Econ 310-2: Intermediate Microeconomics II

Yingni Guo

Northwestern University

Jan 05 2017

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 How does this lecture fit?

This lecture brings us to the first substantive part of the class, the study of
competitive equilibrium.

In 310-1, we have studied how individual consumers and firms make choices.
Intuitively, we can think of these as the foundations for the demand and supply
sides of a market.

Now we want to put these together to study both sides of the market, and to
do this not simply for a single market but for the economy as a whole.

This is referred to as the study of competitive equilibrium or general equilib-

rium.

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 We will be interested in such questions as

how prices organize economic activities;

how prices react to market imbalances;
and ultimately how prices clear markets.

We start by examining competitive markets.

The basic theme will be that competitive markets lead to efficient outcomes.
We will make the notion of efficiency in this statement precise, discuss the extent
to which this suggests that competitive market yields good outcomes, and
discuss the limitation of competitive markets.

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 What difference does it make how markets are organized?

This question has traditionally been addressed in two ways.

First, there was a long-standing debate as to the relative merits of planned mar-
kets versus decentralized markets. The traditional argument was that planned
markets could always duplicate the performance of decentralized markets, and
could do something else if desired, and so were necessarily better.

In practice, the logistical difficulties of a planned market have proved overwhelm-

ing. There is simply too much information to be processed and evaluated.

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 The task of calculating the optimal allocation of the economys resources is so
immense as to be impossible to carry out .... There are some twenty thousand
different job categories in the United States....
John McMillan, Reinventing the Bazaar: A Natural History of Markets

Planned economies now find few advocates.

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 Second, an overlapping and continuing debate concerns the extent to which
decentralized markets should be regulated, and the extent to which they should
be left to operate freely.

One point of view is that free markets generally work well, and the regulation
tends to introduce inefficiency. The alternative is that free markets tend to work
poorly, and that regulation is necessary. The debate reflects differing emphasis
on

efficiency versus equity,

competitive versus imperfectly competitive markets,
different philosophical positions as to which activities should be done within
markets and which should be done without markets.

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 For example: The National Organ Transplant Act of 1984 makes it illegal to
buy or sell a kidney in the US, thus making donation the only viable option for
kidney transplantation.

In 2012, 95,000 American men, women and children were on the waiting list
for new kidneys, the most commonly transplanted organ. Yet only about 16,500
kidney transplant operations were performed that year.... Paying donors for their
organs would finally eliminate the supply-demand gap....
Cash for Kidneys: The Case for a Market for Organs, by Gery S. Becker and Julio J. Elias (WSJ,
Jan 18, 2014)

The laws against buying or selling kidneys reflect a reasonably widespread re-
pugnance, and this repugnance may make it difficult for arguments that focus
only on the gains from trade to make headway in changing these laws.
Repugnance as a Constraint on Markets, by Alvin E. Roth (Journal of Economic Perspectives, Vol
21 No. 3, 2007)

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 We will examine exchange economies with many individuals and many goods.
We start with the simplest model that is complete:

two consumers: Ann and Bob (labeled A and B),

two goods: coconuts and bananas (labeled 1 and 2),
no production (only exchange of goods).

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 Preferences: Endowments:
( A ) 12 ( A ) 21
Ann U A (xA A
1 , x2 ) = x1 x2 , Ann eA = (eA A
1 , e2 ) = (20, 30),
( B ) 13 ( B ) 23 Bob eB = (eB , e B
B B B
Bob U (x1 , x2 ) = x1 x2 . 1 2 ) = (60, 20),
Total (e1 , e2 ) = (80, 50).

Good 2 Good 2

eA
30 b

b
eB
20

OA 20 Good 1 OB 60 Good 1
Anns endowment and preferences Bobs endowment and preferences

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 Allocations
An allocation x = ((xA A B B
1 , x2 ), (x1 , x2 )) determines:

As consumption: xA = (xA A
1 , x2 ),
Bs consumption: x = (x1 , xB
B B
2 ).

Feasible allocations
An allocation x = ((xA A B B
1 , x2 ), (x1 , x2 )) is feasible if

all entries are positive,

1 + x1 e1 ,
xA B

x2 + xB 2 e2 .
A

Consumption is positive. The total amount of consumption does not exceed the
endowments. (This is an exchange economy with no production.)

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 Pareto efficient
An allocation is Pareto efficient if there is no other feasible allocation y with the
properties that
y x , = A, B

y x for some .

Pareto domination
An allocation x is Pareto dominated by y if both consumers are at least as well
off at y and at least one consumer is strictly better off. And y is feasible.

Let us write this as y P x.

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 More generally, an allocation is Pareto efficient if

there is no alternative allocation that is feasible and that makes everyone

at least as well off, and at least one person better off; or, equivalently,
any attempt to make one person better off necessarily makes someone else
worse off.

