Chapter 2

Competition and Efficiency

Reading
Essential reading
Hindriks, J and G.D. Myles Intermediate Public Economics. (Cambridge:
MIT Press, 2005) Chapter 2.
Further reading
Duffie, D. and H. Sonnenschein (1989) Arrow and General Equilibrium
Theory, Journal of Economic Literature, 27, 565598.
Koopmans, T.C. Three Essays on the State of Economic Science. (New
York: McGraw-Hill, 1957) [ISBN 0678013977 hbk].
Ng, Y.-K. Welfare Economics. (Basingstoke: Palgrave Macmillan, 2004)
[ISBN 0333971213 hbk].
Advanced reading
Debreu, G. Theory of Value, (New York: Wiley, 1959) [ISBN
0300015593 pbk].
Mirrlees, J.A. The theory of optimal taxation in K.J. Arrow and M.D.
Intrilligator (eds) Handbook of Mathematical Economics (Amsterdam:
North-Holland, 1986) [ISBN 0444860541 hbk].
The exchange economy
Simplest form of economic activity
the exchange of commodities between parties to obtain mutual
advantage.
Two consumers
labelled 1 and 2
each has initial stock, or endowment
exchange quantities of the two commodities
Market prices
determine rate at which one commodity can be exchanged for
the other
Consumers believe
their choices cannot affect these prices
this is the competitive assumption
The exchange economy
Endowment of
consumer h
Prices
Consumption plan of
consumer h
Budget constraint of h
Preferences of h
( )
h h h
2 1
,e e e =
2 1
, p p
( )
h h h
x x x
2 1
, =
h h h h
p p x p x p
2
2
1
1
2
2
1
1
e e + = +
( )
h h h
x x U
2 1
,
Consumption plan chosen to maximize
utility subject to budget constraint

Equilibrium

2 , 1 ,
2 1 2 1
= + = + i x x
i i i i
e e
The Edgeworth box
Set of possible consumption allocations
represented as points in a rectangle
length of sides equal to endowments
South-west corner: zero consumption
point for consumer 1
North-east corner: zero consumption point
for consumer 2
Diagram constructed this way is called an
Edgeworth box
The Edgeworth box

1
2
2
2
1
2
e e +
2
1
1
1
e e +
1
1
x
1
2
x
2
2
x
2
1
x
x
e
-
-
x
e
common endowment point
consumption allocation
The Edgeworth box
1
2
e
-
-
-
1
x
2
x
2 1
/ p p
Consumers have a common budget constraint
Budget constraint passes through the endowment point
The gradient of the budget constraint is
Utility-maximising choices for the two consumers

2 1
and x x
Equilibrium
Equilibrium
a position where supply is equated to demand
achieved via the adjustment of prices
Equilibrium prices
prices adjust until the indifference curves
have a common point of tangency on the
budget line
this ensures demand is equal to supply


Equilibrium
Equilibrium at common tangency on budget line
1
2
e
-
-
1
x
2
x
Normalisations and Walras law
Only relative prices matter in determining
demands and supplies
Budget constraint



]Demand is homogenous of degree zero
h h h h
h h
h
x
p
p
p
p
x
p
p
p
p p
x
1
2
1
2 1
2
1
1
2
1
2
2 2 1 1
2

(

+ =
+
= e e
e e
( ) ( ) 0 for , , ,
2 1 2 1
> = p p x p p x
h
i
h
i
Normalisations and Walras law
Consumers concerned with the real purchasing
power
nominal income is equal to the value of endowment
a change in the level of prices raises nominal income
and the cost of purchases equally
Implication
must adopt a price normalization to fix the level of
prices
select a numeraire and set its price equal to 1
this is the unit of account


Normalisations and Walras law
Excess demand
Define excess demand by
Then


= 0
Walras law
the value of excess demand is zero
Implication
if demand is equal to supply for good 1 then demand must also
equal supply for good 2.
equilibrium in one market necessarily implies equilibrium
2 1 2 1
i i i i i
x x Z e e + =

| | | |
2
2
1
2
2
2
1
2 2
2
1
1
1
2
1
1
1 1 2 2 1 1
e e e e + + + = + x x p x x p Z p Z p
Equilibrium
Existence of equilibrium
choose good 1 as the numeraire (so p
1
= 1 )
plot the excess demand for good 2 as a
function of p
2

equilibrium is then found where the graph of
excess demand crosses the horizontal axis
excess demand for good 2 is zero so, by
Walras law, it must also be zero for good 1
Equilibrium
( )
2 2
, 1 p Z
2
p
Excess demand and equilibrium
Pareto efficiency
A test of efficiency that can accommodate differences in
preferences
Pareto efficiency
is it possible to undertake a reallocation of resources that can
benefit at least one consumer without harming any other?
if no improving reallocation can be found the initial position is
Pareto efficient.
An allocation is feasible if

