notion of general equilibrium is one of many
possible models of trading market prices as given

It makes strong assumptions that all consumers take This assumption most appropriate when each
consumer is small relative to the market, i.e. when there are many traders and are free to make any trade they wish subject to their budget set
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It also assumes that traders know all market prices

Two-Good, Two-Person Exchange Economy

When the exchange economy consists of
only two consumers and two goods, we can represent it in a two-dimensional diagram known as the Edgeworth Box

Oxford Economist Francis Edgeworth (1849-1926)

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Endowments
Person Bs Origin

G o o d 2

e1B e2B e=(eA,eB) e 2A e1A

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Person As Origin

Good 1

Dimensions of the Edgeworth Box

The Edgeworth Box has length e1A+ e1B and height e2A+ e2B yA and yB, that is non-wasteful:

Each point in the box corresponds to an allocation,

y1A +y1B= e1A +e1B and y2A +y2B= e2A +e2B

At the SW corner of the box, Person B gets all the

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resources in the economy; at the NE corner Person A does. Movements to NE thus increase Person As share of total resources

As Utility Rises to NE
e1B Person B Origin Two Indifference Curves for Person A

e2A

e2B

Person A Origin
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e1A

 When more is better for Person A, higher indifference

curves lie to the NE of lower indifference curves

Every possible allocation for Person A, yA=(y1A,y2A)0, lies on some indifference curve for Person A, i.e., she has indifference curves through bundles that lie outside the Edgeworth Box in the north or east direction (but neither south of the Edgeworth box, where y2A<0, nor to its west, where y1A<0, because consuming negative quantities does not make sense) to an allocation for both Person A and Person B, but each person cares only about her own allocation
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Notice that every single point in the box corresponds

Bs Utility Rises to SW
e1B Person B Origin Two Indifference Curves for Person B

e2A

e2B

Person A Origin
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e1A

Trading Away from Endowments Can Raise Both Peoples Utilities

e1B Person B Mutually Benecial Trades

e2A

e2B

Person A
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e1A

Prices in the Edgeworth Box

e1B Budget Line Person B

Slope=-p1/p2 e2
A

e2B

Person A
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e1A

Person As Budget Set Given Endowment and Prices as Depicted by Budget Line e1B Budget Line Person B

Slope=-p1/p2 e2A e e2B

Person A
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e1A

As Much of Person Bs Budget Set as Fits in the Slide e Person B

B 1

Budget Line

Slope=-p1/p2 e2A e2B

Person A
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e1A

Prices at Which There Exists Excess Demand for Good x

x1B(p;eB) Budget Line x2B(p;eB) x2A(p;eA) e Person B

Person A

x1A(p;eA) x1A(p;eA)+x1B(p;eB)> e1A+e1B 40

 Because there is excess demand for Good 1 at

prices p, the economy is not in a general competitive equilibrium at these prices

For markets to clear, the price of Good 1 relative

to Good 2 must rise: the budget line must become steeper

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Market-Clearing Price
x1B(p;eB) Budget Line B

x2A(p;eA) e

x2B(p;eB)

x1A(p;eA)
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Two Steps to Finding a General Competitive Equilibrium

1. Find Consumers uncompensated demands as a function of price (exactly as you did last term when you take mi=p1e1i+p2e2i) 2. Find price at which Supply=Demand Shortcut: Because only relative and not absolute prices matter, you may set the price of a single good equal to one

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Example
Two goods cherries c and damsons d Utilities u (x ,x )= x x and u (x ,x ) = x x Consider e =(2,0), e =(0,2) Set the price of damsons = 1 and of cherries = p You know from last term that consumers with such
A A A c d A A c d B B B B c d B B c d A

Cobb-Douglas preferences with equal exponents for both goods spend half of income on each good. (If you dont, nding demand is good exercise.)
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A demands xcA(p;eA)=(1/2)(pecA+edA)/p =(1/2)(2p)/p=1 and xdA(p;eA)= (1/2)(pecA+edA)/1=(1/2)(2p)/1=p B demands xcB(p;eB)=(1/2) (pecB+edB)/p =(1/2)(2)/p=1/p and xdB(p;eB) =(1/2) (pecB+edB)/1=(1/2)(2)/1=1 Excess demand for cherries is zero when xcA(p;eA)+ xcB(p;eB)-2=1+(1/p)-2=0 This happens when p=1 Thus, general competitive prices=(1,1) General competitive allocation: ycA= xcA(1,1;eA)=1, ydA= xdA(1,1;eA)=(1/2)(2)/1=1; ycB= xcB(1,1;eB)=(1/2)(2)/1=1 45 and ydB=xdB(1,1;eB)=(1/2)(2)/1=1

Consumers trade from e to y at prices (1,1)

damsons xcB(p;eB) B

xdA(p;eA)

xdB(p;eB)

xcA(p;eA)
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e cherries

Trade and Welfare

Notice that uA(eA)=uA(2,0 )=0; absent trade (in autarky) A gets zero utility. After trade, uA(ycA ,ydA)= uA(1,1 )=1. Person A strictly benets from trade. So too does Person B. off after trade than in autarky because they always have the freedom not to trade. In most cases, like here, consumers will be strictly better off with trade autarky to free trade strictly benets all parties
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In general, consumers must always be weakly better Economists tend to believe that moving from

Another example
Suppose u =x Check that (y
A

Let eA =(0,1), eB =(2,0)

A 1

and uB=min{x1B,x2B}

=(1,1), p=(1,1) is General Competitive Equilibrium

A A B B 1 ,y2 )=(1,0), (y1 ,y2 )

e Slope=-p1/p2=-1

A As indifference curves in red and Bs in blue

Clearly A maximises utility within A budget set by demanding y

As budget set e B Slope=-p1/p2=-1 A As indifference curves in red and Bs in blue y

B maximises utility within budget set by demanding y

Bs budget set e Slope=-p1/p2=-1 B

Changing Endowments
Consider a new economy exactly like rst one except
that As endowment increases: now eA =(0,2) xA(p;eA)= ((p1e1A+ p2e2A)/p1,0) =(p2e2A/p1,0)= (2p2/p1,0)

First, nd demands: since A cares only for Good 1, Since B has Leontief (aka Fixed-Proportions) utility,
B chooses x1B= x2B, so (p1e1B+p2e2B)/(p1+p2)) = (2p1/(p1+p2),2p1/(p1+p2)) xB(p;eB) =((p1e1B+p2e2B)/(p1+p2),

 For the market for Good 1 to clear,

x1A(p;eA)+ x1B(p;eB)e1A+e1B=0+2=2

So 2p /p + 2p /(p +p )2 Because relative prices are all that matter in general

2 1 1 1 2

equilibrium, we can always set one price equal to one

1

Take p =1

 This gives 2p + 2/(1+p )2, or 2p (1+p )+ 22

2 2 2 2

(1+p2)

Thus p=(1,0). Substituting these prices into

2p220, which implies that p2=0

demand gives xA(p;eA) =(0,0), xB(p;eB) =(2,2). Thus p=(1,0), yA=(0,0), yB=(2,2) is our general competitive equilibrium.

Slope=-p1/p2=- A y As indifference curves in red and Bs in blue

Comparing Static Exchange Economies In the rst economy (where e =(0,1)), the general
A

competitive equilibrium has yA =(1,0), and uA(yA)=1+0=1. In the second economy (where eA =(0,2)), the general competitive equilibrium has yA =(0,0), and uA(yA)=0+0=0.

As endowment has increased (with everything else

the same), yet her utility falls!