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General Equilibrium Notes

Stephen L. Parente
University of Illinois
Econ 503 Spring 2010

Not to be quoted without authors permission.

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General Equilibrium
Often, it is necessary to have the right language in order to make progress on a particular
problem. Some would even argue that theory is language.

I. Set Up

A. People: The economy is composed of a people types, with measure i of type iI.
Typically, the number of people types is finite, and often there will be only one type. Individuals
of the same type are identical and their preferences and endowments.

Comment 1: The measure assumption, rather than a finite large number of agents assumption, is
made so that people are truly price takers. With a measure, or a continuum of agents are
infinitesimal, and so no single individual's decision affects price of goods.

B. Commodities: Defined to be anything that is traded. A commodity is a good or service


completely specified physically, temporally, and spatially. (Arrow 1959)

C. Commodity Space: A normed-vector space. An element x of the commodity space S is


a list of the quantities of every commodity. An element of S, denoted by sS is a commodity
vector.

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Mathematical Aside 1: Vector Spaces and Norms
Definition: A Vector space is a set X together with two operations. The first is vector addition
which associated any two elements x and y of X a third element denoted by x + y. The second is
scalar multiplication which associates with any real number and any element of x another
element of x denoted by x. The set X and the two operations must satisfy:

1. x+y = y+x (Commutative)


2. (x+y)+z=x+(y+z) (Associative)
3. A null vector 0 such that x+0=x for all x X
4. (x+y) = x + y
5. (+)x=x+x
6. ()x=(x)
7. 0x=0, 1x=x

Definition: If X is any vector space, a norm on X is any mapping :X that satisfies

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1. (x) 0 x X, (x)= 0 iff x = 0
2. (x + y) (x) + (y), x, y X
3. (x) = || (x)

Comment A1: The function is usually denoted by ||||. The proper way to think of the norm is
a distance from the zero vector. The distance between any two vectors x and y is ||x-y||.

(
Examples: If X = n, so that x=(x1,x2,x3,,xn), x x12 + x 22 + ...x n2 )
1/ 2
. This is the Euclidean
norm. X is called the Euclidean n-space.

Comment 2. If there are L commodities, then the commodity space is typically the Euclidean
space L with the above norm. In the case in which the number of commodities is infinite, i.e.,
x1,x2,x3.the norm is the sup norm defined as
x = sup t xt

Example 1: If there is a single consumption good, the commodity space is 1.


If there is n consumption goods, the commodity space is n.

*************************************************************************

D. Consumption Set for each consumer type i I: Xi S. Describes the set of


technologically feasible consumption vectors for the consumer.

Note the consumption set is not the budget set! The consumption set is in no way defined by the
consumers income or prices.

E. Preferences: We assume that each consumer type has a preference ordering given by a
i i
utility function u :X .

Comment 3: At a more micro level we start with a preference ordering on Xi. If certain axioms
are satisfied, a preference ordering can be characterized by a utility function.

Comment 4: We will impose restrictions so that the utility function u has some desirable
properties
1 Continuity
2. Concavity (strict)- diminishing marginal utility
3. Differentiability concavity iff D2f(x) is negative semi-definite
4. Increasing in its arguments
5. Marginal utility approaches infinity as consumption tends to zero

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Mathematical Aside 2: Concavity

Definition: A set X is convex if x,y X and [0,1], x + (1-)y X

Definition A2: A function f:X is concave, Xn is convex, if x,y X and [0,1], f(x +
(1-)y) f(x) + (1-)f(y)

Comment A1: Why do we desire this property of functions? There are two reasons. First order
necessary conditions for a maximum are sufficient conditions. (The same is true for the Kuhn
Tucker Theorem with restrictions on the constraint functions.) Additionally, concavity
guarantees a global maximum. The assumption of strict concavity of the objective function
ensures that the global maximum is unique.

F. Firms: There is assumed to be a number J firms.

G. Technologies: For each firm j J, there is a technology or production set Yj S.

Comment 4: Each firms production set represents the set of feasible actions- all the possible
input and output schedules for a firm.

Comment 5: For production economies, the convention is to have inputs denoted by negative
components, while outputs take on positive values. In the examples that will follow, I will
almost always depart from this convention.

Comment 6: From a macro perspective, we will be interested in the aggregate production set
Y = jJ Y j .

