Exchange

1
Exchange

• Molly W. Dahl
• Georgetown University
• Econ 101 Spring 2009

2
Exchange

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

and
and
units of good 1
are
units of good 2.
and
3
Starting an Edgeworth Box
Height
The dimensions ofthe box are thequantities
availableof the goods.
Width
4
Feasible Allocations

• What allocations of the 8 units of good 1 and the
  6 units of good 2 are feasible?
• One feasible allocation is the before-trade
  allocation
• i.e. the endowment allocation.

5
The Endowment Allocation
OB
6
OA
8
6
The Endowment Allocation
OB
6
4
OA
6
8
7
The Endowment Allocation
2
OB
2
6
4
OA
6
8
8
The Endowment Allocation
2
OB
2
6
Theendowmentallocation
4
OA
6
8
9
The Endowment Allocation
OB
Theendowmentallocation
OA
10
Other Feasible Allocations

• denotes an allocation to consumer
  A.
• denotes an allocation to consumer
  B.
• An allocation is feasible if and only if

and
11
Feasible Reallocation
OB
OA
12
Feasible Reallocation
OB
OA
13
Feasible Reallocations

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

14
Feasible Reallocations

• 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?

15
Adding Preferences to the Box
For consumer A.
More preferred
OA
16
Adding Preferences to the Box
For consumer B.
More preferred
OB
17
Adding Preferences to the Box
For consumer B.
OB
More preferred
18
Edgeworth Box
OB
OA
19
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?

20
Edgeworth Box
OB
OA
21
Pareto-Improvements
OB
OA
The set of Pareto-improving allocations
22
Pareto-Improvements

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

23
Pareto-Improvements
OB
OA
The set of Pareto-improving reallocations
24
Pareto-Improvements
25
Pareto-Improvements
26
Pareto-Improvements
Tradeimproves bothAs and Bs welfares.This is
a Pareto-improvementover the endowment
allocation.
27
Pareto-Improvements
New mutual gains-to-trade region is the
set of all further Pareto-
improving
reallocations.
Tradeimproves bothAs and Bs welfares.This is
a Pareto-improvementover the endowment
allocation.
28
Pareto-Improvements
Further trade cannot improve
both A and Bs
welfares.
29
Pareto-Optimality
Better forconsumer A
Better forconsumer B
30
Pareto-Optimality
Both A andB are worseoff
A is strictly better off but B is strictly
worse off
B is strictly betteroff but A is strictlyworse
off
Both Aand B are worse off
31
Pareto-Optimality
The allocation isPareto-optimal since theonly
way one consumers welfare can be increased is
todecrease the welfare of the otherconsumer.
32
Pareto-Optimality
An allocation where convexindifference curves
are only just back-to-back is
Pareto-optimal.
The allocation isPareto-optimal since theonly
way one consumers welfare can be increased is
todecrease the welfare of the otherconsumer.
33
Pareto-Optimality

• Where are all of the Pareto-optimal allocations
  of the endowment?

34
Pareto-Optimality
All the allocations marked bya are
Pareto-optimal.
OB
OA
35
Pareto-Optimality

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

36
Pareto-Optimality
All the allocations marked bya are
Pareto-optimal.
OB
OA
The contract curve
37
Pareto-Optimality

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

38
The Core
OB
OA
The set of Pareto-improving reallocations
39
The Core
OB
OA
40
The Core
Pareto-optimal trades blocked by B
OB
OA
Pareto-optimal trades blocked by A
41
The Core
Pareto-optimal trades not blocked by A or B
are the core.
OB
OA
42
The Core

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

43
The Core

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

44
Trade in Competitive Markets

• Consider trade in perfectly competitive markets.
• Each consumer is a price-taker trying to maximize
  her own utility given p1, p2 and her own
  endowment. That is, ...

45
Trade in Competitive Markets
For consumer A.
OA
46
Trade in Competitive Markets

• So given p1 and p2, consumer As net demands for
  commodities 1 and 2 are

and
47
Trade in Competitive Markets
For consumer B.
OB
48
Trade in Competitive Markets

• So given p1 and p2, consumer Bs net demands for
  commodities 1 and 2 are

and
49
Trade in Competitive Markets

• A general equilibrium occurs when prices p1 and
  p2 cause both the markets for commodities 1 and 2
  to clear i.e.

and
50
Trade in Competitive Markets
Can this PO allocation be achieved?
OB
OA
51
Trade in Competitive Markets
Budget constraint for consumer A
OB
OA
52
Trade in Competitive Markets
Budget constraint for consumer A
OB
OA
53
Trade in Competitive Markets
OB
OA
Budget constraint for consumer B
54
Trade in Competitive Markets
OB
OA
Budget constraint for consumer B
55
Trade in Competitive Markets
OB
OA
But
56
Trade in Competitive Markets
OB
OA
and
57
Trade in Competitive Markets

• So at the given prices p1 and p2 there is an
• excess supply of commodity 1
• excess demand for commodity 2.
• Neither market clears so the prices p1 and p2 do
  not cause a general equilibrium.

58
Trade in Competitive Markets
So this PO allocation cannot be achieved by
competitive trading.
OB
OA
59
Trade in Competitive Markets
Which PO allocations can beachieved by
competitive trading?
OB
OA
60
Trade in Competitive Markets

• Since there is an excess demand for commodity 2,
  p2 will rise.
• Since there is an excess supply of commodity 1,
  p1 will fall.
• The slope of the budget constraints is
  -p1/p2 so the budget constraints will pivot about
  the endowment point and become less steep.

61
Trade in Competitive Markets
Which PO allocations can beachieved by
competitive trading?
OB
OA
62
Trade in Competitive Markets
Which PO allocations can beachieved by
competitive trading?
OB
OA
63
Trade in Competitive Markets
Budget constraint for consumer A
OB
OA
64
Trade in Competitive Markets
OB
OA
Budget constraint for consumer B
65
Trade in Competitive Markets
OB
OA
So
66
Trade in Competitive Markets
OB
OA
and
67
Trade in Competitive Markets

• At the new prices p1 and p2 both markets clear
  there is a general equilibrium.
• Trading in competitive markets achieves a
  particular Pareto-optimal allocation of the
  endowments.
• This is an example of the First Fundamental
  Theorem of Welfare Economics.

68
First Fundamental Theorem of Welfare Economics

• Given that consumers preferences are
  well-behaved, trading in perfectly competitive
  markets implements a Pareto-optimal allocation of
  the economys endowment.

69
Second Fundamental Theorem of Welfare Economics

• 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.

70
Second Fundamental Theorem of Welfare Economics

• 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.

71
Second Fundamental Theorem
OB
OA
The contract curve
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Second Fundamental Theorem
OB
OA
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Second Fundamental Theorem
Implemented by competitive trading from the
endowment w.
OB
OA
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Second Fundamental Theorem
Can this allocation be implementedby competitive
trading from w?
OB
OA
75
Second Fundamental Theorem
Can this allocation be implementedby competitive
trading from w? No.
OB
OA
76
Second Fundamental Theorem
But this allocation is implementedby competitive
trading from q.
OB
OA