A feasible allocation is Pareto efficient if there
is no alternative allocation with
.
1 1

= =
=
H
h
h
H
h
h
x e
{ }
H
x x ,...,
1

( ) ( ) H h x U x U
h h h h
,..., 1 , = >

( ) ( ) h x U x U
h h h h
one least at for ,

>
{ }
H
x x

,...,

1
Pareto efficiency
Edgeworth box
allocation a is not
Pareto efficient
the move to b raises
the utility of both
consumers
allocation c is Pareto
efficient since any
change in allocation
must make at least
one consumer worse-
off.
1
2
-
-
-
a
b
c
The Two Theorems
The Two Theorems of welfare
economics
the basis for claims concerning the
desirability of the competitive outcome
the First Theorem states that a competitive
equilibrium is Pareto efficient
the Second Theorem that any Pareto efficient
allocation can be decentralised as a
competitive equilibrium
The Two Theorems
1
2
e
-
-
e
Contract curve
Pareto efficient allocations given by tangencies of the indifference
curves.
The locus of tangencies is the contract curve.
A competitive equilibrium is given by a price line tangential to both
indifference curves at the same point.
Equilibrium at point e.
The Two Theorems
There is no point preferred by both consumers
to point e.
Since any change makes at least one consumer
worse-off, the equilibrium is Pareto efficient.
First Theorem of Welfare Economics: A
competitive equilibrium is Pareto efficient.
At a Pareto efficient equilibrium the marginal
rates of substitution of the two consumers are
equal
2
2 , 1
1
2 , 1
MRS MRS =
The Two Theorems
The Second Theorem: can a given Pareto efficient
allocation be made into a competitive equilibrium?
This is the process of decentralisation.
Decentralisation is possible if the consumers
indifference curves are convex.
The common tangent at a Pareto efficient allocation provides the
budget constraint
The convexity ensures that given this budget line the Pareto
efficient allocation will also be the optimal choice of the
consumers.
The construction is completed by choosing a point on this budget
line as the initial endowment point.
The Two Theorems
1
2
e
-
-
e
' e
-
The Pareto efficient allocation e is made a competitive equilibrium by:
- selecting w as the endowment point.
- trading by consumers will take the economy to e.
- if the endowments of the consumers are initially given by w a
transfer of endowment ia necessary.
The Two Theorems
Second Theorem of Welfare
Economics: Suppose that an allocation is
Pareto efficient. Then, with convex
preferences, there exists a set of prices
such that the allocation is a competitive
equilibrium given those prices.
Lump-sum taxation
It is implicit in the Second Theorem that income
is reallocated
The practical value of the Second Theorem
depends on the possibility of redistribution
The Theorem sees this as done is by making
lump-sum transfers between consumers
Quantities of endowments are transferred between
consumers
A transfer is lump-sum if no change in a consumers
behaviour can affect the size of the transfer.
The transfer is optimal if the resulting equilibrium is
the policy makers most preferred outcome.
Lump-sum taxation
1
2
e
e
' e
1
1
~
x
The initial endowment point is w.
Point e is to be decentralised.
At the initial point the income level of h is at prices .
The value of the transfer to consumer h that is necessary to
achieve the budget constraint through point e is .
One way to achieve this is to transfer a quantity of good 1
from consumer 1 to consumer 2.

p e
h

p
h h
p p e e '
1
1
~
x
Lump-sum taxation
Lump-sum transfers can be rephrased in terms
of lump-sum taxes.
Consumer 1 pays tax of amount
The tax revenue is given to consumer 2.
This pair of taxes move the budget constraint in
exactly the same way as the lump-sum transfer.
The taxes are also lump-sum: their values
cannot be affected by any change in behaviour.

1
1
1
~

x p T =
Lump-sum taxation
Lump-sum taxes have a central role in
public economics
Achieve distributional objectives without
reducing total endowment
Redistribution is achieved with no
efficiency cost
This applies to lump-sum taxes in general.
If they can be employed in the manner
described they are the perfect taxes.