Intermediate Microeconomic

Theory

Buying and Selling

An Endowment Economy

We have now developed a theory of choice.

Given this theory, we can already consider

the role of markets and prices.

As is the norm in economic theory, we start

with the simplest possible world and build
up.

So consider a desert island economy (a

Robinson Crusoe economy).

An Endowment Economy

Key feature of this simple economy, is that

there is no money, only goods.

Specifically, an individual is endowed

with a given amount of various goods.

If there is a market, an individual can

potentially choose to trade some of his
endowed amount of one good for more of
another.

An Endowment Economy

For simplicity, assume there are only

two goods on island:

coconut milk
mangos

Budget Set:

Suppose Al (one of the inhabitants) has

endowment of wc = 8 and wm = 4 (8 gallons
of coconut milk and 4 lbs. of mangos).

If there were no markets on the island,

how would we graphically depict Als
budget set?

Budget Set in an Endowment Economy

How would Als budget set change if 1gallon

coconut milk could be traded for 1/2 lb. of
mangos and vice versa?

How about if 1gallon coconut milk could be

traded for 2 lbs. of mangos?

How would Als budget set be affected by the

above price changes if his endowment was 10
gal. coconut milk, 0 mangos?
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Buying and Selling in an Endowment

Economy
Preferences:

Suppose the utility Al gets from coconut milk and

mangos is given by some utility function u(q c,qm).

Further suppose that by consuming his endowment

he gets utility of u(8, 4) and his MRS at (8,4) is -1.
qm

slope = -1
4

qc
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Buying and Selling in an Endowment

Economy

Market Participation:

Suppose a market opened up where

Al could buy 1 gal. milk for 2 lbs.
of mangos and vice versa .
What would Al do? Would this
market make Al better off?

Suppose instead a market opened up

where Al could buy 1 gal. coconut
milk for 1/2 lb. of mangos and vice
versa.
What would Al do? Would this
market make Al better off?

Buying and Selling in an Endowment

Economy

So in an endowment economy with 2 goods,

If an individual chooses to consume a bundle with

more of good 1 than he is endowed with (and
therefore less of good 2 than he is endowed with), he
must be a buyer of good 1 and a seller of good 2.

If an individual chooses to consume a bundle with

less of good 1 than he is endowed with (and therefore
more of good 2 than he is endowed with), he must be
a seller of good 1 and a buyer of good 2.

Buying and Selling in an Endowment

Economy

What relative price (i.e. terms of trade) would cause Al to

be neither a buyer or a seller of coconuts?

Buying and Selling in an Endowment

Economy

Clearly what matters is relative price.

We have been calculating the price of a gallon of coconut

milk in terms of lbs of mangos
e.g. 1 more gal coconut milk costs X lbs of mangos.

Note: this system could be adopted for any number of

goods.

1 lb of fish costs Y lbs of mangos

2 sharpened stones cost Z lbs. of mangos.

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Buying and Selling in an Endowment

Economy

Therefore, for a market with K goods, we only need K-1 prices,

and make one good a numeraire (a good we compute every other
goods price relative to).

So we have been using lbs of mangos as numeraire, meaning pc = 2 implies

one more gal coconut milk costs 2 lbs mangos.
What would be cost of another lb of mangos if mangos are numeraire?
Alternatively, we could use coconut milk as numeraire good, then pm = 1/2
implies that one would need to trade 1/2 gal coconut milk for one more lb. of
mangos.
What would be cost of another gal of coconut milk now?

Note that regardless of which good we select as numeraire, relative terms

of trade are the same (i.e. 2 lbs mangos traded for 1 gal coconut milk is
equivalent to 1 lb mangos traded for lb coconut milk)
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Buying and Selling in an Endowment

Economy

Are there historic examples of numeraire

goods in primitive economies?

In what way did numeraire type goods

come up in NYT article on barter goods in
Russia?

Note: Numeraire goods are completely

distinct from composite goods.

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Buying and Selling in an Endowment Economy

Analytically

Lets consider Al again.

Let his endowment be given by {wc ,wm}

Suppose mangos are the numeraire good and the relative price of
coconuts is pc.

Suppose Als preferences are captured by a generic Cobb-Douglas

utility function u(qc,qm) = qcaqmb

How do we analytically describe Als behavior?

What is general form of his budget constraint?

What is general expression for his optimal bundle?

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Buying and Selling in an Endowment Economy

Analytically

So for generic Cobb-Douglas preferences u(qc,qm) = qcaqmb, with

endowment {w1,w2} and relative prices such that one more unit of
good 1 costs p1 units of good 2 (the numeraire), the optimal bundle
will again be given by the corresponding demand functions, which
will now be:

a p1w1 (1) w2
q1 ( p1 , w1 , w2 )
ab
p1
b p1w1 (1) w2
q2 ( p1 , w1 , w2 )
ab
1

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Buying and Selling in an Endowment Economy

Analytically

Define: qcA(pc, wcA,wmA) as Als gross demand for coconut milk

qmA(pc, wcA,wmA) as Als gross demand for mangos.

If qcA(pc, wcA,wmA) wcA > 0, Al buys coconut milk, or is net demander

of coconut milk,
If qcA(pc, wcA,wmA) wcA < 0, Al sells coconut milk, or is net supplier of
coconut milk.
Analogue holds for mangos.

Also note that:

If qcA(pc, wcA,wmA) wcA > 0, then qmA(pc, wcA,wmA) wmA < 0, and

If qmA(pc, wcA,wmA) wmA > 0, then qcA(pc, wcA,wmA) wcA < 0

Intuitively, if Al is buying coconut milk, he must be selling mangos, and

vice versa.
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Buying and Selling in an Endowment Economy

Analytically

Example:

Let his preferences be captured by U= qc0.5qm0.5 and

endowment be given by wc = 8 and wm = 4.

Suppose mangos numeraire and the relative price of coconut milk in terms of
lbs of mangos is pc = 2

What will be Als gross and net demands for coconut milk?

What will this mean about whether Al is a net demander or net supplier of
mangos?

What if the relative price of coconuts (in terms of mangos) dropped to p c =

0.50?
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Buying and Selling in an Endowment

Economy
Als Gross Demands when 1 coconuts
Als Gross Demands when 1 coconut
can be traded for lb mango
(pc = 0.50)

can be traded for 2 mangos

(pc = 2)
qm
qm

8
10

qmA
qm A
8
qcA

12

qc

16

qcA

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Buying and Selling in an Endowment Economy

Analytically

Example (alternate numeraire):

What would happen if we used coconut milk as numeraire, with p m = 0.5, but let
Als endowment again be given by wc = 8 and wm = 4?

What will be Als gross and net demands for coconut milk?

What will this mean about whether Al is a net demander or net supplier of
mangos?

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Revealed Preference

Suppose:

Bob is endowed with 4 gal. coconut milk

and 4 lbs. mangos.
Current price of 1 gal. coconut milk in
terms of lbs of mangos is 2 (i.e. pc = 2)
At these prices, we know Bob is a net
demander of coconut milk.

If price of gal. of coconut milk fell pc = 1,

would Bob still be net demander of
coconut milk?

What if price of gal. of coconut milk rose

to pc = 3, would Bob still be a net
demander of coconut milk?
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