Suppose that allocation x is not Pareto efficient. Then there is an alternative

allocation y that Pareto dominates x.

Notice that P is a relation over allocations that is transitive but not complete.
As a result, Pareto efficiency can be a weak criterion.

Definitions of .. complete and .. transitive relations.

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 Question: is the current endowment e a Pareto efficient allocation?
No. At the current endowment e = ((20, 30), (60, 20)), we have
1
U A (eA A
1 , e2 ) = 600
1/2
, U B (eB B
1 , e2 ) = 24000 .
3

The allocation ((30, 20), (50, 30)) is feasible and Pareto dominates e:
1
U A (30, 20) = 6001/2 , U B (50, 30) = 45000 3 .

More generally, how can we find the set of all Pareto efficient allocations?

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 Edgeworth box

Each point in the Edgeworth box is a feasible allocation with no waste.

: ((xA
Example: Allocation x A B B
1 , x2 ), (x1 , x2 )) = ((50, 40), (30, 10)).

The Edgeworth box is a graphical summary of fundamentals (endowments and

preferences).

Good 1 60 OB
Good 2
b
x

e
30 b
20

Good 2
OA 20 Good 1

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 Allocation f Pareto dominates allocation e.
Allocation g Pareto dominates allocation f, e.
Allocation g is Pareto efficient. The indifference curves at g are tangent. The
marginal rates of substitution of A and B are equated.

Good 1 60 OB
Good 2

e
30 b
f 20
b

b
g

Good 2
OA 20 Good 1

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 The set of all Pareto efficient allocations is called the Contract Curve. Along the
contract curve, the marginal rates of substitution of A and B are equated.

Good 1 60 OB
Good 2

e
30 b
20

Good 2
OA 20 Good 1

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 An allocation x is individually rational if both consumers prefer the allocation to
their original endowments:

xA A eA and xB B eB .

Voluntary trade leads to outcomes that are on the contract curve (that are
Pareto efficient) and that are individually rational (as shown by the dashed red
line between the two indifference curves).

Good 1 60 OB
Good 2

e
30 b
20

Good 2
OA 20 Good 1

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 In-class example (I): characterize the contract curve

Preferences:

Ann U A (xA A 1
1 , x2 ) = 2 xA A
1 + x2 ,
B B B

B B
Bob U (x1 , x2 ) = x1 + x2 .

The total endowment is e = (e1 , e2 ). The marginal rate of substitution of A is

U A
1
xA xA
M RS A
= 1
U A
=
2 2
.
xA
xA
1
2

The marginal rate of substitution of B is

U B
xB xB
M RS B
= 1
U B
= 2 .
xB
xB
1
2

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 In-class example (I): characterize the contract curve

1 , x2 ) = (e1 x1 , e2 x2 )
We solve for the contract curve by substituting (xB B A A
A B
and equating M RS and M RS ,

1
xA e2 xA
2
2 = 2
.
A
x1 e1 xA
1

The contract curve is given by

4e2 x1
xA
2 = .
e1 + 3x1

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 In-class example (I): characterize the contract curve

The contract curve is displayed when e1 = 6, e2 = 5. To characterize the set

of Pareto efficient allocations, we only need to know the total endowment and
consumers preferences.

Good 1 OB
Good 2

Good 2
OA Good 1

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 In-class example (II): Pareto domination is not a complete relation

A relation is complete if for all x and y we have x y or y x or both.

Question: Is Pareto domination P a complete relation?

Preferences:

Ann U A (xA A A A
1 , x2 ) = x1 + x2 ,
Bob U (x1 , x2 ) = x1 + 2xB
B B B B
2 .

Endowment: e = (e1 , e2 ) = (11, 11).

x = ((5, 5), (6, 6)),

y = ((6, 4), (5, 7)),
z = ((3, 3), (8, 8)).

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 In-class example (II): Pareto domination is not a complete relation

Preferences:

Ann U A (xA A A A
1 , x2 ) = x1 + x2 ,
Bob U (x1 , x2 ) = x1 + 2xB
B B B B
2 .

Endowment: e = (e1 , e2 ) = (11, 11).

allocation UA UB
x = ((5, 5), (6, 6))
y = ((6, 4), (5, 7))
z = ((3, 3), (8, 8))

Youll find that x does not dominate z and z does not dominate x. We cannot
compare x and z in terms of Pareto domination.

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 In-class example (II): Pareto domination is a transitive relation

A relation is transitive if whenever x y and y z, then x z.

Pareto domination is a transitive relation. If x P y and y P z, then every
consumer is at least as well off at x than at z and some consumer is strictly
better off at x than at z.

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