Does a price system equilibrium yield efficient prices?

The EdgeworthFrancis Edgeworth (1845–1926) introduced a variety of mathematical tools, including calculus, for considering economics and political issues, and was certainly among the first to use advanced mathematics for studying ethical problems. box considers a two-person, two-good “exchange economy.” That is, two people have utility functions of two goods and endowments (initial allocations) of the two goods. The Edgeworth box is a graphical representation of the exchange problem facing these people and also permits a straightforward solution to their exchange problem.

Figure 14.1 The Edgeworth box

What points are efficient? The economic notion of efficiency is that an allocation is efficient if it is impossible to make one person better off without harming the other person; that is, the only way to improve 1’s utility is to harm 2, and vice versa. Otherwise, if the consumption is inefficient, there is a rearrangement that makes both parties better off, and the parties should prefer such a point. Now, there is no sense of fairness embedded in the notion, and there is an efficient point in which one person gets everything and the other gets nothing. That might be very unfair, but it could still be the case that improving 2 must necessarily harm 1. The allocation is efficient if there is no waste or slack in the system, even if it is wildly unfair. To distinguish this economic notion, it is sometimes called Pareto efficiency.Vilfredo Pareto (1848–1923) was a pioneer in replacing concepts of utility with abstract preferences. His work was later adopted by the economics profession and remains the modern approach.

We can find the Pareto-efficient points by fixing Person 1’s utility and then asking what point, on the indifference isoquant of Person 1, maximizes Person 2’s utility. At that point, any increase in Person 2’s utility must come at the expense of Person 1, and vice versa; that is, the point is Pareto efficient. An example is illustrated in Figure 14.2 "An efficient point".

Figure 14.2 An efficient point

This process of identifying the points that are Pareto efficient can be carried out for every possible utility level for Person 1. What results is the set of Pareto-efficient points, and this set is also known as the contract curve. This is illustrated with the thick line in Figure 14.3 "The contract curve". Every point on this curve maximizes one person’s utility given the other’s utility, and they are characterized by the tangencies in the isoquants.

The contract curve need not have a simple shape, as Figure 14.3 "The contract curve" illustrates. The main properties are that it is increasing and ranges from Person 1 consuming zero of both goods to Person 2 consuming zero of both goods.

Figure 14.3 The contract curve

Example: Suppose that both people have Cobb-Douglas utility. Let the total endowment of each good be one, so that x_{2} = 1 – x_{1}. Then Person 1’s utility can be written as

\(\begin{equation}u_{1}=x^{a} y^{1-a}\end{equation}\), and 2’s utility is \(\begin{equation}u_{2}=(1-x)^{\beta}(1-y)^{1-\beta}\end{equation}\) Then a point is Pareto efficient if

\begin{equation}αy (1−α)x = ∂ u 1 ∂x ∂ u 1 ∂y = ∂ u 2 ∂x ∂ u 2 ∂y = β(1−y) (1−β)(1−x) .\end{equation}

Thus, solving for y, a point is on the contract curve if

\begin{equation}y= (1−α)βx (1−β)α+(β−α)x = x (1−β)α (1−α)β + β−α (1−α)β x = x x+( (1−β)α (1−α)β )(1−x) .\end{equation}

Figure 14.4 Contract curves with Cobb-Douglas utility

Key Takeaways

The Edgeworth box considers a two-person, two-good “exchange economy.” The Edgeworth box is a graphical representation of the exchange problem facing these people and also permits a straightforward solution to their exchange problem. A point in the Edgeworth box is the consumption of one individual, with the balance of the endowment going to the other.

Pareto efficiency is an allocation in which making one person better off requires making someone else worse off—there are no gains from trade or reallocation.

In the Edgeworth box, the Pareto-efficient points arise as tangents between isoquants of the individuals. The set of such points is called the contract curve. The contract curve is always increasing.

EXERCISES

If two individuals have the same utility function concerning goods, is the contract curve the diagonal line? Why or why not?

For two individuals with Cobb-Douglas preferences, when is the contract curve the diagonal line?