Desired Properties on the Technology set of Firms:


1. The aggregate production set is convex. (Rules out increasing returns to scale)
2. Either S is finite dimensional or Y has a non-empty interior. A point y0 Int(Y) if and
only if there exists > 0, such that ||y-y0|| < , implies y Y.

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Comment 7: There are other desirable properties of the production set. For instance, (i) Y is
non-empty; (ii) Y is closed, (iii) no free lunch (it is not possible to produces something from
nothing) (iv) inaction (0 Y) and (v) free disposal (the absorption of any additional amount
of inputs without any reduction in output is always possible).

Free disposal: Suppose y Y and y ' y (so that y produces at most the same quantity
of outputs as y using at least the same quantity of inputs). Then y ' Y . In other words,
Y R+card ( S ) Y . More intuitively, extra amounts of inputs (outputs) can be disposed
of or eliminated at no cost.
As shown below, you can always produce y2 by adding more the input (good 1), i.e.,
moving to the left of the horizontal line that intersects the Production possibilities frontier
at y. Likewise, you can always produce an amount of the output keeping the input
quantities less than y1.

Free Disposal

y=(y1,y2)

{ y} 2+

H. Endowments:
These are the initial resources of the economy. They are given by a vector S .

Comment 8. Often people own these initial resources. There are 3 options for handling these
endowments. The first option is to give consumers ownership to a technology characterized by

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the set { y S | y = i } , where i is the endowment of the type i consumer. The second option is
to deal with net trades and then xi + i is the argument of a type i utility function. The third
option is to keep the endowment separate and to modify the resource constraint. The third
option is the one we shall use in this course.

Comment 9: Sometimes we will be dealing with worlds in which there is no production, so


called pure exchange or endowment economies. The economy simply has an endowment of each
good. A relevant question is what is the technology set for such a world? The convention is to
specify the set of technology feasible commodities as those which satisfy free disposal. This of
course assumes we use the 3rd option above for handling the endowments of individuals.

Definition: A pure exchange economy if its only technologically feasible possibility is that of
(S )
free disposal, namely, Y j = card
+ .

I. Feasibility
Definition of (type i identical) Feasible Allocation: An allocation (x,y) is
feasible if

a. xi Xi for each consumer type iI


b. yj Yj for each firm j = 1,2, J
c. i x i = + y j
i j

Comment 10: If utility is quasi-concave, then restricting attention to type-identical allocations


makes sense. This will be proved later.

Comment 11: Thus, far nothing has been said about an allocation mechanism. Prices are one
way be which allocations are made. Prices are the mechanism in a Competitive Equilibrium.

II. Competitive Equilibrium:


The C.E. is a simple way to choose among feasible allocations.
Need two things: a system of property rights and a price system.

Property Rights: individual endowments of resources and claims to profits.


Endowments: i S
Property Rights: ij [0,1] (Claims to profits of firm j by individual i)

Price system: p (p1,p2,p3,,pL)

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Comment 9: For S infinite dimensional, the price system is a linear function mapping from
the space S into the real numbers, and the appropriate concept of the Competitive equilibrium
is a Valuation Equilibrium.

Definition of Competitive Equilibrium: A Competitive Equilibrium is an


allocation (x*,y*) and a price vector p* such that
a. utility maximization: given the price vector, p*, xi* maximizes consumer is utility
subject to his budget constraint.
U i ( x *i ) U i ( x i ) for all x i X i such that p * x i p * i + ij p * y * j where xi* is in
j

the budget set

b. Profit maximization. For every j J, p * y * j p * y j for all y j Y j .

c. Market clearing: for each good: x


i
i
i*
(k )dk = + y j*
j

Comment 10: Walrasian vs. Valuation C.E. Thus, far we have implicitly been defining goods by
their physical characteristics. Later, we will think of goods being defined by time. In the latter
case there is an issue of when trades take place. There are two possibilities: trade can either take
place at the start of the first period or it can take place sequentially as time evolves. In the first,
case, individuals trade promises to deliver a certain number of goods at a particular date in time.
This is the concept of a Valuation Equilibrium.

Convex Preferences and Type-i-Identical CE


Definition- A competitive Equilibrium is type-i-identical if for all i and for all k , k ' [0, i ] ,
x i* ( k ) = x i* ( k ' ) .

