ECON501: Lecture Notes

Microeconomic Theory II
by Jorge Rojas
Contents
1 General Equilibrium 2
1.1 Walrasian Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Existence of Walrasian Equilibria . . . . . . . . . . . . . . . . . . . . . . 3
1.3 Existence of Walrasian Equilibria . . . . . . . . . . . . . . . . . . . . . . 4
2 Jones Model 5
2.1 Input endowment magnication eect . . . . . . . . . . . . . . . . . . . . 5
2.2 Output price magnication eect . . . . . . . . . . . . . . . . . . . . . . 6
2.3 Magnication eects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
3 Welfare Economics 6
3.1 FIRST THEOREM OF WELFARE ECONOMICS . . . . . . . . . . . . 7
3.2 SECOND THEOREM OF WELFARE ECONOMICS . . . . . . . . . . . 7
4 Public Goods and Externalities 8
4.1 Public Goods and Competitive Markets . . . . . . . . . . . . . . . . . . . 9
4.2 Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
4.2.1 Production Externality . . . . . . . . . . . . . . . . . . . . . . . . 10
4.2.2 Common Property Rights . . . . . . . . . . . . . . . . . . . . . . 11
4.2.3 Congestion Externality . . . . . . . . . . . . . . . . . . . . . . . . 11
5 Practical Themes 12
5.1 Intertemporal Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
5.2 Robinson Crusoe (Coop-structure) . . . . . . . . . . . . . . . . . . . . . 13
5.3 Fisher Separation Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1
ECON501: Lecture Notes
Microeconomic Theory II
by Jorge Rojas
Abstract
This is a summary containing the main ideas in the subject. This is not a
summary of the lecture notes, this is a summary of ideas and basic concepts. The
mathematical machinery is necessary, but the principles are much more important.
1
1 General Equilibrium
The single-market story is a partial equilibrium model. While in the general equilib-
rium model all prices are variable, and equilibrium requires that all markets clear.
There is a special case called pure exchange economy where all the economic
agents are consumers. Each consumer i is completely described:
1. the preferences _
i
or the corresponding utility function u
i
2. the initial endowment
i
The consumption bundle is denoted by x
i
= (x
1i
, . . . , x
ki
) and an allocation is written
as x = (x
i
, . . . , x
n
). An allocation x is a collection of n consumption bundles describing
what each of the n agents holds.
Denition 1. Feasible Allocation.
A feasible allocation is one that is physically possible, therefore:
n

i=1
x
i

n

i=1

i
In a two goods, two agents economy, the Edgeworth box is a useful tool to represent
the situation:
Figure 1: Edgeworth Box.
1
Without Equality in Opportunities, Freedom is the privilege of a few, and Oppression the reality of
everyone else.
University of Washington Page 2
ECON501: Lecture Notes
Microeconomic Theory II
by Jorge Rojas
1.1 Walrasian Equilibrium
Let us dene p = (p
1
, . . . , p
k
) which is exogenously given. Each consumer solves the
problem:
Max
x
i
u
i
(x
i
)
s.t. px
i
= p
i
Notice that for an arbitrary price vector p, it might not be possible to make the desired
transactions for the simple reason that aggregate demand may not be equal to aggregate
supply:
n

i=1
x
i
(p, p
i
) ,=
n

i=1

i
Denition 2. Walrasian Equilibrium.
We dene a W.E. to be a pair (p

, x

) such that:
n

i=1
x
i
(p, p
i
)
n

i=1

i
p

is a Walrasian equilibrium of there is no good for which there is positive excess demand.
1.2 Existence of Walrasian Equilibria
We know that the demand functions are H.O.D. zero in prices. As the sum of homo-
geneous functions is homogeneous, then the aggregate excess demand function is also
H.O.D. zero in prices.
z(p

