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CHAPTER 16 • General Equilibrium and Economic Efficiency 603 TABLE 16.1 INDIVIDUAL THE ADVANTAGE OF TRADE INITIAL ALLOCATION TRADE FINAL ALLOCATION James 7F, 1C - 1F, + 1C 6F, 2C Karen 3F, 5C + 1F, - 1C 4F, 4C Suppose James and Karen have 10 units of food and units of clothing between them Table 16.1 shows that initially James has units of food and unit of clothing, and Karen units of food and units of clothing To decide whether a trade would be advantageous, we need to know their preferences for food and clothing Suppose that because Karen has a lot of clothing and little food, her marginal rate of substitution (MRS) of food for clothing is 3: To get unit of food, she will give up units of clothing However, James’s MRS of food for clothing is only 1/2: He will give up only 1/2 a unit of clothing to get unit of food There is thus room for mutually advantageous trade because James values clothing more highly than Karen does, whereas Karen values food more highly than James does To get another unit of food, Karen would be willing to trade up to units of clothing But James will give up unit of food for 1/2 unit of clothing The actual terms of the trade depend on the bargaining process Among the possible outcomes are a trade of unit of food by James for anywhere between 1/2 and units of clothing from Karen Suppose Karen offers James unit of clothing for unit of food, and James agrees Both will be better off James will have more clothing, which he values more than food, and Karen will have more food, which she values more than clothing Whenever two consumers’ MRSs are different, there is room for mutually beneficial trade because the allocation of resources is inefficient: Trading will make both consumers better off Conversely, to achieve economic efficiency, the two consumers’ MRSs must be equal This important result also holds when there are many goods and consumers: An allocation of goods is efficient only if the goods are distributed so that the marginal rate of substitution between any pair of goods is the same for all consumers The Edgeworth Box Diagram If trade is beneficial, which trades can occur? Which of those trades will allocate goods efficiently among customers? How much better off will consumers then be? We can answer these questions for any two-person, two-good example by using a diagram called an Edgeworth box Figure 16.4 shows an Edgeworth box in which the horizontal axis describes the number of units of food and the vertical axis the units of clothing The length of the box is 10 units of food, the total quantity of food available; its height is units of clothing, the total quantity of clothing available In the Edgeworth box, each point describes the market baskets of both consumers James’s holdings are read from the origin at OJ and Karen’s holdings in the reverse direction from the origin at OK For example, point A represents the initial allocation of food and clothing Reading on the horizontal axis from left to right at the bottom of the box, we see that James has units of food; reading upward along the vertical axis on the left of the diagram, we see that he has unit of clothing For James, therefore, A represents 7F and 1C This leaves 3F and • Edgeworth box Diagram showing all possible allocations of either two goods between two people or of two inputs between two production processes
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