General Equilibrium Theory: Examples

3 examples of GE:
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pure exchange (Edgeworth box)

1 producer - 1 consumer

several producers

and an example illustrating the limits of the partial equilibrium

approach

First example: Edgeworth Box

A pure exchange economy (no production possibilities):
2 consumers i = A, B
2 commodities l = 1, 2
individual endowments i = (i1 , i2 )
global endowment $ = A + B
allocation x = (xA , xB ) with xi = (xi1 , xi2 ), xi 0
price p = (p1 , p2 )
Edgeworth box = allocations such that xA + xB = $
Endogenous wealth: wi = p.i
The budget line splits the box into the 2 budget sets

Individual Preferences
represented by a utility function ui
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continuous (the representation of preferences by a utility

function requires transitive, complete, continuous
preferences)

strictly quasi-concave (unique optimum)

strictly monotonic (stronger than locally non satiated)

Offer curve of i = optima of i (parameterized by p)

Definition : a Walrasian equilibrium is (x , p) such that

1. individual optimality : i, xi solves
max ui (x) ,

p.xp.i

2. market clearing
X

xi = $

= intersection points of the two offer curves (other than the

endowment point)
GE determines the relative price only ( one defines a numeraire,
a good with price 1, without loss of generality)
Uniqueness is not guaranteed
Examples : Cobb-Douglas, linear, Leontief preferences

Two examples of non existence:

1. An important one: non convexity of one ui : no intersection of
the offer curves because of a discontinuity
2. A more subtle one: non strict monotonicity of one ui :
impossible to clear the markets by adjusting the prices

Illustration of the 2 Welfare Theorems

Th 1 : The allocation x of an equilibrium (x , p) is Pareto-optimal
Definition : Equilibrium with nominal transfers = (x , p, tA , tB ) s.t.
1. tA + tB = 0 (tA , tB IR )
2. i, xi maximizes ui (xi ) under p.xi p.i + ti
3. xA + xB = $
Th 2 : If x is a PO allocation, then x is the allocation of an
equilibrium with transfers
(compute the relative price p2 /p1 = MRS, then define the transfer:
ti = p.xi p.i )
Th 2 requires the convexity of preferences (not Th 1)
real transfers can be considered as well (example:
p.xi p.i + p1 ti , transfer of good 1)

Second example: 1 consumer + 1 producer

2 commodities: leisure (price w ), consumption good (price p)
firm:
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production function q = f (z) (f 0 > 0 > f 00 )

max pq wz

consumer:
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utility u (l, x)

endowment (L, 0)

owns the firm

Definition: A Walrasian equilibrium is (l , x ),(q , z ),(w , p)

1. individual optimality: (q , z ) solves
max pq wz
q=f (z)

(l , x ) solves
max

wl+pxwL+

u (l, x) , with = pq wz

2. market clearing
l + z = L and x = q
In this example, equilibrium is unique.

Illustration of the 2 Welfare Theorems

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Th 1 : The (unique) equilibrium allocation is PO

Th 2 : The (unique) PO allocation is the equilibrium

allocation (no transfer is needed in this example)

Without the convexity assumptions (preferences and production

set):
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An equilibrium is still PO (Th 1 still holds)

A PO allocation may not be an equilibrium allocation, even

with transfers (Th 2 does not hold)

Remark: production function and production set

Definition of the production set Y :
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y Y if and only if y = (y1 , ..., yL ) is a technologically

feasible vector

convention sign: yl < 0 whenever l is an input, yl > 0

whenever l is an output

For a technology defined by a production function f (the output is

good L, inputs are goods 1, ..., L 1):
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the associated production set Y is

n
o
y IR L /yL f (y1 , ..., yL1 )

Y convex f concave

Example: f (z) = Az
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< 1 : DRTS (f concave), everything is OK

= 1 : CRTS (f linear), technology determines the relative

prices, = 0, the production level is determined by demand
(the supply is infinitely elastic)

