EC 2101:

Microeconomic
Analysis I
Kwong-Yu Wong
26 Recap

§ Analysis often require measurement of welfare

§ Comparison is in dollars, as utility can hardly be compared across individuals
§ Consumer Surplus: compare consumer at different satisfaction level
§ Compensating Variation: compare at before change level
§ Equivalent Variation: compare at after change satisfaction level

§ Market Demand is the horizontal sum of individual demand.

§ General equilibrium considers more than one market simultaneously
§ Exchange economy can now be analysed with the consumer theory
§ Edgeworth Box: a tool to represent consumption of 2 consumer on a graph
§ Pareto efficiency: no other feasible allocation that one is happier without
sacrificing anyone
Lecture 5
General Equilibrium Analysis:
Exchange Economy
Ø Budget Constraint
Ø Competitive Equilibrium
Budget Constraint
26 Consumer Choice in the Exchange Economy

§ Given an endowment allocation,

which allocation will the consumers end up at?
§ Each consumer will choose her utility-maximizing basket
given her budget constraint.
§ The budget constraint is determined by
prices and endowments.
26 Budget Constraint in the Exchange Economy

§ Suppose the market for each good is perfectly competitive.

§ I.e., consumers are price-takers.

§ Let 𝑝! be the price of good 1 and 𝑝" be the price of good 2.

§ Consumer A’s budget constraint is:

𝑝!𝑥!# + 𝑝"𝑥"# ≤ 𝑝!𝜔!# + 𝑝"𝜔"#

§ Consumer B’s budget constraint is:

𝑝!𝑥!$ + 𝑝"𝑥"$ ≤ 𝑝!𝜔!$ + 𝑝"𝜔"$
26 Budget Constraint: Example

§ Suppose 𝑝! = $3 and 𝑝" = $4.

§ Suppose Consumer A’s endowment is (8,2).

§ Consumer A’s endowment is worth
𝑝!𝜔!# + 𝑝"𝜔"# = $3 / 8 + $4 / 2 = $32,
which is equivalent to having $32 of income.

§ Suppose Consumer B’s endowment is (4,4).

§ Consumer B’s endowment is worth
𝑝!𝜔!$ + 𝑝"𝜔"$ = $3 / 4 + $4 / 4 = $28,
which is equivalent to having $28 of income.
26 Budget Constraint: Example

§ Consumer A’s budget constraint is:

𝑝!𝑥!# + 𝑝"𝑥"# ≤ 𝑝!𝜔!# + 𝑝"𝜔"#
3𝑥!# + 4𝑥"# ≤ 32

§ Consumer B’s budget constraint is:

𝑝!𝑥!$ + 𝑝"𝑥"$ ≤ 𝑝!𝜔!$ + 𝑝"𝜔"$
3𝑥!$ + 4𝑥"$ ≤ 28

§ A consumption plan 𝑥 % = 𝑥!% , 𝑥"% is affordable

if it satisfies the budget constraint.
 Budget Constraint: Example

𝑥"# B’s budget line:

3𝑥!$ + 4𝑥"$ = 28 4 0$
𝑥!$
6

Not affordable for A

Affordable for B
Affordable for A
Not affordable for B 𝜔
2 4
A’s budget line:
3𝑥!# + 4𝑥"# = 32
𝑥!#
0# 8 12
𝑥"$
Slope of budget line = 𝑝! /𝑝" .
The endowment allocation, 𝜔, is on the budget line.
Competitive
Equilibrium
 Consumer A’s Optimal Choice

𝑥"#
0$
𝑥!$
6
𝛼

𝜔
2
A’s budget line:
𝑝! 𝑥!# + 𝑝" 𝑥"# = 𝑝! 𝜔!# + 𝑝" 𝜔"#
𝑥!#
0# 8 12
𝑥"$
Given the endowment and the prices,
consumer A wants to sell some of good 1
in exchange for some of good 2.
 Consumer B’s Optimal Choice

𝑥"#
4 0$
𝑥!$
6

𝛽
𝜔
4
B’s budget line:
𝑝! 𝑥!$ + 𝑝" 𝑥"$ = 𝑝! 𝜔!$ + 𝑝" 𝜔"$
𝑥!#
0# 12
𝑥"$
Given the endowment and the prices,
consumer B wants to sell some of good 2
in exchange for some of good 1.
 Can the consumers obtain their optimal choice?

𝑥"#
𝑥!$ 𝜔!$ 0$
𝑥!$
6 Amount of good 1
B wants to buy
𝛼
𝑥"#
Amount of good 2
A wants to buy 𝛽 𝑥"$
𝜔"# 𝜔 𝜔"$
Amount of good 2
B wants to sell

𝑥!#
0# 𝑥!# 𝜔!# 12
𝑥"$
Amount of good 1
A wants to sell
 Markets do not clear at the current prices
26

§ At 𝑝! = $3, there is an excess supply of good 1.

§ The amount that B wants to buy is less than
the amount that A wants to sell.

§ At 𝑝" = $4, there is an excess demand for good 2.

§ The amount that A wants to buy is more than
the amount that B wants to sell.