Definition- Two competitive equilibrium are equivalent if


i. for every type i, the average xi(k) are the same.
ii. For every j, the yj are the same
iii. The price system is the same

Definition- A function f defined on a convex set X is (weakly) quasi-concave if


f ( x) f ( x' ) and [0,1] implies f (x + (1 ) x' ) f ( x' ) .

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Definition- Preferences of agents of type i are convex if the Xi are convex and the Ui is quasi-
convave.

Proposition. If preferences of each type are convex, than any competitive equilibrium is
equivalent to a type-i-identical equilibrium.

Proof. For a C.E., all agents of the same type have the same maximization problem, and thus,
must end up receiving the same utility, u i .By the convexity of Xi the mean type-i consumption
x i belong to Xi. Additionally, x i is within the budget constraint since the budget constraint is a
convex set. By utility maximization, u i ( x i ) u i . Quasi-concavity, implies that u i ( x i ) u i .
Thus x i maximizes utility.

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An Example of an Endowment Economy: Two Goods and two Agents

Consumers: NA type A agents and NB type B agents


Preferences: log(c1i ) + log(c 2i ) i = A, B
Endowments

Describe the economy in the A-D language and solve out the competitive Equilibrium

Conclusions: Only can determine relative prices. Walras Law. This is simply an artifact
of a property of preferences, namely local non-satiation.

Walras Law If preferences are locally non-satiated, the value of excess demand is zero.

Definition: Local Non-Satiation of Preferences. If for every x Xi, and > 0 there exists z Xi
such that ||x-z|| ui(z)> ui(x)

Or

If for every xXi and for every iI, there exists a sequence {xn} converging to x, such that
ui(xn)> ui(x), n=1,2,..then preferences are locally non-satiated.

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Local Non-Satiation rules out thick indifference curves.

x2
||x-y|| <

U1

x1

What about the efficiency property of the allocation picked out by the C.E. mechanism?

III. Welfare Theorems


A. Definition of Pareto Optimal Allocation: An allocation is Pareto
Optimal if it is feasible and there exists no other feasible allocation that makes at least one
person better off without making no individual worse off.

Alternatively, feasible allocation x* Pareto Dominates feasible allocation x if


a. Ui(xi*) > Ui (xi) for some i= 1, 2,..I
b. Ui (xi*) Ui (xi) for all i= 1, 2,..I

B. First Welfare Theorem: If Preferences are locally non-satiated, then any


Walrasian Competitive Equilibrium is Pareto Optimal.

Relation between utility and preference ordering. The assumption that utility is strictly increasing
in all its arguments is sufficient for local non-satiation of preferences.

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An Example where the C.E. is not Pareto Optimal
B

UB

UA

Comment 12: What about externalities either in production or consumption? The First Welfare
Theorem does not apply here because in Arrow-Debreu economies it is assumed that there is a
market for every good.

C. 2nd Fundamental Welfare Theorem


Definition of Price (valuation) Quasi-equilibrium with transfers.
( )
Given an economy specified by { X i , u i }iI=1 , {Y j } Jj =1 , an allocation (x*,y*) and a price vector
p 0 constitute a price (valuation) quasi-competitive equilibrium with transfers if there is an
assignment of wealth levels ( w1 , w 2 ....w I ) with i w i = p * + j p * y * j such that
i. For every j, y * j maximizes profits in Yj (profit Maximization)
ii. For every i, if xi Xi and u i ( x i ) u i ( x *i ) then p * x i w i , (Cost Minimization)
iii. x
i
*i
= + y * j (Market clearing)
j

Comment 13. A Quasi-Equilibrium with Transfers differs from an Equilibrium with Transfers in
that for the latter x *i maximizes utility for all xi in the consumer is budget constraint. What we
want for equilibrium is that if u i ( x i ) > u i ( x *i ) then p x i > w i . Any price equilibrium with
transfers is a quasi-equilibrium with transfers. The converse is not, however, true. What
condition (ii) really says is that we have cost minimization over the set of allocations weakly
preferred to x *i .

