Essential Microeconomics -1-

3.1 THE 2 × 2 EXCHANGE ECONOMY

Private goods economy 2

Pareto efficient allocations 3
Edgeworth box analysis 6
Market clearing prices and Walras’ Law 14
Walrasian Equilibrium 16
Equilibrium and Efficiency 22

© John Riley October 4, 2012

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Private goods exchange economy

Consumer (or household) h, h = 1,..., H has strictly increasing preferences  over X h =  n+ .
h

We assume that the basic preference axioms are satisfied so that these are represented by a continuous
utility function U h (⋅) .

Where it is helpful we will assume that U is continuously differentiable (U (⋅) ∈ 1 ).

Endowments: The initial allocation of commodities is {ω h }hH=1 .

H H
h H
Feasible allocations: The final allocation {x } h =1 is feasible if
=h 1=h 1
∑ x ≤ ∑ ωh
h

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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

Since {xˆ h }hH=1 it cannot be the case that U 1 ( x1 ) > U 1 ( xˆ1 ) .

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

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Two commodity 2 consumer case (Alex and Bev)

For the special 2 × 2 case, Alex and Bev must
share the aggregate endowment ω = (ω1 , ω2 ) .

Let xˆ B be the allocation to Bev and let B̂ be the set

of allocations that Bev prefers over xˆ B .
This is depicted in Figure 3.1-2. For any x B ∈ Bˆ ,
the allocation to Alex is x A= ω − x B . Thus the best
possible allocation to Alex that leaves Bev no worse
off is Alex’s utility maximizing allocation in B̂ .
Figure 3.1-2: Bev’s upper contour set

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Edgeworth box diagram

Since preferences are strictly increasing
a PE allocation uses all the endowment
x A + x B =ω =ω A + ω B
In the diagram the sum of the two consumption
vectors is the vector (ω1 , ω2 ) , that is, the right
hand corner of the Edgeworth box.

Figure 3.1-3: Edgeworth box Diagram

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For Pareto-efficiency, there can be no mutually

preferred alternative. One PE allocation is
depicted in Figure 3.1-4. As long as an allocation
{xˆ A , xˆ B= ω − xˆ A }
is in the interior of the Edgeworth box, a necessary
condition for the allocation to be PE is that the
slopes of the two indifference curves must be
equal. Thus the graph of the PE allocations is the set
of allocations to Alex (and hence Bev) satisfying

Figure 3.1-4: PE allocations

∂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

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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

© John Riley October 4, 2012

Essential Microeconomics -8-

*
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

© John Riley October 4, 2012

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Appealing to the Ratio Rule and then setting

demand equal to supply,
x2A x2B x2A + x2B ω2
= = = .
x1A
x1B
xa + x1 ω1
A B

Thus, in a PE allocation each consumer is

allocated a fraction of the aggregate endowment.
It follows that for each consumer the marginal
rate of substitution is
1/σ
ω 
MRS ( xˆ ) = k  2  .
h h
(3.1-1)
 ω1 
Figure 3.1-4: PE allocations with identical CES preferences
The PE allocations are depicted in Figure 3.1-4.

© John Riley October 4, 2012

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Walrasian Equilibrium for an Exchange Economy

Let p ≥ 0 be a price vector of this exchange economy.
In a WE each consumer is a price taker.
We write the set of consumers as H = {1,..., H } .

***

© John Riley October 4, 2012

Essential Microeconomics -11-

Walrasian Equilibrium for an Exchange Economy

Let p ≥ 0 be a price vector of this exchange economy.
In a WE each consumer is a price taker.
We write the set of consumers as H = {1,..., H } .
We assume that preferences are strictly convex so consumer h has is a unique most preferred
consumption vector, x h ( p, ω h ) .

x h ( p, ω h ) solves Max{U h ( x) | p ⋅ x ≤ p ⋅ ω h } .
x

**

© John Riley October 4, 2012

Essential Microeconomics -12-

Walrasian Equilibrium for an Exchange Economy

Let p ≥ 0 be a price vector of this exchange economy.
In a WE each consumer is a price taker.
We write the set of consumers as H = {1,..., H } .
We assume that preferences are strictly convex so consumer h has is a unique most preferred
consumption vectr, x h ( p, ω h ) .

