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Understanding General Equilibrium in Economy - Market Efficiency Analysis

This review delves into the model of choice of individuals in an economy, exploring how preferences lead to demands with multiple agents. It discusses the formation of prices and efficiency in markets using apples and oranges as examples. By examining feasible allocations and geometric representations, concepts like Pareto efficiency and the contract curve are explained. The text explores the working of markets, competitive equilibriums, and the First Welfare Theorem in relation to Pareto optimality.

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Understanding General Equilibrium in Economy - Market Efficiency Analysis

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  1. L12 General Equilibrium

  2. Review • Model of choice of individual • We know preferences and we find demands • With many such agents: • Q1: How prices are formed? • Q2: Are markets efficient?

  3. “Economy” with apples and oranges • Two consumers, A and B. • Total resources available • Feasible allocation and

  4. Geometric representation • Four numbers and geometric representation • Insane? • No: Edgeworth box • Collection of all feasible allocations

  5. OB Edgeworth Box OA

  6. Desirable Allocation: Pareto Efficient • When allocation is “socially” efficient? - Maximizing sum of utilities? NO! - Weaker notion: Pareto efficiency! • Allocation x Pareto efficient, if there does not exist allocation y that is A) at least as good as x for all B) is strictly better for at least one

  7. OB Pareto Efficiency OA

  8. OB Pareto Efficiency=Tangenency OA

  9. OB Contract Curve • The contract curve is the set of all Pareto-optimal allocations. OA

  10. Cobb-Douglass example

  11. OB Contract Curve • The contract curve is the set of all Pareto-optimal allocations. OA

  12. How do Markets Work? How do markets work? • Individuals respond optimally to prices • Prices are such that markets clear We call a competitive equilibrium

  13. Excess supply, Demand OB OA

  14. Excess Demand, Supply, Equilibrium OB OA

  15. Excess Demand, Supply, Equilibrium OB OA

  16. Cobb-Douglass example

  17. Invisible Hand OB • Are markets (Pareto) efficient? • First Welfare Theorem: allocation in Competitive equilibrium is Pareto optimal • Proof OA

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