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Counter Example 1 Counter Example 2
B E B
UA
E

E
UA

p=(1,0)
B
U UB
A A

p=(1,0), ( x1A , x 2A ) = (0,1) ( x1B , x 2B ) = (1,0)

Counter Example 1: Consumer A. His commodity set XA is defined to be the NE half of the
quadrant (shaded region). Consumer Bs is the entire quadrant. Consumer As preferences are
Leontiff. They are nice for consumer B.

We can have the case that an allocation is Pareto Optimal but does not maximize the consumers
utility under the budget constraint associated with the transfers and price vector.

Assumptions for 2nd Welfare Theorem (Harris)


Assumption 1 For each i, Xi is convex
Assumption 2. Strict concavity of utility
Assumption 3: Utility is continuous
Assumption 4: The aggregate production possibility set is convex. (There are no increasing
returns to scale)
Assumption 5. Either the commodity space is finite-dimensional, or Y has an interior point.

Comment 13: If each of the Yjs are convex, then the aggregate Production set is convex.

2nd Fundamental Theorem of Welfare.


( )
Given an economy specified by { X i , u i }iI=1 ,{Y j } Jj =1 , and assume assumptions 1-5 hold. Let
(x*,y*) be a Pareto Optimal Allocation and assume that for at least one consume x *i is not a
satiation point. Then, there exists p 0 such that (x*,y*,p) is a Price Quasi-Equilibrium with
Transfers.

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Importance of assumption of concavity of Utility- No Utility Maximization

UA
B
U
A

Importance of assumption of convex Technology. No Profit Maximization

U
x2

x1

D. Price Equilibrium with Transfers:


A P.O. allocation is a P.E.T. if for each i, there exists and x i ' X i such that px i ' < px i* .

In both examples on page 8, this condition is violated. In particular, there is no other allocation
for the type A consumer that is cheaper.

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IV. Pareto Optimal Allocations and Social Planners
Problem
In this section, we will demonstrate why the Welfare Theorems are so useful to
macroeconomists. We begin by showing how to find the Pareto Optimal allocations associated
with an economy.

Proposition: An allocation (xi*,yj*) is Pareto Optimal if and only if it solves the following
planners problem

Maximize iI
iU i ( x i )

subject to feasibility

By the First Welfare Theorem, we know that the Competitive Equilibrium is Pareto Optimal, so
{ }
it must be the solution to the above problem for a particular set of Pareto Weights i iI . The
Negeshi (1960) algorithm allows one to find this set of Pareto Weights.

There are 4 steps in this algorithm

1. Solve the Planners problem for a given set of weight. This yields consumption
allocations as a function of the Pareto weights and the models primitives.
2. Back out the date-0 AD prices {p t ( )}t =0 by using the planners solution for the
T

marginal rate of substitution between date t+1 and date t, and exploiting the fact that
in a competitive equilibrium this ratio equals the ratio of prices.
u i / cti+1 ( ) p t +1 ( )
=
u i / cti ( ) pt ( )
To get the entire price sequence, you need to start with period t=1 and t=0 with the
p0() normalized to 1.
3. Next solve for transfers that support the PO allocation as a PCE with transfers. This is
T
i ( ) = pt ( )[cti ( ) ti ]
t =0
4. Solve for the Pareto weights for which the transfer for each agent type equals 0.

Example:

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Not only is it easier to solve the CE by solving the SP problem, but by doing so, we can often
conclude that the Competitive Equilibrium exists and is unique. Specifically, if we can show the
solution to the planners problem for given Pareto weights exists and is unique, we have can
conclude that the CE exists and is unique. What this requires is that the planners problem is a
nice convex programming problem with concave objective and convex constraints.

HETEROGENEITY AND AGGREGATION

Example 2: Pure Exchange Economy

As can be seen, the P.O. allocations (x*,y*) are a function the Pareto weights, i. Therefore, for
every set of Pareto weights, there is a P.C.T. In this case you might think that the 2nd Welfare
Theorem is not much use for solving for the C.E with the assumed system of property rights and
endowments. For many model economies, however, the Social Planners problems will not tell
us the individual consumptions associated with the C.E. (i.e. you will not necessarily have the
transfers be zero in the P.C.E.T.) However, in macroeconomics we are more often concerned
with the aggregate allocations and prices. As long as consumer preferences are identical and
homothetic, the distribution of endowment has no effect on the aggregate allocations and
equilibrium prices. For such economies, the S.P. approach is particularly useful. In other words,
if preferences are homothetic, the distribution of endowments is inconsequential for the
aggregate allocations and prices. In this case, we can aggregate up and maximize the utility of
the representative consumer subject to the aggregate resource constraint. For a more explicit
treatment, see Chipman JET 1974.

