Competitive Equilibrium

Question 1

How do we find the competitive equilibrium?

Answer 1

• We need to introduce the price mechanism, via a trading process, to adjust prices so that we find a price ratio where the market is in equilibrium.
• The two consumer’s price ratios will be equal, and demand will equal supply at equilibrium.

Question 2

The trading system

Answer 2

• This comes in the form of a budget constraint.
• It will pass through the endowment point, as the two consumers could just return to their original endowment.
• Its slope will change as the price ratio changes and will pivot around the endowment point as this happens.

Question 3

What happens when there is excess supply and demand?

Answer 3

The price ratio CHANGES until the price ratios of the two consumers are equal.

Excess supply: price falls.
Excess demand: price increases.

If there is excess demand on the x-axis and excess supply on the y axis, the budget constraint will get flatter around the endowment point.

If there is excess supply on the x-axis and excess demand on the y axis, the budget constraint will get steeper around the endowment point.