(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 628

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 6 units of clothing
between them. Table 16.1 shows that initially James has 7 units of food and 1
unit of clothing, and Karen 3 units of food and 5 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 1
unit of food, she will give up 3 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 1 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 3 units of clothing. But James will give up 1 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 1 unit of food by James for anywhere between
1/2 and 3 units of clothing from Karen.
Suppose Karen offers James 1 unit of clothing for 1 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 6

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 7 units of food; reading
upward along the vertical axis on the left of the diagram, we see that he has 1
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.