Definition: A function f: : n+ is homogenous of degree k if f(x) = kf(x) for all >0,


.
Definition: A function V : n+ is homothetic if it is a monotone transformation of a
homogenous function, i.e., v = g(f(x)) where g is monotonic and f is homogenous, f : n+
and g: .
Theorem: Let f : n+ be a strictly monotone function. Then f is homothetic iff for all x, y
n+ , f ( x) f ( y ) f (x) f (y ) for all > 0.

Eisenberg Theorem: Suppose that fi(p,Ii) are the same for all individuals and fi is homothetic,
then f i ( p, I i ) = f i ( p, I i )
i

This says is that the tangent to the indifference curves is constant along a ray from the origin.

X2

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X1

IV. Time
A good is indexed by time.
e.g. An apple today versus an apple tomorrow.
Arrow-Debreu prices: price of a date t good in units of date-0 good.
All trading occurs at date 0: Buying and selling contracts for delivery of goods at date t

A. Finite Horizon: T
1. Commodity Space
A. S N(T+1) where N denotes the number of physical goods and T denotes the
number of periods
B. Euclidean Norm

2. Consumption Set Xi S. Convex

3. Preferences: V: Xi
T
V (c) = t u (ct ) where 0 < < 1, and ct N
t =0
b. Properties of u(ct)
i. strictly increasing and concave
ii. Additively Separable enjoyment of consumption today is
independent of consumption in other periods.

b. Subjective Time Discount Factor


iii. human behavior
iv. helps guarantee that consumption streams have finite utility value
(when T=)

Example 1: Pure Exchange Economy with two Types of Consumers and two
goods

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Example 2: Production Economies: Neoclassical Growth without Labor
ct1 1
Preferences: U (ct ) =
1
Technology: yt = At k t 0 < < 1
kt+1 = (1-)kt+xt

Endowments: k0

Alternative Assumptions on Property Rights

Households own firms,


and either Households own capital or firms own capital.

When Firms own the capital, k is not part of the commodity space because it is not traded.

Characterizing the C.E.

Claim 1: This economy satisfies all the properties of the 2nd Welfare Theorem
Social Planners Problem:
T
maxT
{ct , kt +1 }t = 0
u (c )
t =0
t
t

subject to
ct + kt+1 Af(kt) + (1-)kt
ct 0, kt+1 0.

Derivation of FONCs to Social Planners Problem:

Claim 2: This is a nice concave programming problem. Therefore, solution to social planners
problem is unique and, thus, so is the C.E.

B. Infinite Horizon Models


1. Limit of Finite Horizon Model.

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When is the limit of the solution of the finite horizon model the maximum to the
infinite horizon model?
lim max = max lim ?
T XT T

Interchanging the max and limits is difficult to prove.

2. The Transversality Condition: The Neo-classical Growth Model Again


a. Planners Problem

max
{ct , kt +1 }t = 0
u (c )
t =0
t
t

subject to
ct + kt+1 Af(kt) + (1-)kt
ct 0, kt+1 0.

c. FONCs
d. Characterizing the Competitive Equilibrium
i. Steady State Equilibrium- An Equilibrium in which all variables are constant.
ii. Balanced (Constant) Growth Path Equilibrium

3. Interpretation of Utility- Dynastic Preferences versus Overlapping


Generations
a. Interpret infinite horizon problem as the problem of a dynastic family
b. Each generation values the utility of the next generation and leaves some bequests
c. As long as parents care enough about their childrens utility, then dynastic problem
will correspond to individual generations problems
i. suppose parents maximize their utility plus discounted childrens
utility by choosing bequests/capital per children
ii. max{u (ct ) + n V (ct +1 )}
subject to
ct + nk t +1 = rkt k t + (1 )k t + wt
where
v(ct +1 ) = u (ct ) + nV (ct + 2 )
e. An alternative is the overlapping generations model

4. The Welfare Theorems in the context of Infinite Horizon Problems

a. Choice of Normed Vector Space


i. continuity of utility functions
ii. existence of an interior point

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b. 1st Welfare Theorem
iii. Applies for an Arrow-Debreu economy.
iv. Importance of finite set of Agents- The overlapping
Generations counterexample.
c. 2nd Welfare Theorem-
v. If assumption 1-5, then for every P.O. allocation there
exists a linear functional : X i ((x + y) = (x) +
(y) such that (,x) is a valuation equilibrium .
vi. Dot product (inner product) is a linear functional.
vii. Linear functional associated with P.O. allocation may not
have an inner product representation
viii. Need to restrict preferences and technologies so that people
do not care too much about the future.

