Lecture 10 - Exchange

Question 1

Edgeworth Box

Answer 1

• Edgeworth and Bowley devised a diagram called an Edgeworth box to show all possible allocations of the available quantities of goods 1 and 2 between 2 consumers
• The dimensions of the box are the quantities available of the goods

Question 2

Pareto Improvements

Answer 2

• An allocation of the endowment that improves the welfare of a consumer without reducing the welfare of another is a Pareto improving allocation
• Since each consumer can refuse to trade, the only possible outcomes from exchanges are Pareto improving allocations

Question 3

Pareto Optimal

Answer 3

The allocation is Pareto optimal since the only way one consumer’s welfare can be increased is to decrease the welfare of the other consumer

Question 4

Contact Curve

Answer 4

Is the set of all Pareto optimal allocations

Question 5

Core

Answer 5

• 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

Question 6

First Fundamental Theorem of Welfare Economics

Answer 6

Given that consumer’s preferences are well behaved, trading in perfectly competitive markets implements a Pareto-optimal allocation of the economy’s endowment

Question 7

Second Fundamental Theorem of Welfare Economics

Answer 7

• The First Theorem is followed by a second that states that any Pareto optimal allocation (any point on the contract curve) can be achieved by trading in competitive markets provided that endowments are first appropriately rearranged amongst the consumers
• Given that consumers’ preferences are well behaved for any Pareto optimal allocation there are prices and an allocation of the total endowment that makes the Pareto optimal allocation implementable by trading in competitive markets