Econ 310-2: Intermediate Microeconomics II

Yingni Guo

Northwestern University

Jan 10 2017

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 How does this lecture fit?

We will start by examining a general equilibrium model of competitive markets.

We examine exchange economies, in which there are only consumers, with no

production.

We will define the notion of a competitive equilibrium, examine its properties,

and establish conditions under which a competitive equilibrium exists.

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 We will find:

competitive equilibria are ecient. This gives us a fairly strong competitive

markets are good, in terms of eciency result.
any ecient outcome can be achieved by a competitive market. This gives
us a weak competitive markets are good, in terms of equity result.

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 It is not obvious that competitive markets should lead to ecient outcomes.
Who coordinates economic activity?

Adam Smith, father of the invisible hand, suggests that no one does. Everyone
in the economy is concerned only with themselves:

It is not from the benevolence of the butcher, the brewer, or the baker, that we
expect our dinner, but from their regard to their own self-interest. We address
ourselves, not to their humanity but to their self-love, and never talk to them of
our own necessities but of their advantages.

But somehow the invisible hand brings coordination.

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 Example: solve for the competitive equilibrium

Preferences: Endowments:
( A ) 12 ( A ) 21
Ann U A (xA A
1 , x2 ) = x1 x2 , Ann eA = (eA A
1 , e2 ) = (20, 30),
( B ) 13 ( B ) 23 Bob e = (e1 , eB
B B
B B B
Bob U (x1 , x2 ) = x1 x2 . 2 ) = (60, 20),
Total (e1 , e2 ) = (80, 50).

Good 1 60 OB
Good 2

e
30 b
20

Good 2
OA 20 Good 1

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 Example: solve for the competitive equilibrium

Preferences: Endowments:
( A ) 12 ( A ) 21
Ann U A (xA A
1 , x2 ) = x1 x2 , Ann eA = (eA A
1 , e2 ) = (20, 30),
( B ) 13 ( B ) 23 Bob eB = (eB , e B
B B B
Bob U (x1 , x2 ) = x1 x2 . 1 2 ) = (60, 20),
Total (e1 , e2 ) = (80, 50).

Suppose that there are 1000 Anns and 1000 Bobs trading coconuts and ba-
nanas:

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 Solve for demand functions
The first step is to solve for a consumer demand for each good as a function of
the price vector p = (p1 , p2 ).

Take A as an example. She maximizes her utility subject to the budget constraint:

( )1/2 ( )1/2
max U A (xA A A
1 , x2 ) = x 1 xA
2
xA A
1 ,x2

subject to xA A
1 p1 + x2 p2 = 20p1 + 30p2 .

20p +30p xA
1 p1
Substituting xA
2 with
1
p2
2
, we rewrite As problem as an uncon-
strained maximization problem:
( ) 1 ( 20p + 30p xA p ) 12
2 1 2 1 1
max xA
1 .
xA
1
p2

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 Solve for demand functions
Taking the first-order condition with respect to xA
1 and setting it to zero, we
obtain As demand for good 1:
20p1 + 30p2
xA
1 (p1 , p2 ) = .
2p1

Substituting xA
1 into the budget constraint, we solve for As demand for good 2:

20p1 + 30p2
xA
2 (p1 , p2 ) = .
2p2
Similarly, we can solve for Bs demand for good 1 and good 2:
60p1 + 20p2 2(60p1 + 20p2 )
xB
1 (p1 , p2 ) = , xB
2 (p1 , p2 ) = .
3p1 3p2
Note that only the relative price p1 /p2 . Without loss, we can assume that p2 = 1.

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 Solve for excess demand functions
The excess demand of A for coconuts is her demand minus her coconut endow-
ment:
20p1 + 30
1 (p1 , p2 ) e1 =
xA 20.
A
2p1
Similarly, we can solve for As excess demand for bananas and Bs excess demand
for coconuts and bananas.
20p1 + 30
2 (p1 , p2 ) e2 =
xA 30,
A
2

60p1 + 20
1 (p1 , p2 ) e1 =
xB 60,
B
3p1
2(60p1 + 20)
2 (p1 , p2 ) e2 =
xB 20.
B
3

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 Solve for demand functions
Given prices p1 , p2 for good 1 and 2, the budget line of each consumer is the line
with slope p1 /p2 through his endowment.

Good 2 Good 2

b xB (p)
A
30 b e
b
xA (p)

20 b eB

OA 20 Good 1
OB 60 Good 1
Anns endowment and preferences Bobs endowment and preferences

Note again that what matters, of course, is the relative prices of the two goods,
as these determine the slope of the budget line.

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 Solve for p = (p1 , 1) at which markets clear

We have set good 2 to be the numeraire, that is, p2 = 1.

Suppose p1 = 1. Market does not clear.
There is excess demand of good 2 and excess supply of good 1.
The price of good 1 relative to good 2 is too high.

Good 1 60 OB
Good 2

e
30 b
xA (p) 20
b

Good 2
OA 20 xB (p) b Good 1

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 Solve for p = (p1 , 1) at which markets clear

Market clears when the demand for each good equals the supply:
20p1 + 30 60p1 + 20
+ = 80.
2p1 3p1

Market clears when (p1 , p2 ) = ( 13

30
, 1).
The thin black line is the budget constraint at this competitive price.
The allocation is given by x.

