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We assume that the basic preference axioms are satisfied so that these are represented by a continuous
utility function U h (⋅) .
Pareto-efficient allocations
An allocation {xˆ h }hH=1 is Pareto efficient if there is no other feasible allocation in which at least one
consumer is strictly better off and no consumer is worse off.
Consider an alternative allocation {x h }hH=1 in which consumers 2,…,H are all at least as well off.
That is, U h ( x h ) ≥ U h ( xˆ h ) ≡ Uˆ h
Therefore U 1 ( x1 ) ≤ U 1 ( xˆ1 ) and so {xˆ h }hH=1 solves the following maximization problem.
H H
= 1
xˆ arg Max{U ( x ) | U ( x ) ≥ U
1 1
=ˆ h , h 2,..., H , ∑ x h ≤ ∑ ω h }
h h
h
{x }
=h 1=h 1
∂U A A ∂U B B
( xˆ ) ( xˆ )
∂x ∂x
=
MRS A
( xˆ A ) = 1 1
ω.
, where xˆ A + xˆ B =
∂U A
∂U B
( xˆ A ) ( xˆ B )
∂x2 ∂x2
x1
For a PE allocation in the interior of the Edgeworth
box, the indifference curves of the two consumers
must have the same slope, that is,
1/σ 1/σ
x2A x2B x2A x2B
A = B hence A = B . Figure 3.1-4: PE allocations with identical CES preferences
x1 x1 x1 x1
*
Example: Identical CES Preferences
If preferences are identical and CES with an
elasticity of substitution σ , the MRS for Alex
and Bev are
1/σ
x2h
MRS ( x ) = k h .
h h
x1
For a PE allocation in the interior of the Edgeworth
box, the indifference curves of the two consumers
must have the same slope, that is,
1/σ 1/σ
x2A x2B x2A x2B
A = B hence A = B . Figure 3.1-4: PE allocations with identical CES preferences
x1 x1 x1 x1
a1 b1 a1 + b1
Ratio Rule: = =
a2 b2 a2 + b2
a1 b1
Proof: If = = k then a1 = ka2 and b1 = kb2 and so a1 + b1= k (a2 + b2 ) .
a2 b2
a1 + b1
Hence =k.
a2 + b2
***
x h ( p, ω h ) solves Max{U h ( x) | p ⋅ x ≤ p ⋅ ω h } .
x
**
x h ( p, ω h ) solves Max{U h ( x) | p ⋅ x ≤ p ⋅ ω h } .
x
Excess demand: ( p) x( p) − ω .
z=
x h ( p, ω h ) solves Max{U h ( x) | p ⋅ x ≤ p ⋅ ω h } .
x
Excess demand: ( p) x( p) − ω .
z=
j clears if z j ( p ) ≤ 0 and p j z j ( p ) = 0 .
Walras’ Law: If preferences satisfy local non-satiation and all markets but one clear then the
remaining market must also clear.
If preferences satisfy local non-satiation, then a consumer must spend all of his income.
Why is this?
**
Walras’ Law: If preferences satisfy local non-satiation and all markets but one clear then the
remaining market must also clear.
If preferences satisfy local non-satiation, then a consumer must spend all of his income.
Why is this?
Then for any price vector p the market value of excess demands must be zero.
p ⋅ z ( p ) = p ⋅ ( x − ω ) = p ⋅ ( ∑ ( x h − ω h )) = ∑ ( p ⋅ x h − p ⋅ ω h ) .
h∈H h∈H
Because all consumers spend their entire wealth the right hand expression is zero. Hence
n
) pi zi ( p ) + ∑ p j z j ( p=
p ⋅ z ( p= ) 0.
j =1
j ≠i
Walras’ Law: If preferences satisfy local non-satiation and all markets but one clear then the
remaining market must also clear.
If preferences satisfy local non-satiation, then a consumer must spend all of his income.
Why is this?
Then for any price vector p the market value of excess demands must be zero.
p ⋅ z ( p ) = p ⋅ ( x − ω ) = p ⋅ ( ∑ ( x h − ω h )) = ∑ ( p ⋅ x h − p ⋅ ω h ) .
h∈H h∈H
Because all consumers spend their entire wealth the right hand expression is zero. Hence
n
) pi zi ( p ) + ∑ p j z j ( p=
p ⋅ z ( p= ) 0.
j =1
j ≠i
Therefore if all markets but market i clear then market i must clear as well.
vector p = ( p1 , p2 ) .
**
vector p = ( p1 , p2 ) .
vector p = ( p1 , p2 ) .
The heavily shaded triangles indicate the desired trades Figure 3.1-5: Excess supply of commodity 1
Class Exercise: Which (if any) of these figures depicts a Walrasian equilibrium?
In the left figure the budget line is tangential to Bev’s indifference curve at xˆ A .
In the middle figure slope of the budget lies between the slopes of the two consumers at xˆ A .
In the right figure the budget line is tangential to Alex’s indifference curve at xˆ A .