Chapter Twenty-Nine Exchange

u Two consumers, A and B. u Their endowments of goods 1 and 2 are u E.g. u The total quantities available and units of good 1 units of good 2. and are

Exchange u 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

Width =

Starting an Edgeworth Box Width = Height =

Starting an Edgeworth Box Width = Height = The dimensions of the box are the quantities available of the goods.

Feasible Allocations u What allocations of the 8 units of good 1 and the 6 units of good 2 are feasible? u How can all of the feasible allocations be depicted by the Edgeworth box diagram?

Feasible Allocations u What allocations of the 8 units of good 1 and the 6 units of good 2 are feasible? u How can all of the feasible allocations be depicted by the Edgeworth box diagram? u One feasible allocation is the before- trade allocation; i.e. the endowment allocation.

Width = Height = The endowment allocation is and The Endowment Allocation

Width = Height = The Endowment Allocation

OAOA OBOB 6 8

OAOA OBOB

OAOA OBOB

OAOA OBOB The endowment allocation The Endowment Allocation

More generally, … The Endowment Allocation

OAOA OBOB The endowment allocation

Other Feasible Allocations u denotes an allocation to consumer A. u denotes an allocation to consumer B. u An allocation is feasible if and only if and

Feasible Reallocations OAOA OBOB

OAOA OBOB

u All points in the box, including the boundary, represent feasible allocations of the combined endowments.

Feasible Reallocations u All points in the box, including the boundary, represent feasible allocations of the combined endowments. u Which allocations will be blocked by one or both consumers? u Which allocations make both consumers better off?

There are two goods, bread and fish, and two traders Alice and Bob. Alice’s initial endowment is 5 units of fish and 2 units of bread. Bob has 3 units of fish and 8 units of bread. For these traders, an Edgeworth box with bread on the horizontal axis and fish on the vertical will be A) 5 units wide and 8 units tall. B) 13 units wide and 5 units tall. C) 10 units wide and 8 units tall. D) 8 units wide and 6 units tall. E) 18 units wide and 18 units tall.

Adding Preferences to the Box OAOA For consumer A.

Adding Preferences to the Box More preferred For consumer A. OAOA

Adding Preferences to the Box For consumer B. OBOB

Adding Preferences to the Box More preferred For consumer B. OBOB

Adding Preferences to the Box More preferred For consumer B. OBOB

Adding Preferences to the Box OAOA For consumer A.

Adding Preferences to the Box OAOA OBOB

Edgeworth’s Box OAOA OBOB

Pareto-Improvement u An allocation of the endowment that improves the welfare of a consumer without reducing the welfare of another is a Pareto-improving allocation. u Where are the Pareto-improving allocations?

Edgeworth’s Box OAOA OBOB

Pareto-Improvements OAOA OBOB The set of Pareto- improving allocations

Pareto-Improvements u Since each consumer can refuse to trade, the only possible outcomes from exchange are Pareto-improving allocations. u But which particular Pareto- improving allocation will be the outcome of trade?

The white area shows allocations that are better for both consumers than the initial allocation. OAOA OBOB A A) A) A) True B) False

Pareto-Improvements OAOA OBOB The set of Pareto- improving reallocations

Pareto-Improvements

Trade improves both A’s and B’s welfares. This is a Pareto-improvement over the endowment allocation.

Pareto-Improvements New mutual gains-to-trade region is the set of all further Pareto- improving reallocations. Trade improves both A’s and B’s welfares. This is a Pareto-improvement over the endowment allocation.

Pareto-Improvements Further trade cannot improve both A and B’s welfares.

Pareto-Optimality Better for consumer B Better for consumer A

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

Pareto-Optimality The allocation is Pareto-optimal since the only way one consumer’s welfare can be increased is to decrease the welfare of the other consumer.

Pareto-Optimality The allocation is Pareto-optimal since the only way one consumer’s welfare can be increased is to decrease the welfare of the other consumer. An allocation where convex indifference curves are “only just back-to-back” is Pareto-optimal.

Pareto-Optimality u Where are all of the Pareto-optimal allocations of the endowment?

Pareto-Optimality OAOA OBOB

OAOA OBOB All the allocations marked by a are Pareto-optimal.

Pareto-Optimality u The contract curve is the set of all Pareto-optimal allocations.

Pareto-Optimality OAOA OBOB All the allocations marked by a are Pareto-optimal. The contract curve

Pareto-Optimality u But to which of the many allocations on the contract curve will consumers trade? u That depends upon how trade is conducted. u In perfectly competitive markets? By one-on-one bargaining?

The Core OAOA OBOB The set of Pareto- improving reallocations

The Core OAOA OBOB

OAOA OBOB Pareto-optimal trades blocked by B Pareto-optimal trades blocked by A

The Core OAOA OBOB Pareto-optimal trades not blocked by A or B

The Core OAOA OBOB Pareto-optimal trades not blocked by A or B are the core.

The Core u The core is the set of all Pareto- optimal allocations that are welfare- improving for both consumers relative to their own endowments. u Rational trade should achieve a core allocation.

In a two person exchange economy, the core is A) The set of all Pareto optimal allocations. B) The set of Pareto optimal allocations that are better for both traders than the initial allocation. C) The set of all fair allocations. D) The set of feasible allocations.

The Core u But which core allocation? u Again, that depends upon the manner in which trade is conducted.