Good 1 60 OB
Good 2

e
30 b
20
b
x

Good 2
OA 20 Good 1

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 Defining Competitive equilibrium:

Environment Competitive equilibrium

Goods: 1, 2, ... A set of prices: p1 , p2 , ...
Consumers: A, B, ... An allocation: xA , xB , ...
Endowments: eA , eB , ... Each consumer maximizes his/her
Preferences: U A (xA ), U B (xB ), ... utility given the prices.
All markets clear.

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 More generally, suppose there are n goods:
Fix a set of prices p = (p1 , ..., pn ).

First, we have budget constraints, that each consumer cannot spend more than
he/she earns:
p1 x A A A A
1 + ... + pn xn = p1 e1 + ... + pn en ,

p1 xB B B B
1 + ... + pn xn = p1 e1 + ... + pn en .

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 A typical consumer faces the maximization problem

max U (x1 , ..., xn )

x1 ,...,xn

s.t. p1 x1 + ... + pn xn = p1 e1 + ... + pn en .

This gives rise to n demand functions for this consumer

xi (p) : this consumers demand for good i,

where i = 1, ..., n.

and then to the excess demand functions

zi (p) = xi (p) ei .

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 A competitive equilibrium is a collection of prices p = (p1 , ..., pn ) and a corre-
sponding allocation x such that all markets clear, i.e., for all i = 1, ..., n, we
have
i (p) + xi (p) (ei + ei ) = 0.
ziA (p) + ziB (p) = xA B A B

Intuitively, this gives us n equations, one for each market, in n unknowns, the
prices. Hence, we are asking whether prices can simultaneously clear all markets.

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 Not all of these equations are independent. Suppose that the first n1 equations
hold, i.e., all markets but one are balanced,

i (p) + xi (p) (ei + ei ) = 0, for all i = 1, 2, ..., n 1.

xA B A B

Then we can multiply the market-balance equations for each of the first n 1
markets by its price and add them to get

i (p) + xi (p)) pi (ei + ei ) = 0, for all i = 1, 2, ..., n 1,

pi (xA B A B

n1
n1

i (p) + xi (p))
pi (xA B
= pi (eA B
i + ei ) = 0,
i=1 i=1

n1
n1

i (p) ei ) +
pi (xA i (p) ei ) = 0.
A
= pi (xB B

i=1 i=1

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 On the other hand, for every consumer, we know that the budget must balance,

n
n

i (p) ei ) = 0,
pi (xA i (p) ei ) = 0.
A
pi (xB B

i=1 i=1

which implies that

n1
n1

i (p)ei ) = pn (xn (p)en ),

pi (xA i (p)ei ) = pn (xn (p)en ).
A A A
pi (xB B B B

i=1 i=1

Substituting this into our original equation, we get

pn (xA
n (p) en ) pn (xn (p) en ) = 0,
A B B

and hence (dividing by pn ) the nth market balances.

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 This is called Walras law: if all markets but one are in equilibrium, then that
last market must also be in equilibrium.
Idea of proof: budget constraints imply that the the values of excess demand
must sum to zero. That is:

n
n
p i Di pi Si = 0,
i=1 i=1

where Di and Si are the aggregate demand and supply of good i.

It tells us that competitive markets set only relative prices, not absolute prices.
We are always free to set the price of one good, called the numeraire.

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 In-class example
Lets consider an example. Let there be two (equal-sized groups of) consumers
A and B, with Cobb-Douglas utility functions

U A (xA A A A 1
1 , x2 ) = (x1 ) (x2 )

U B (xB B B B 1
1 , x2 ) = (x1 ) (x2 ) .
Their endowments are eA = (eA A B B B
1 , e2 ) and e = (e1 , e2 ).

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 We can write As optimization problem as the corresponding Lagrangian,

L(xA A A A A 1
1 , x2 , ) = (x1 ) (x2 ) 1 + p2 e2 p1 x1 p2 x2 ).
+ (p1 eA A A A

The first-order conditions are

L
= (xA
1)
1
(xA
2)
1
p1 = 0,
xA
1
L A
= (1 )(xA
1 ) (x2 ) p2 = 0,
xA
2
L
1 + p2 e2 p1 x1 p2 x2 = 0.
= p1 eA A A A

p1 1 A
Taking the ratio of the first two equations, we get xA2 = p2 x1 . Substituting
A
x2 into the last equation, we can solve for As demand for good 1 (as a function
of p)
p1 eA A
1 + p2 e2
xA
1 = .
p1

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 A similar Lagrangian can be written for Bs optimization problem. We can solve
for Bs demand for good 1

p1 eB B
1 + p2 e2
xB
1 = .
p1

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 The prices (p1 , p2 ) give us a competitive equilibrium if

p1 eA A
1 + p2 e 2 p1 eB B
1 + p2 e2
+ eA
1 e1 = 0
B
p1 p1
p1 eA A
1 + p2 e 2 p1 eB B
1 + p2 e2
(1 ) + (1 ) eA
2 e2 = 0.
B
p2 p2

We can choose one good, say 2, and let it be the numeraire, or p2 = 1. (Another
way of saying this: these functions are homogeneous of degree zero in prices.)
We then have one equation and one variable:

p1 eA A
1 + e2 p1 eB B
1 + e2
+ eA
1 e1 = 0,
B
p1 p1

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 which we can solve for
eA
2 + e2
B
p1 = .
(1 )e1 + (1 )eB
A
1

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 This looked straightforward. It leaves two questions:

What are the properties of competitive equilibria?

When do competitive equilibria exist?

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