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Unformatted text preview: Microeconomics I - Lecture #10, April 21, 2009 10 General Equilibrium, Edgeworth Diagram Up until now we have generally considered the market for a single good in isolation. We have viewed the demand and supply functions for a good as depending on its price alone, disregarding the prices of other goods. But in general the prices of other goods will affect peoples demands and supplies for a particular good. Certainly the prices of substitutes and complements for a good will influence the demand for it, and, more subtly, the prices of goods that people sell will affect the amount of income they have and thereby influence much of other goods they will be able to buy. Up until now we have been ignoring the effect of these other prices on the market equilibrium. When we discussed the equilibrium conditions in a particular market, we only looked at one part of the problem: how demand and supply were affected by the price of the particular good we were examining. This is called partial equilibrium analysis. In this lecture we start with so called general equilibrium analysis - how demand and supply conditions interact in several markets to determine prices of many goods. We will analyze a simple example with two people in the economy: A and B and two goods: 1 and 2. We denote A s consumption bundle ( x A 1 ,x A 2 ), where x A 1 is A s consumption of the first good and x A 2 is a consumption of the second good. Similarly, ( x B 1 ,x B 2 ) represents consumption bundle of consumer B . Furthermore, we denote A = ( A 1 , A 2 ) an initial endowment bundle of consumer A and we denote initial endowment bundle of consumer B as B = ( B 1 , B 2 ). Example: Consider the following story from the Second World War. There are two prisoners of war in a German camp: British (consumer A) and French (consumer B). Both of them have a right to get some weekly amount of tea (good 1) and coffee (good 2). British prisoner has the endowment A = (1 , 4) and French prisoner, being privileged, has the endowment B = (5 , 4). The prisoners have standard preferences. The two prisoners are totally separated and the direct exchange is not possible. Their situation is depicted on the picture below. 50 If there is no trade both consumers will consume their endowments. The question is whether both consumers can be better off in presence of trade. To analyze the case where consumers can trader two goods between themselves we use a convenient graphical tool called the Edgeworth box. The Edgeworth box provides a powerful way of graphically studying exchange and the role of markets....
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- Spring '11