) =
n

i=1
[x
i
(p

, p

i
)
i
] 0
So, z : R
k
+
0 R
k
Theorem 1. Walras Law: For any price vector p, we have p z(p) = 0, i.e., the value
of the excess demand is identically zero.
The proof is direct. z = 0 since x
i
() must satisfy the budget constraint for each agent
i.
Corollary 1. Market Clearing: If demand equals supply in (k 1) markets, and
p
k
> 0 then demand must equal supply in the kth market.
Denition 3. Free Goods: If p

is a Walrasian Equilibrium and

z
j
(p

) < 0, then p

j
= 0
In other words, if some good is in excess supply at a Walrasian equilibrium, it must
be a free good.
Denition 4. Desirability: If p
i
= 0, then z
i
(p) > 0 i = 1, . . . , k.
The following theorem is essential to solve applied problems since we will impose
equality of the demand and the supply, almost all the time.
Theorem 2. Equality of Demand and Supply.
University of Washington Page 3
ECON501: Lecture Notes
Microeconomic Theory II
by Jorge Rojas
If all goods are desirable and p

is a Walrasian equilibrium, then z(p

) = 0. The
proof is done by contradiction.
Since the aggregate excess demand z(p) is H.O.D. zero, we can express everything in
terms of relative prices. Thus, we get:
p
i
=
p
i

k
j=1
p
j
,and therefore,
k

i=1
p
i
= 1
So, p (k 1)-dimensional unit simplex. S
k1
= p R
k
+
:

k
i=1
p
i
= 1
Theorem 3. BROUWER FIXED-POINT THEOREM
If f : S
k1
S
k1
is a continuous function from the unit simplex to itself, there is
some x S
k1
such that x = f(x).
Another useful calculus tool is the Intermediate Value Theorem. If f is a real-valued
continuous function on the interval [a, b], and I is a number between f(a) and f(b), then
there is a c [a, b] such that f(c) = I.
Theorem I below is one of the most important theorems in modern economics (in my
opinion). This theorem can be used for the good or for the bad. So, be wise!
1.3 Existence of Walrasian Equilibria
If z : S
k1
R
k
is a continuous function that satises Walras law, i.e., p z(p) 0,
then there exists some p

S
k1
such that z(p

) 0
I write the proof for this theorem given its importance in economics and the fact that
the proof for this idea took around a hundred years to exist in its formal way.
Proof:
Dene g : S
k1
S
k1
by:
g
i
(p) =
p
i
+ max(0, z
i
(p))
1 +

k
j=1
max(0, z
j
(p))
i = 1, . . . , k
Thus,

k
i=1
g
i
(p) = 1
The map g has a nice economic interpretation. Suppose that there is excess demand in
some market, so that z
i
(p) 0, then the relative price of that good is increased.
By the Brouwers xed-point theorem there is a p

such that p

= g(p

). So,
p

i
=
p

i
+ max(0, z
i
(p

))
1 +

k
j=1
max(0, z
j
(p

))
i
=
p

i
k

j=1
max(0, z
j
(p

)) = max(0, z
i
(p

)) i
University of Washington Page 4
ECON501: Lecture Notes
Microeconomic Theory II
by Jorge Rojas
we multiply by z
i
(p

), we get:
z
i
(p

) p

i
_
k

j=1
max(0, z
j
(p

))

= z
i
(p

) max(0, z
i
(p

)) i
now, we sum across all the agents, so we get:
_
k

j=1
max(0, z
j
(p

))

i=1
z
i
(p

)p

i
=
k

i=1
z
i
(p

) max(0, z
i
(p

))
By Walras Law, we know that:

k
i=1
z
i
(p

)p

i
= p

z(p

) = 0
=
k

i=1
_
z
i
(p

) max(0, z
i
(p

))

= 0 (1)
Each term of the sum in (1) is greater or equal to zero since each term is either 0 or
z
2
i
(p

) > 0 if z
i
(p

) > 0. However, if any term were strictly greater than zero, the
equality would not hold.
Hence, every term of the summation must be equal to zero, so:
z
i
(p

