The 2 × 2 Exchange Economy
Key ideas: Pareto efficiency, Edgeworth Box diagram, first and second welfare theorems
In this chapter the focus shifts from the individual agent to the market. Specifically we examine the allocation that results if all economic agents are price takers and prices adjust until markets clear. Rather than attempt to bring firms and consumers into the analysis all at once, we focus here on equilibrium in which there is no production. Consumers have endowments of commodities that they may exchange. As we see later, the ideas developed here extend very directly to economies with production.
Even though this chapter focuses on equilibrium outcomes, it is helpful to keep in mind a possible adjustment process that might lead to equilibrium. Suppose that there is an auctioneer who calls out prices for each of the commodities. Consumers and firms respond with the demands that they would make at these prices. The auctioneer lowers prices in markets where there is excess supply and raises them in markets where there is excess demand. At a price-taking (Walrasian) equilibrium, all markets clear.