General Equilibrium:
a. Exchange Economy
b. Production Economy
c. Welfare Economy
Partial and General Equilibrium
• Partial equilibrium
– Single market
– Each agent could determine his demands for and
supplies of the good
– Price is adjusted to clear market
– At the equilibrium, no agent would desire to change
his action
– Other prices are assumed to remain constant
Partial and General Equilibrium-(2)
• General Equilibrium
– all product and factor markets are simultaneously
in equilibrium.
– commodity prices make each demand equal to its
supply.
– factor prices make the demand for each factor equal
to its supply.
• An economy can be in general equilibrium only if all consumers,
all firms, all industries and all factor-services are in equilibrium
simultaneously and they are interlinked through commodity
and factor prices.
Partial and General Equilibrium-(3)
• Assumptions:
– There is perfect competition both in the commodity and
factor markets.
– Tastes and habits of consumers are given and constant.
– Incomes of consumers are given and constant.
– Factors of production are perfectly mobile between
different occupations and places.
– There are constant returns to scale.
– All firms operate under identical cost conditions.
– There are no changes in the techniques of production.
– There is full employment of labor and other resources.
GE in Pure exchange economy
• All of the economic agents are consumer.
• Consumers are described by their preferences
and goods that they possess.
• Agents trade goods among themselves and
attempt to make them better off.
• What are the desirable outcomes of such
a process?
Pure Exchange Economy: Agents and Goods
• All economic agents are consumers.
• Each consumer i is described by his preference or
utility function (ui).
• His initial endowment of k goods is wi.
• Consumer behavior
–each consumer attempts to choose the
most preferred bundle that he can afford.
Pure Exchange Economy: Agents and
Goods...(2)
• How goods are allocated among the agents?
Pure Exchange Economy: Agents and
Goods…(3)
• If two goods and two agents, then allocation ,
preference and endowment can be explained in
Edgeworth box.
Edgeworth Box for 2 agents and 2 goods
• Good 2 0, CB
.W
O. C A Good1
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.
• But which core allocation?
– depends upon the manner in which trade is
conducted.
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.
X2B
Trade in competitive market
Trade in competitive market
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.
• Hence, the prices p1 and p2 do not cause a
general equilibrium.
Trade in Competitive Markets
• Since there is an excess demand for commodity
2, p2 will rise.
• Since there is an excess supply of commodity1,
p1 will fall.
• The budget constraints will pivot about
the endowment point and become less
steep.
X2B
Trade in Competitive Markets
• At the new prices p and p both markets clear;
1 2
there is a general equilibrium.
• Trading in competitive markets achieves a
particular Pareto‐optimal allocation of the
endowments.
Walrasian equilibrium
• Many agents;
• Many goods x=(x1,x2,………xn)
• Price vector are given, P= (p1,p2, ……….pn)
• Maximization problem:
Walrasian equilibrium…(2)
• Demand function:
• Market value of endowment is equal to income;
• Aggregate demand;
• Aggregate supply;
• A set of prices for which demand equals supply in
every market.
– Very rare case
Walrasian equilibrium…(3)
• Assume, there are some undesirable goods.
– They may be excess supply.