) 0 i = 1, . . . , k
2 Jones Model
The Jones Model assumes Constant Returns to Scale (CRS). This implies the zero-prot
conditions. There are two inputs L, T that produce two outputs M, F. Output prices
p
M
, p
F
are exogenously given, while the endogenous variables are F, M, w, r.
To determine the technical coecients, we solve the minimization cost problem for
each rm (we have assumed that one rm produces only one output).
Max wL
i
+rT
i
(2)
s.t. G(L
i
, T
i
) = 1
where G(L
i
, T
i
) is the production function for good i. The solution to this problem
corresponds to the technical coecients, i.e., L

i
= a
Li
and T

i
= a
Ti
. Recall that a
pq
is
the amount of input p that is necessary to produce one unit of output q.
2.1 Input endowment magnication eect
Theorem 4. Rybczynski Theorem.
An expansion in one factor (input) leads to an absolute decline in the output of the
commodity that uses the other factor more intensively.
Assuming that:
a
LM
a
TM
>
a
LF
a
TF
M is more labour intensive than F
If L increases, then F will decrease.
The proof for theorem (4) is done using the full-employment conditions, and taking
dierentials.
University of Washington Page 5
ECON501: Lecture Notes
Microeconomic Theory II
by Jorge Rojas
2.2 Output price magnication eect
Theorem 5. Stolper-Samuelson Theorem.
Assume M is more labour intensive than F, and p
F
is constant. An increase in
p
M
raises the return to the factor used intensively in M production by an even greater
relative amount.
M is labour intensive and p
M
increases =
dw
w
>
dp
M
p
M
The proof for theorem (5) is done using the zero-prot conditions, and taking dier-
entials.
To avoid multiple equilibria, we impose that one output is more intensive in one input
for all (w, r) R
2
+
. Thus, the lines intersect only ones.
2.3 Magnication eects
Input endowment magnication eect (3). General Rybczynski theorem.
_
a
LF
a
TF
>
a
LM
a
TM
_

_
dL
L
>
dT
T
_
=
dF
F
>
dL
L
>
dT
T
>
dM
M
(3)
Output price magnication eect (4). General Stolper-Samuelson theorem.
_
a
LF
a
TF
>
a
LM
a
TM
_

_
dp
F
p
F
>
dp
M
p
M
_
=
dw
w
>
dp
F
p
F
>
dp
M
p
M
>
dr
r
(4)
3 Welfare Economics
Denition 5. Pareto Eciency
A feasible allocation x is a weakly Pareto ecient allocation if there is no feasible
allocation x

such that all agents strictly prefer x

to x.
A feasible allocation x is a strongly Pareto ecient allocation if there is no feasible
allocation x

such that all agents weakly prefer x

to x, and some agent strictly prefers

x

to x.
Suppose that preferences are continuous and monotonic. Then an allocation is weakly
Pareto ecient if and only if it is strongly Pareto ecient.
Denition 6. Walrasian Equilibrium.
An allocation-price pair (x, p) is a Walrasian equilibrium if:
(1) the allocation is feasible:

n
i=1
x
i

n
i=1

i
(2) If x

i
is preferred by agent i to x
i
, then p x

i
> p
i
, i.e., the agent is only better o
with a bundle that cannot aord.
University of Washington Page 6
ECON501: Lecture Notes
Microeconomic Theory II
by Jorge Rojas
3.1 FIRST THEOREM OF WELFARE ECONOMICS
If (x, p) is a Walrasian equilibrium, then x is Pareto ecient.
Proof:
Suppose is not, and let x

be a feasible allocation that all agents prefer to x. Then by

property 2 of the denition of Walrasian equilibrium, we have that:
p x

i
> p
i
i = 1, . . . , n
summing over i = 1, . . . , n and using the fact that x

is feasible, we have that:

p
n

i=1

i
= p
n

i=1
x

i
>
n

i=1
p
i
which is a contradiction.
3.2 SECOND THEOREM OF WELFARE ECONOMICS
Suppose x

is a Pareto ecient allocation in which each agent holds a positive amount

of each good. Suppose that preferences are convex, continuous, and monotonic.
Then, x

is a Walrasian equilibrium for the initial endowments

i
= x

i
i = 1, . . . , n.
Another version: The following lines are taken from MWG, pages 551-552.
Denition 7. Given an economy specied by ((X
i
, _
i
)
I
i=1
, Y
j