x h ( p, ω h ) solves Max{U h ( x) | p ⋅ x ≤ p ⋅ ω h } .
x

Total endowment vector: ω = ∑ ωh

h∈H

Total or “market” demand: x( p ) = ∑ x h ( p, ω h )

h∈H

Excess demand: ( p) x( p) − ω .
z=

© John Riley October 4, 2012

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Walrasian Equilibrium for an Exchange Economy

Let p ≥ 0 be a price vector of this exchange economy.
In a WE each consumer is a price taker.
We write the set of consumers as H = {1,..., H } .
We assume that preferences are strictly convex so consumer h has is a unique most preferred
consumption vector, x h ( p, ω h ) .

x h ( p, ω h ) solves Max{U h ( x) | p ⋅ x ≤ p ⋅ ω h } .
x

Total endowment vector: ω = ∑ ωh

h∈H

Total or “market” demand: x( p ) = ∑ x h ( p, ω h )

h∈H

Excess demand: ( p) x( p) − ω .
z=

Definition: Market Clearing Prices

Let z j ( p ) be the excess demand for commodity j at the price vector p ≥ 0 . The market for commodity

j clears if z j ( p ) ≤ 0 and p j z j ( p ) = 0 .

© John Riley October 4, 2012

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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?

**

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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

© John Riley October 4, 2012

Essential Microeconomics -16-

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.

Definition: Walrasian Equilibrium price vector

The price vector p > 0 is a WE price vector if all markets clear.

© John Riley October 4, 2012

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Edgeworth box example

In a Walrasian equilibrium consumers choose

the best point in their budget sets given a price

vector p = ( p1 , p2 ) .

In the figure these are the dotted orange

and green triangles.

Figure 3.1-5: Excess supply of commodity 1

**

© John Riley October 4, 2012

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Edgeworth box example

In a Walrasian equilibrium consumers choose

the best point in their budget sets given a price

vector p = ( p1 , p2 ) .

In the figure these are the dotted orange

and green triangles.

It is very important to note that consumers consider

only their budget sets. In the case depicted, both of

N

these budget sets extend beyond the boundary of the

Edgeworth box (the set of feasible allocations).

Figure 3.1-5: Excess supply of commodity 1

© John Riley October 4, 2012

Essential Microeconomics -19-

Edgeworth box example

In a Walrasian equilibrium consumers choose

the best point in their budget sets given a price

vector p = ( p1 , p2 ) .

In the figure these are the dotted orange

and green triangles.

It is very important to note that consumers consider

only their budget sets. In the case depicted, both of

N

these budget sets extend beyond the boundary of the

Edgeworth box (the set of feasible allocations).

The heavily shaded triangles indicate the desired trades Figure 3.1-5: Excess supply of commodity 1

of the two consumers. As depicted, Alex

wants to trade from the endowment point N to his most preferred desired consumption x A , whereas
Bev wishes to trade from N to x B . Thus, there is excess supply of commodity 1.

© John Riley October 4, 2012

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By lowering the price of commodity 1 (relative to

commodity 2) the budget line becomes less steep

until eventually supply equals demand. The

Walrasian equilibrium E is depicted in Figure 3.1-6.

Figure 3.1-6: Walrasian equilibrium

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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 .

© John Riley October 4, 2012

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Equilibrium and Efficiency

In Figure 3.1-6 the WE allocation is in the interior of the

Edgeworth box. Thus the marginal rates of substitution
must both be equal to the price ratio:
∂U A A ∂U B B
(x ) (x )
∂x p ∂x
=
MRS A
(x A ) = 1
= 1
= 1
MRS B ( x B )
∂U A
p2 ∂U B
(x A ) (x B )
∂x2 ∂x2 N

Since the MRS are equal, it follows that the

WE allocation must be PE.
Figure 3.1-6: Walrasian equilibrium

© John Riley October 4, 2012