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!