J
j=1
, ) an allocation
(x

, y

) and a price vector p = (p

1
, . . . , p
L
) ,= 0 constitute a price quasi-equilibrium
with transfers if there is an assignment of wealth levels (w
1
, . . . , w
I
) with

i
w
i
=
p +

j
p y

j
such that:
(i) j, y

j
maximises prots in Y
j
; that is,
p y
j
p y

j
y
j
Y
j
(ii) i, if x
i
~
i
x

i
then p x
i
w
i
(iii)

i
x

i
= +

j
y

j
Theorem 6. Second fundamental theorem of Welfare Economics.
Consider an economy specied by ((X
i
, _
i
)
I
i=1
, Y
j

J
j=1
, ), and suppose that every
Y
j
is convex and every preference relation _
i
is convex [i.e., the set x

i
X
i
: x

i
_
i
x
i

is convex for every x

i
X
i
] and locally non-satiated. Then, for every Pareto optimal
allocation (x

, y

), there is (exists) a price vector p = (p

1
, . . . , p
L
) ,= 0 such that (x

, y

, p)
is a price quasi equilibrium with transfers.
Exercise.
Calculating Pareto Ecient Allocations.
There are two goods X, Y , two individuals A, B, two inputs

L,

T (exogenously
University of Washington Page 7
ECON501: Lecture Notes
Microeconomic Theory II
by Jorge Rojas
xed), X = F(L
X
, T
X
) and Y = G(L
Y
, T
Y
). We solve the following optimization problem
to nd the locus of Pareto ecient allocations.
Max u
A
(X
A
, Y
A
) (5)
s.t. u
B
(X
B
, Y
B
) = u
B
F(L
X
, T
X
) = X
A
+X
B
G(L
Y
, T
Y
) = Y
A
+Y
B
L
X
+L
Y
=

L
T
X
+T
Y
=

T
We form the Lagrangean:
/ = u
A
(X
A
, Y
A
) +[ u
B
u
B
(X
B
, Y
B
)] +[X
A
+X
B
F(L
X
, T
X
)]
+[Y
A
+Y
B
G(L
Y
, T
Y
)] +[

L L
X
L
Y
] +[

T T
X
T
Y
]
This leads to the ecient conditions.
Eciency in Consumption
u
A
X
A
u
A
Y
A
=
u
B
X
B
u
B
Y
B
=

Eciency in Production
F
L
X
F
T
X
=
G
L
Y
G
T
Y
=

Ecient Product Mix

u
A
X
A
u
A
Y
A
=
u
B
X
B
u
B
Y
B
=
G
L
Y
F
L
X
=
G
T
Y
F
T
X
= MRT =
MC
X
MC
Y
where MRT is the usual marginal rate of transformation and MC is the marginal
cost.
4 Public Goods and Externalities
Denition 8. A public good is a commodity for which use of a unit of the good by one
agent does not preclude its use by other agents.
2
Suppose that X is a public good (for example, education, healthcare, national
defense) and Y is a private good (for example, wine, cigarettes, cars). There are two
agents in this basic model i = A, B. They face the following maximization problem:
Max
{X,Y
A
}
u
A
(X, Y
A
)
s.t. u
B
(X, Y
B
) = u
B
F(T
X
) = X
G(T
Y
) = Y
A
+Y
B
T
X
+T
Y
=

T
2
Mas-Colell, Whinston and Green (MWG), page 359.
University of Washington Page 8
ECON501: Lecture Notes
Microeconomic Theory II
by Jorge Rojas
We setup the following Lagrangean:
/ = u
A
(X, Y
A
)+[ u
B
u
B
(X, Y
B
)] +[F(T
X
)X] +[G(T
Y
)Y
A
Y
B
] +[

T T
X
T
Y
]
After solving the FOCs, we get a general result for Pareto eciency in this basic and
well-behaved model:
u
A
X
u
A
Y
A
+
u
B
X
u
B
Y
B
. .
Marginal Benet (agreggated)
=
G

