Microeconomics 2

John Hey

Lecture 9

• Today I am going to start by reviewing the main points from Chapter/Lecture 8 ...

• ... which I regard as the most important lecture/chapter of the module.

• And then I will look at Chapter/Lecture 9...

• ... which I think says essentially...

• ... nothing.

Summary of Chapter 8

• The contract curve - the locus of tangency points of the individuals’ indifference curves - shows the allocations that are efficient in the sense of Pareto.

• There always exist the possibility of mutually advantageous exchange if preferences are different and/or endowments are different (unless the endowment point is on the contract curve).

• Perfect competitive equilibrium (with both individuals taking the price as given) always leads to a Pareto efficient allocation.

• If one of the individuals chooses the price the allocation is usually not Pareto efficient (monopoly/monopsony – undesirable for inefficiency).

The contract curve

• The contract curve shows the allocations that are efficient in the sense of Pareto.

• If a point is off the contract curve then there is always some other point on the contract curve that is better for both individuals.

• If a point is on the contract curve, then any movement away from that point is bound to make at least one of the two individuals worse off.

• (Some slight qualifications to these results might be needed if the indifference curves are not smoothly convex everywhere.)

Perfect competition equilibrium

• Perfect competitive equilibrium (with both individuals taking the price as given) always leads to a Pareto efficient allocation.

• Why?• Because at that equilibrium the price line must

be tangential to the (highest possible) indifference curves for both individuals.

• Hence at that equilibrium the indifference curves must be tangential...

• ...and hence the equilibrium must be on the contract curve.

The competitive equilibrium depends on the preferences and the endowments

• If one individual changes his or her preferences in such a way that he or she now prefers more a particular good than before...

• ... the relative price of that good rises.

• If an individual is endowed with more of a good than before...

• ... the relative price of that good falls.

Scenario 2: B likes good 1 less than before - hence equilibrium price of good 2 rises

Scenario 3: both individuals have the same taste

Scenario 6: each individual starts with just 1 of the 2 goods

Chapter 9: welfare

• Note that the competitive equilibrium is just one of the points on the contract curve, one of the choices for society.

• Is it the ‘best’ point?

• Is there a ‘best’ point?

• Social Choice theory. Voting.

• Arrow’s Impossibility Theorem.

• Why not assume a social welfare function?

Social welfare functions?

• Suppose there are N people in society...

• ..with utilities u1, u2,...,uN

• Why not define social welfare as W=f(u1, u2,...,uN ) where W is non-decreasing in all un?

• Different political parties have different forms for the function f(.).

• Classical Utilitarianism: W= u1+u2+...+uN

• Nash: W= u1u2...uN

• Rawls: W= min[u1,u2,...,uN]

• Let us go to the html file...

Summary

• Note that these are John Hey’s views.

• Economists can not distinguish between different points along the contract curve.

• We need to employ a Social Welfare Function (politics).

• This may require us to be able to measure (and hence compare) the utility of different people. How?

Chapter 9

• Goodbye!