> 1 : IRTS (f convex), no equilibrium

Remark: Returns to Scale

For a technology defined by a production set Y :
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decreasing (DRTS) y Y , a [0, 1] , ay Y

increasing (IRTS) y Y , a 1, ay Y

constant (CRTS) y Y , a 0, ay Y

For a technology defined by a production function f :

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L1
DRTS: z IR+
, a 1, f (az) af (z)

L1
IRTS: z IR+
, a 1, f (az) af (z)

L1
CRTS: z IR+
, a 0, f (az) = af (z) (f homogenous of
degree 1)

Third example: J producers

J firms use L inputs to produce one different output each
global inputs endowment z = (
z1 , ..., zL )  0
fj
2
technologies fj (C , zjl > 0 and D 2 fj negative definite)
exogenous output prices p = (p1 , ..., pJ )
input prices w = (w1 , ..., wL )
JL+L
Definition : An equilibrium is (z , w ) IR+
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j, zj maximizes pj fj (zj ) w .zj

P

j zj = z

1st Order Conditions (for an interior equilibrium only, j, zj  0)

= a system of equations with unknown (z, w ) characterizes the
equilibrium
fj
(zj ) = wl ,
zjl
X
l,
zjl = zl .

l, j, pj

Illustration of Th 1: an equilibrium allocation z maximizes the

production value:
X
pj fj (zj )
Pmax
j

zj =
z

Proof:
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P
P
the joint profit j (pj fj (zj ) w .zj ) is j pj fj (zj ) w .
z.
Hence, the max of joint profit and the max of the prod value
have the same solution.
P
the FOC of max joint profit (under the constraint j zj = z)
are the same as the FOC of equilibrium
fj
(zj ) = wl ,
zjl
X
l,
zjl = zl .

l, j, pj

j
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hence z maximizes the joint profit.

Producers (but not consumers) can be aggregated: a unique firm

with J technologies make the same decisions (and gets the same
profit) as J independent firms with one technology each.

GE versus partial equilibrium: a taxation example

N towns, 1 firm/town (production function f )
Labor supply (inelastic) : M workers,
Wage w , good = numeraire


At equilibrium, w = f 0 M
N
P
(from max profit : w = f 0 (ln ) and market clearing: n ln = M equilibrium is symmetric)
Introduction of a tax t in town 1 : w + t = f 0 (l1 )

Partial equilibrium analysis in town 1:

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workers freely move between towns + w in towns 2,...,N w

remains constant in town 1

hence l1 determined by w + t = f 0 (l1 )

the profit decreases, not the wage

the firm bears the whole burden of the tax t

GE Analysis:
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w and l1 , ..., lN determined by:

w + t = f 0 (l1 ) and n 2, w = f 0 (ln )
l1 + ... + lN

= M

(hence l2 = ... = lN =
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Ml1
N1 )

Introduction of a small tax dt

dw + dt = f 00 (l1 ) dl1 and dw = f 00 (l) dl
dl1 + (N 1) dl

= 0

(denote l = l2 = ... = lN )

Variation of the profit of a firm 1 = f (l1 ) (w + t) l1 and

= f (l) wl
d1 = f 0 (l1 ) dl1 (w + t) dl1 l1 (dw + dt)
d = f 0 (l) dl wdl ldw
And

M
M
dl1 wdl1
(dw + dt)
d1 = f
N
N
 
M
0 M
d = f
dl wdl dw
N
N
0

with l1 = l =

M
N

at the no tax equilibrium (t = 0)

Variation of the aggregate profit d1 + (N 1) d


  
0 M
w (dl1 + (N 1) dl)
= f
N
M
M
(dw + dt) (N 1) dw
N
N
= 0
since
dw + dt = f
dl1 + (N 1) dl

00

M
N


dl1 and dw = f

00

M
N


dl

= 0

the workers bear the whole burden of the tax (w decreases,

not the profit)

The end of the chapter