Microeconomics 2 John Hey

Lecture 9 Today I am going to start by reviewing the main points from Chapter/Lecture which I regard as the most important lecture/chapter of the module. And then I will look at Chapter/Lecture which I think says essentially nothing.

Summary of Chapter 8 The contract curve - the locus of tangency points of the individuals’ indifference curves - shows the allocations that are efficient in the sense of Pareto. There always exist the possibility of mutually advantageous exchange if preferences are different and/or endowments are different (unless the endowment point is on the contract curve). Perfect competitive equilibrium (with both individuals taking the price as given) always leads to a Pareto efficient allocation. If one of the individuals chooses the price the allocation is usually not Pareto efficient (monopoly/monopsony – undesirable for inefficiency).

The contract curve The contract curve shows the allocations that are efficient in the sense of Pareto. If a point is off the contract curve then there is always some other point on the contract curve that is better for both individuals. If a point is on the contract curve, then any movement away from that point is bound to make at least one of the two individuals worse off. (Some slight qualifications to these results might be needed if the indifference curves are not smoothly convex everywhere.)

Perfect competition equilibrium Perfect competitive equilibrium (with both individuals taking the price as given) always leads to a Pareto efficient allocation. Why? Because at that equilibrium the price line must be tangential to the (highest possible) indifference curves for both individuals. Hence at that equilibrium the indifference curves must be tangential......and hence the equilibrium must be on the contract curve.

The competitive equilibrium depends on the preferences and the endowments If one individual changes his or her preferences in such a way that he or she now prefers more a particular good than before the relative price of that good rises. If an individual is endowed with more of a good than before the relative price of that good falls.

Scenario 2: B likes good 1 less than before - hence equilibrium price of good 2 rises

Scenario 3: both individuals have the same taste

Scenario 6: each individual starts with just 1 of the 2 goods

Chapter 9: welfare Note that the competitive equilibrium is just one of the points on the contract curve, one of the choices for society. Is it the ‘best’ point? Is there a ‘best’ point? Social Choice theory. Voting. Arrow’s Impossibility Theorem. Why not assume a social welfare function?

Social welfare functions? Suppose there are N people in society.....with utilities u 1, u 2,...,u N Why not define social welfare as W=f(u 1, u 2,...,u N ) where W is non-decreasing in all u n ? Different political parties have different forms for the function f(.). Classical Utilitarianism: W= u 1 +u u N Nash: W= u 1 u 2...u N Rawls: W= min[u 1,u 2,...,u N ] Let us go to the html file...

Summary Note that these are John Hey’s views. Economists can not distinguish between different points along the contract curve. We need to employ a Social Welfare Function (politics). This may require us to be able to measure (and hence compare) the utility of different people. How?

Chapter 9 Goodbye!