Edgeworth Box Analysis: Two Consumers

Lecture 25 November 19 2002

Slides adapted from slide set for Microeconomics by Pindyck and Rubinfeld, Prentice Hall, 1998.

The Edgeworth Box Analysis

Francis Edgeworth developed this method of analysis in the last portion of the 19th century. Provides a powerful way of graphically studying exchange and the role of markets. Understanding the Edgeworth Box is critical to understanding exchange and markets.

To Form and Edgeworth Box

Rotate one of the graphs onto the other one until it forms a box.
y1

Here the axes for Jane have been rotated

x2

Jane

y2 Bill x1

Move axes for Jane to close box

x2 y1 Jane

The Edgeworth Box

x2 Jane y2

Total Fixed Supply of y

y2 Bill x1 y1 Bill x 1 Total Fixed Supply of x

Consider two consumers and two products

The Edgeworth Box

y1 0

x1 y1 0

y1 0

x1 Bill

y1 0

x1 Jane

x1

The Edgeworth Box

The Edgeworth Box

y1 0

x1

y1 0

x1

y1 0

y1
x1

0 x1

The Edgeworth Box

The Edgeworth Box

y1 0

x1 y1 0

y 1 0 x

x1

y1

0 x1

The Edgeworth Box

The Edgeworth Box

x2 III1 II1 I1 Jane y2

y1 0

x1

The Edgeworth Box

x2 III1 II1 I1 Jane y2

A What about A here?

III 1 I I2 I 12
2

C y1 Bill x 1

Pareto Optimal
When no change can make one better off without making the other worse off.

y1 0 Trading area? A C y1
I2 II 12 III 1
2

x1

Bill x 1

The Edgeworth Box

x2 III1 II1 B I1 Jane y2

PARETO OPTIMAL

C y1
I2 I I 12

III 1

Bill x 1

The Edgeworth Box

x2 IV2 III2 II2 B E E A E C y1 Bill x 1 I1 II1 III1 I V1 Contract line I2 Jane y2

The Edgeworth Box Contract Line

Is the locus of Pareto optimal points
E A E C y1 Bill x 1 I1 II1 III1 I V1 x2 IV2 III2 II2 B E I2 Jane y2

The Edgeworth Box

III2 II2 B E E y1 y1 E C y1 Bill x 1 x1 I1 II1 III1 x1 y1 Bill x 1 A y2 y2 Pareto improving-from A or B to E or E C x2 I2 x2 x 2 Jane y2

The Edgeworth Box

x2 III2 II2 B E E A E I2 Jane y2

I1 II1

III1

Understanding the Picture

Any point in the Edgeworth box indicates a particular distribution of the two goods among the two individuals, e.g., Bill and Jane. Each individual has an indifference curve going through that point. If the distribution is Pareto optimal, those two indifference curves are tangent at that point.

Prices that are consistent with the Pareto optimal point

At that tangency of the two indifference curves, the slope of the tangency line--the straight line drawn through the point of tangency--represents the relative prices for the two goods. Hence, there are relative prices that will be consistent with the Pareto optimum.

The Edgeworth Box

x2 III2 II2 B E E A E C y1 Bill x 1 I1 II1 III1 Price or budget line I2 Jane y2

Tangent line is really a budget line for both individuals

If one extends the tangent line to each axis, we now have a budget line. For example, the budget line for Jane is IJane = Pxx jane + Pyy Jane where I is the income Jane could get from selling the X and Y she holds at the Pareto optimum point.

Budget Line for Jane

Ijane/Py IJane = Pxx jane + Pyy Jane

Marginal Rate of Substitution

MRSxy = the number of units of y one is willing to give up per unit of x and stay on same indifference curve. Slope of indifference curve gives the marginal rate of substitution.

E C y Jane x Ijane/Px Price or budget line

Ijane/Py

Marginal Rate of Substitution curve Slope of indifference

gives the marginal rate of substitution

MARGINAL RATE OF SUBSTITUTION

D Price or budget line Ijane/Px

MRS xy =

m arg inal utility of x m arg inal utility of y

MRS = M arginal Utility o f x

y Jane x

At point D
Slope of indifference curve equals the slope of the budget line or MRSxy = -Px/ Py

NOW RETURN TO EDGEWORTH BOX ANALYSIS

At point E, the indifference curve for Jane is just tangent to the indifference curve for Bill, and the price line is the tangency line at E. In other words, Slope(Indifference curve for Jane) = Slope(Indifference curve for Bill) = Slope of price line
P Bill M R Sxy = M RxS= M R S J a n e RS M mrs xy Py

The prices (ratio of prices) can produce the optimum

The Edgeworth Box

x2 III2 II2 B E E I2 Jane y2

MRS

Jane xy

P Bill = x = MRS xy Py

A E C y1 Bill x 1 I1 II1 III1 Price or budget line