Trade in Competitive Markets u Consider trade in perfectly competitive markets. u Each consumer is a price-taker trying to maximize her own utility given p 1, p 2 and her own endowment. That is,...

Trade in Competitive Markets OAOA For consumer A.

Trade in Competitive Markets u So given p 1 and p 2, consumer A’s net demands for commodities 1 and 2 are and

Trade in Competitive Markets u And, similarly, for consumer B …

Trade in Competitive Markets For consumer B. OBOB

Trade in Competitive Markets u So given p 1 and p 2, consumer B’s net demands for commodities 1 and 2 are and

Trade in Competitive Markets u A general equilibrium occurs when prices p 1 and p 2 cause both the markets for commodities 1 and 2 to clear; i.e. and

Trade in Competitive Markets OAOA OBOB

OAOA OBOB Can this PO allocation be achieved?

Trade in Competitive Markets OAOA OBOB Budget constraint for consumer A

Trade in Competitive Markets OAOA OBOB Budget constraint for consumer A

Trade in Competitive Markets OAOA OBOB Budget constraint for consumer B

Trade in Competitive Markets OAOA OBOB Budget constraint for consumer B

Trade in Competitive Markets OAOA OBOB But

Trade in Competitive Markets OAOA OBOB and

Trade in Competitive Markets u So at the given prices p 1 and p 2 there is an – excess supply of commodity 1 – excess demand for commodity 2. u Neither market clears so the prices p 1 and p 2 do not cause a general equilibrium.

Trade in Competitive Markets OAOA OBOB So this PO allocation cannot be achieved by competitive trading.

Trade in Competitive Markets OAOA OBOB Which PO allocations can be achieved by competitive trading?

Trade in Competitive Markets u Since there is an excess demand for commodity 2, p 2 will rise. u Since there is an excess supply of commodity 1, p 1 will fall. u The slope of the budget constraints is - p 1 /p 2 so the budget constraints will pivot about the endowment point and become less steep.

Trade in Competitive Markets OAOA OBOB Which PO allocations can be achieved by competitive trading?

Trade in Competitive Markets OAOA OBOB Which PO allocations can be achieved by competitive trading?

Trade in Competitive Markets OAOA OBOB Which PO allocations can be achieved by competitive trading?

Trade in Competitive Markets OAOA OBOB Budget constraint for consumer A

Trade in Competitive Markets OAOA OBOB Budget constraint for consumer A

Trade in Competitive Markets OAOA OBOB Budget constraint for consumer B

Trade in Competitive Markets OAOA OBOB Budget constraint for consumer B

Trade in Competitive Markets OAOA OBOB So

Trade in Competitive Markets OAOA OBOB and

Trade in Competitive Markets u At the new prices p 1 and p 2 both markets clear; there is a general equilibrium. u Trading in competitive markets achieves a particular Pareto-optimal allocation of the endowments. u This is an example of the First Fundamental Theorem of Welfare Economics.

First Fundamental Theorem of Welfare Economics u Given that consumers’ preferences are well-behaved, trading in perfectly competitive markets implements a Pareto-optimal allocation of the economy’s endowment.

Every Pareto optimal allocation is a Walrasian Equilibrium A) True B) False

Every Pareto optimal allocation is a Walrasian Equilibrium A) True B) False

Every Walrasian Equilibrium is in the core. A) True B) False

Second Fundamental Theorem of Welfare Economics u The First Theorem is followed by a second that states that any Pareto- optimal allocation (i.e. any point on the contract curve) can be achieved by trading in competitive markets provided that endowments are first appropriately rearranged amongst the consumers.

u Given that consumers’ preferences are well-behaved, for any Pareto- optimal allocation there are prices and an allocation of the total endowment that makes the Pareto- optimal allocation implementable by trading in competitive markets. Second Fundamental Theorem of Welfare Economics

Second Fundamental Theorem OAOA OBOB The contract curve

Second Fundamental Theorem OAOA OBOB

OAOA OBOB Implemented by competitive trading from the endowment .

Second Fundamental Theorem OAOA OBOB Can this allocation be implemented by competitive trading from  ?

Second Fundamental Theorem OAOA OBOB Can this allocation be implemented by competitive trading from  ? No.

Second Fundamental Theorem OAOA OBOB But this allocation is implemented by competitive trading from .

Walras’ Law u Walras’ Law is an identity; i.e. a statement that is true for any positive prices (p 1,p 2 ), whether these are equilibrium prices or not.

Walras’ Law u Every consumer’s preferences are well-behaved so, for any positive prices (p 1,p 2 ), each consumer spends all of his budget. u For consumer A: For consumer B:

Walras’ Law Summing gives

Walras’ Law Rearranged, That is,...

Walras’ Law This says that the summed market value of excess demands is zero for any positive prices p 1 and p 2 -- this is Walras’ Law.

Implications of Walras’ Law Suppose the market for commodity A is in equilibrium; that is, Then implies

Implications of Walras’ Law So one implication of Walras’ Law for a two-commodity exchange economy is that if one market is in equilibrium then the other market must also be in equilibrium.

Implications of Walras’ Law What if, for some positive prices p 1 and p 2, there is an excess quantity supplied of commodity 1? That is, Then implies

Implications of Walras’ Law So a second implication of Walras’ Law for a two-commodity exchange economy is that an excess supply in one market implies an excess demand in the other market.