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Stephen L. Parente
University of Illinois
Econ 503 Spring 2010
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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.
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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:
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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
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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 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.
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 .
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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.
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
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.
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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.
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.
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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
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?
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.
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
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.
Comment 13: If each of the Yjs are convex, then the aggregate Production set is convex.
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Importance of assumption of concavity of Utility- No Utility Maximization
UA
B
U
A
U
x2
x1
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.
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.
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.
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
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.
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
When Firms own the capital, k is not part of the commodity space because it is not traded.
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.
Claim 2: This is a nice concave programming problem. Therefore, solution to social planners
problem is unique and, thus, so is the C.E.
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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
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
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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.
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.
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.
The equilibrium allocations are the same for the endowment economy studied in the first part for
suitable preference parameters.
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
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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.
t 1 1
iii. pt =
s =0 1 + r
s
a. No-Ponzi Games
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