(T
Y
)
F

(T
X
)
. .
Marginal Cost
(6)
Remark 1. Private goods and public goods have a dierent condition for optimality.
Therefore, it is really important to make sure that public good is treated as such and not
otherwise. As a society, we must dene these goods. For instance, is education a public
good or a private one?
1. Private goods =MRS
A
= MRS
B
= MRT
2. Public goods =MRS
A
+ MRS
B
= MRT
4.1 Public Goods and Competitive Markets
This is the case in which we let the private sector, namely, rms to provide a public good.
So, suppose the markets are competitive and we have two rms. One provides the public
good and the other one the private good. Therefore, each rm solves their maximization
problem, i.e., they try to maximise prots. In general terms,
Max
{K,L}

X
= p
x
F(K, L) wL rK (7)
So, from (7) we get the price for the good X, and likewise for good Y . Now, assume that
the consumers own the land T and the rms, so they can use the prots(prots are zero
if F() has CRS). Then, the consumers have to solve the problem given by:
Max
{X
i
,Y
i
}
u
i
(X
i
+X
i
, Y
i
) i = A, B
s.t. p
x
X
i
+p
y
Y
i
= rT
i
+ prots (8)
After some manipulation, we get the condition MRS
A
= MRS
B
= MRT which is
clearly dierent to the Pareto Optimal condition for public goods. Therefore, competitive
markets will NOT be ecient in the provision of public goods. Notice that property
rights do not play any role in this analysis. They will not change the main results.
Remark 2. If the agents are identical in their utility functions, then there is no free-
riders. However, if the agents have dierent utility functions, then there will be free-
riders. In this situation, we apply the Kuhn-Tucker conditions to solve the problem.
Moreover, the free-rider will be the agent that cares less about the public good (in a model
in which there are only two goods, the public and the private ones, and only two agents.
In more general setups, game theory and mechanism designed are needed).
Remark 3. If individuals have identical homothetic utility functions, then we do not
care about the distribution of wealth (result coming from Gorman form analysis).
It seems that in Chile many leaders and economists believe that we all have the same
preferences because inequality is monstrous (Chile is top 20!)
3
.
3
Chile is the 17th most unequal country in the world, according to the CIA. Source
https://www.cia.gov/library/publications/the-world-factbook/rankorder/2172rank.html and using other
surveys we are top 10!
University of Washington Page 9
ECON501: Lecture Notes
Microeconomic Theory II
by Jorge Rojas
4.2 Externalities
Figure (2) shows an example of an externality. There are two main types of externalities:
Positive and Negative. A well-known example of negative externality in Chile is related
to the mining companies based on foreign capital. The mining companies go to the
source of mineral, extract the natural resources and generate a lot of pollution, and pay
less than 5% in taxes. The farmers and peasants who live nearby see the death of their
animals and the pollution of their water. An example of a positive externality is this note.
I am writing it for me, but I share it with anyone who wants to download from Scrib.com.
There are three main types of externalities:
1. Production externality
2. Common Property Rights
3. Congestion externality
Figure 2: Example of an externality.
4.2.1 Production Externality
Suppose that there are two rms i = A, B and they produce goods X and Y , respectively.
Firm A pollutes in its production process and this pollution aects the prots of rm B.
Production and Pollution
Firm A Firm B
price good X: p price good Y: q
cost function: C(X) cost function: D(Y, s)
Pollution: s = s(X)
So, in this situation, the methodology of analysis is standard. First, we analyse each rm
separately obtaining the individual optimal outcome. Second, we put the two rms
together and we maximise joint prots. Thus, we obtain the social optimal outcome.
In general, the prots coming from both rms working together will be greater than
summing the prots from each rm working on its own (Cooperation is positive if
not needed).
Private marginal cost: C