IV. Uncertainty
Debreus approach: Goods are indexed by location, space, time and states of nature.

Thus, an apple in Urbana-Champaign on Wednesday January 25th if it snows is a different


commodity from an apple in Urbana-Champaign on Wednesday January 25th if it is sunny.

In Debreus formulation, people buy and sell claims to these goods. They are contingent claims
because of the precarious state of nature. At the beginning of the period people buy (sell) a
contract that promises so many units of a good to be delivered to them if the state of the world is
s.

Notice that this form of trade requires that everyone can verify what the exact state of the world
is at the end of the period. SYMMETRIC INFORMATION.

Definition. For every physical commodity, n=1,2,.N, and state z=1,2,.Z, a unit of (state-)
contingent commodity nz is a title to receive a unit of the physical commodity n if and only if the
state z occurs. A state- contingent commodity vector is specified as xNZ.

Preferences: Expected Utility


EU ( x) = z u ( x1z , x 2 z ,....x Nz )
zZ
Probabilities are can be subjective and thus can differ by individuals.

Production set: for every state, z, the input-output vector of physical commodities is feasible
for firm j when state z occurs.

Example. Suppose there are two states of nature, z1 and z2, representing good and bad weather.
There are two commodities, seeds and crops (n=2). Assume that a unit of seeds produces a unit
of crops only with good weather.

Y j = { y 4 : y1 0, y 3 = 0, y 2 0, y 4 0, y1 ( y 2 )}

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Comment: When dealing with contingent commodities, the convention is to call the Walrasian
Competitive Equilibrium an Arrow-Debreu equilibrium.

Example 1. I=2, N=1, Z=2 No Aggregate uncertainty


Suppose that = (1,0} and 2 = (0,1)
1

The aggregate endowment for this economy is (1,1)


The uncertainty in this model is with respect to the breakdown of the endowments of apple and
oranges. In the case of z=1, agent of type 1 gets 1 apple whereas agent of type 2 gets 1 apple in
the other state.

The equilibrium allocations are the same for the endowment economy studied in the first part for
suitable preference parameters.

Example 2: I=2, N=1, Z=2, Aggregate Uncertainty


Suppose that 1 = (2,0) and 2 = (0,1)
The aggregate endowment for this economy is (2,1). Here the economys endowment differs
according to the state of nature.
Assume that consumer 1 has subjective probabilities over the two states of nature.
Assume that consumer 2 has subjective probabilities
Definition: An Arrow-Debreu Equilibrium is a vector of prices (p1,p2)

V. Sequence Approach
1. In A-D economy all markets trade of goods and services occur at the beginning of
time. Deliveries are made thereafter.

2. More realistic is to have markets open over time. Sequence Approach (Spot Market)

3 Example. Pure Endowment Economy with Two Types of Consumers and Finite
Horizon

4. Definition of a Sequence Competitive Equilibrium:

5. Equivalence Between Sequence Approach and A-D Date-0 Approach


a. One can start with last period and iterate backwards on the budget
constraints to arrive at the A-D budget constraints

b. A-D prices and Spot market prices

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i. In A-D economy, pt is the price of the good at date t
measured in the date 0 good.

ii. In Sequence approach, there is the one period real interest


rate, rt, which gives the price of a unit of todays
consumption in terms of tomorrows

t 1 1
iii. pt =
s =0 1 + r
s

5. Infinite Horizon Models

a. No-Ponzi Games

i. additional assumption required to prevent unlimited


borrowing by households
T 1 1
ii. lim bT = 0.
T s = 0 1 + r
s

iii. No Ponzi Games Assumption guarantees that sequence


and date 0 approaches are the same

6. Government Policy and Ricardian Equivalence

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