Exchange

UWI Mona , WJC Dept. of Economics

Nadia Grant -Reid

ECON 2001 Intermediate Microeconomics

Exchange
 EXCHANGE

Two consumers, A and B.

Their endowments of goods 1
and 2
are A
( A , and B ( 1B ,
A)
E.g. andB ).
(6,4)
A 2
1
The total quantities
A
available B B ( 2,2).
units of good 1
are 1 12 6 2
8A B units of good
and 2
2.
2 4
 EXCHANGE

Edgeworth and Bowley devised a

diagram, called an Edgeworth box,
to show all possible allocations of
the available quantities of goods 1
and 2 between the two consumers.
 STARTING AN EDGEWORTH
BOX

Height =
A
The dimensions of
the box are the
B quantities available
2 2 of the goods.
42
6
A B
Width = 1 1 6 2
 FEASIBLE
ALLOCATIONS

What allocations of the 8 units of

good 1 and the 6 units of good 2
are feasible?
How can all of the feasible
allocations be depicted by
the Edgeworth box diagram?
One feasible allocation is the
before- trade allocation; i.e. the
initial endowment allocation.
 THE INITIAL ENDOWMENT
ALLOCATION

Height = The initial endowment

A allocation is
A (6,4)
B
and
2 2
B ( 2,2).
42
6
A B
Width = 1 628

 THE INITIAL ENDOWMENT
ALLOCATION

OB

OA
A (6,4)
8 B
( 2,2)
 THE INITIAL ENDOWMENT
ALLOCATION

OB

6
4

OA
6 A (6,4)
8
 THE INITIAL ENDOWMENT
ALLOCATION
2
OB
2

6
4

OA
6
B
8
( 2,2)
 THE INITIAL ENDOWMENT
ALLOCATION
2
OB
2

6 The initial
4 endowment
allocation
OA
6 A (6,4)
B
8
( 2,2)
THE INITIAL
ENDOWMENT
ALLOCATION

More generally,
 THE INITIAL ENDOWMENT
ALLOCATION
B
1 O
B
B
A

2
2
A The
B
endowment
2 2 allocation
OA
A
1
A B
1
 OTHER FEASIBLE
ALLOCATIONS

A A
(x 1 , x2 ) denotes an allocation
consumer
to A.
(x1 B , x2B ) denotes an allocation
consumer
to B.
An allocation is feasible if and only
if
x 1A xB1 A1 B
A B
2 x1B
and x A 2 2

2 .
 OTHER FEASIBLE
ALLOCATIONS
xB
1
OB
A

xB
2
2
B

2 A
x2
OA
x 1A
A B
1
 OTHER FEASIBLE
ALLOCATIONS
xB
1
OB
A
xB
2
2
B

xA
2
2
OA
x 1A
A B
1
 OTHER FEASIBLE
ALLOCATIONS

All points in the box, including

the boundary, represent feasible
allocations of the combined
endowments.
Which allocations will be blocked
by
one or both consumers?
Which allocations make
both consumers better off?
 ADDING PREFERENCES TO
THE BOX
For consumer
X2 A.

2 OA A
X1
2
 ADDING PREFERENCES TO
THE BOX

For consumer B.
X2

OB
1 X1
B
 ADDING PREFERENCES TO
THE BOX
B
For consumer B. 1
X1 OB

B
2

X2
 For consumer
X2 A.

A
2 OA A
1 X2
 B
1 OB
X2

A B
2 OA A 2
1 X1
 PARETO EFFICIENT
ALLOCATIONS

A
Pareto Efficient Allocation is an allocation
where:
1. No one can be made better off.
2. All gains from trade are exhausted: This is
the tangency of indifference curve condition.
The tangency condition is :
=
=
 PARETO EFFICIENT
ALLOCATIONS

3. No way to make some one better off without

making someone else worse off: Basically, if
we are at a tangency point, for us to raise the
utility of one agent can only be achieved by
reducing the utility of the other agent.

4. There are no mutually advantageous trades

to be made: This essentially means that if you
were to allocate an equilibrium to the agents,
no one could unilaterally negotiate a better
arrangement for everyone.
 PARETO EFFICIENT
ALLOCATIONS

It should be obvious as well that a

Pareto Efficient point suggested above
is not unique. In fact, there is an infinite
number of these points.
 PARETO IMPROVEMENT

An allocation of the endowment

that improves the welfare of a
consumer without reducing the
welfare of another is a Pareto-
improving allocation.
Where are the Pareto-
improving allocations?
 PARETO IMPROVEMENT
B
1
OB
X2

A B
2
2 OA A
1 X1
The set of Pareto-
improving allocations
 PARETO IMPROVEMENT

The only possible outcomes from

exchange are Pareto-improving
allocations.
But which particular Pareto-
improving allocation will be
the outcome of trade?
PARETO IMPROVEMENT
PARETO IMPROVEMENT
 PARETO IMPROVEMENT

Trade
improves both
As and Bs welfares.
This is a Pareto-improvement
over the endowment
allocation.
 PARETO IMPROVEMENT

New mutual gains-to-trade region

is the set of all further
Pareto-
improving
reallocations.

Trade
As and Bsboth
improves welfares.
This is a Pareto-improvement
over the endowment
allocation.
PARETO IMPROVEMENT

Further trade cannot

improve
both A and Bs
welfares.
 PARETO OPTIMALITY

Better for
consumer
A

Better for
consumer B
PARETO OPTIMALITY

A is strictly better off

but B is strictly worse
off
 PARETO OPTIMALITY

A is strictly better off

but B is strictly worse
off

B is strictly better
off but A is strictly
worse off
 PARETO OPTIMALITY

Both A and
B are worse A is strictly better off
off but B is strictly
worse
off

B is strictly better
off but A is strictly
worse off
 PARETO OPTIMALITY
Both A and
B are worse A is strictly better off
off but B is strictly
worse
off

B is strictly better Both A

off but A is and B are
strictly worse off worse
off
 PARETO OPTIMALITY

The allocation is
Pareto-optimal since the
only way one
consumers
welfare can be increased is to
decrease the welfare of the
other consumer.
 PARETO OPTIMALITY

An allocation where convex

indifference curves are
only
just back-to-back is
Pareto-optimal.

The allocation is
Pareto-optimal since the
only way one
consumers
welfare can be increased is to
decrease the welfare of the
 PARETO OPTIMALITY

Where are all of the Pareto-

optimal
allocations of the endowment?
 PARETO IMPROVEMENT
B
1
OB
X2

A B
2
2 A
1 X1
 PARETO IMPROVEMENT
B
1
OB
X2

A B
2
2 A
All the allocations marked by 1 X1
a are Pareto-
 PARETO IMPROVEMENT
B
1
OB
X2

A B
2
2 A
1 X1
The Contract curve
 PARETO IMPROVEMENT

The contract curve or the Pareto

set is the set of all Pareto-optimal
allocations in the Edgeworth box.
END
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