(X)
Social marginal cost:C

(X) +
D
s
s

(X) also called true MC

University of Washington Page 10
ECON501: Lecture Notes
Microeconomic Theory II
by Jorge Rojas
To solve the problem of externalities there are three main economic tools that can be
deployed by the government or by the private counterparts:
1. Taxes (You subtract X from the polluters prot function)
2. Licenses
3. Agreements between the private agents
Theorem 7. COASE THEOREM: Under zero transaction costs, if trade of the
externality can occur, then bargaining will lead to an ecient outcome no matter how
property rights are allocated.
4
4.2.2 Common Property Rights
An example of this situation is shing on international waters. Suppose that each agent
has only one boat, and the cost of sending the boat is constant. Then:
Equilibrium: R(X) = C
Pareto Eciency: Max XR(X) XC
In general, when there is a negative externality, the Pareto ecient outcome of shing
(production) will be less than the competitive one.
Figure 3: Social optimal versus private optimal. Graph from http://tutor2u.net
4.2.3 Congestion Externality
Suppose that there is a bridge with some demand for trips. The demand function is given
by:
X = t , > 0 t =
X

where X is the number of crossings and t the time per trip. In addition, there is a
congestion function
t = +X , > 0
4
MWG, page 357, second paragraph.
University of Washington Page 11
ECON501: Lecture Notes
Microeconomic Theory II
by Jorge Rojas
The conditions for this problem will be given by:
For Equilibrium:
X

. .
Marginal benet
= +X
. .
Marginal cost
For Pareto Eciency: First, we need to calculate the true marginal cost. This is
done as X private cost = X ( + X), then we just dierentiate to get the MC. On
the benet side, there is no change, since the externality is fully negative.
+ 2X
. .
Social marginal cost
=
X

. .
Marginal benet (unchanged)
To achieve the Pareto ecient outcome the government could install a toll. The idea
is to make the users pay the true value of their trips. Thus, the toll price should be
= P
Soc
P
Op
(assuming we already translated time to money).
Figure 4: Congestion in a bridge.
5 Practical Themes
5.1 Intertemporal Approach
There is one agent that consumes at two points in time and the interest rate, r, is
exogenously given. The agent, therefore, solves the problem:
Max
{C
0i
,C
1i
}
u(C
0i
, C
1i
) (9)
s.t. p
0
C
0i
+p
1
C
1i
= p
0

0i
+p
1

1i
or equivalently, C
0i
+
C
1i
1+r
=
0i
+

1i
1+r
since
p
0
p
1
= 1 +r.
University of Washington Page 12
ECON501: Lecture Notes
Microeconomic Theory II
by Jorge Rojas
5.2 Robinson Crusoe (Coop-structure)
There is one consumer and one rm that produces only one good with only one input
(labour). C: consumption
L: leisure per day
H: hours of work per day
Q = F(H): output produced
The rm wants to maximise prots (it wants more and more):
Max
{H}
= pF(H) wH (10)
while the consumer (who owns the rm) solves:
Max
{C,L}
u(C, L) (11)
s.t. pC = pC
0
+wH +

(p, w)
H +L = 24hrs
Remark 4. A brief note on Returns to Scale.
1. DRS prots are positive and the setup is compatible with perfect competition.
2. CRS prots are zero (zero-prot conditions) and is compatible with P.C.
3. IRS rm may run into innite size, but this setup is NOT compatible with P.C.
since the SOCs are never satised. (IRS implies a monopoly, duopoly or another
setup).
5.3 Fisher Separation Theorem
In a Robinson Crusoe two-periods type model, but with n agents. Each agent i solves
the problem:
Max
{C
0i
,C
1i
}
u(C
0i
, C
1i
) (12)
s.t. C
0i
+
C
1i
1+r
=
0i
+

1i
1+r
+
F
i
(I
0i
)
1+r
I
0i
where Q
1i
= F
i
(I
0i
) and I
0i
is the amount that is invested at t = 0 to produce Q
1i
. Agent
i has an initial endowment
i
Irving Fisher showed that this problem can be solved in two stages:
1. maximize the value produces by the rm, i.e.,
F
i
(I
0i
)
1+r
I
0i
2. using I

0i
solve the whole consumer problem
We dene the net borrowing for i as NB
i
= C

0i
+I

0i
(r)
0i
. In equilibrium we get that

I
i=1
NB
i
= 0.
University of Washington Page 13