§ For each good, the sum of the quantity demanded

does not equal the sum of the quantity available.
𝑥!# + 𝑥!$ < 𝜔!# + 𝜔!$
𝑥"# + 𝑥"$ > 𝜔"# + 𝜔"$
 Competitive Equilibrium
26

§ A competitive equilibrium comprises

∗ ∗ ∗ ∗
an allocation 𝑥!# , 𝑥"# , 𝑥!$ , 𝑥"$ and
a pair of prices 𝑝!∗ , 𝑝"∗ such that:
§ Each consumer maximizes her utility
given her budget constraint.
#∗ #∗ $∗ $∗
§ Let 𝑥! , 𝑥" , 𝑥! , 𝑥"
denote each consumer’s
optimal choice given the equilibrium prices 𝑝!∗ , 𝑝"∗ .

§ The markets for both goods clear:

∗ ∗
𝑥!# + 𝑥!$ = 𝜔!# + 𝜔!$
#∗ $∗
𝑥" + 𝑥" = 𝜔"# + 𝜔"$
 Markets do not clear at the current prices

𝑥"#
𝑥!$ 𝜔!$ 0$
𝑥!$
6
𝛼
𝑥"#
𝛽 𝑥"$
𝜔"# 𝜔 𝜔"$

𝑥!#
0# 𝑥!# 𝜔!# 12
𝑥"$
There is an excess supply of good 1.
There is an excess demand for good 2.
26 Markets do not clear at the current prices

§ Since there is an excess supply of good 1,

§ the price of good 1 will decrease.

§ Since there is an excess demand for good 2,

§ the price of good 2 will increase.

§ Thus 𝑝!/𝑝" will fall.

§ The budget line will become flatter.
§ The budget line will still go through
the endowment allocation.
 Reaching an Equilibrium

𝑥"#
𝜔!$ 0$
𝑥!$
6
𝛼
𝛽
𝑥"$
𝜔"# 𝜔 𝜔"$

𝑥!#
0# 𝜔!# 12
𝑥"$
 Reaching an Equilibrium

𝑥"#
$∗ 𝜔!$ 0$
𝑥!
𝑥!$
6

∗ $∗
𝑥"# 𝑥"
𝐸
𝜔"# 𝜔 𝜔"$

𝑥!#
0# #∗ 𝜔!# 12
𝑥!
𝑥"$
At the new prices,
markets for both goods clear,
and each consumer maximizes her utility given her budget constraint.
26 Finding the Competitive Equilibrium

§ Each consumer maximizes her utility

given her budget constraint.
§ Consumer A: Tangency condition
Budget line
§ Consumer B: Tangency condition
Budget line

§ The markets for both goods clear.

§ The market for good 1 clears.
§ The market for good 2 clears.
 Exercise
Finding the Competitive Equilibrium
26

§ Suppose the consumers’ utility functions are:

𝑈 # 𝑥!# , 𝑥"# = 𝑥!# 𝑥"#
𝑈 $ 𝑥!$ , 𝑥"$ = 𝑥!$ 𝑥"$

§ The consumers’ endowments are:

𝜔!# , 𝜔"# = 10,6

𝜔!$ , 𝜔"$ = 10,4

§ Find the equilibrium prices 𝑝!∗ , 𝑝"∗

#∗ #∗ $∗ $∗
and the equilibrium allocation 𝑥! , 𝑥" , 𝑥! , 𝑥" .
 Exercise
Finding the Competitive Equilibrium
26
§ Two consumers, Ron and David, collectively own 600 Magic:The Gathering (MTG) cards and
500 Pokémon cards. Let 𝑥% denote the quantity of MTG cards owned by Ron and 𝑦% denote
the quantity of Pokémon cards owned by Ron. Similarly, let 𝑥& denote the quantity of MTG
cards owned by David and $𝑦& $ denote the quantity of Pokémon cards owned by David.
Suppose, further, that for Ron, 𝑈 % = 𝑥% 𝑦% , while for David, 𝑈 & = 𝑥& 𝑦&" . Finally, suppose the
initial allocation is such that 𝑥% = 300, $𝑦% = 450, 𝑥& = 300, and 𝑦& = 50 (i.e.,
300,450 , 300,50 ). Set MTG cards, 𝑥, as the numeraire.

§ Suppose, before Ron and David exchange their cards, David won a new set of 100 MTG cards
that rendered 200 cards of all Ron's MTG cards useless and Ron just threw them away. Then,
when they exchange, what is the new competitive equilibrium price? (Round off to 2 decimal
places when needed)

§ What if the endowment did not change, but 𝑈 % = min(𝑥% , 𝑦% ) and 𝑈 & = min(𝑥& , 2𝑦& )?
 Exercise
Finding the Competitive Equilibrium
26
 Exercise
Meaning of Prices
26

§ In the exchange economy,

there is no income and there is no money.

§ But the competitive equilibrium refers to:

§ A pair of equilibrium prices.
§ An equilibrium allocation.

§ If there is no money, what do prices mean?

 Exercise
Meaning of Prices
26
 Exercise
PE, CE, Prices, Endowments
26

§ Indicate whether the following statements are True or False.

Explain briefly.
§ Pareto efficiency depends on prices.
§ Pareto efficiency depends on the endowment allocation.
§ A competitive equilibrium depends on prices.
§ A competitive equilibrium depends on the endowment
allocation.
 Exercise
PE, CE, Prices, Endowments
26
26 Summary

§ Exchange economy can now be analysed with the consumer theory

§ Budget constraint depends on the endowment and prices.
§ Even in an endowment economy without money, price still exists at its
primitive form, a ratio to exchange goods
§ Competitive equilibrium is found by finding the prices that has 2 features
1. Consumers maximizes their utility given the budget constraint
2. Total consumptions equal to total endowment. (aka Market Clearing)