General equilibrium theory

Lecture notes

Alberto Bisin
Dept. of Economics
NYU

November 5, 2011
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Contents

1 Introduction 1

2 Demand theory: A quick review 3

2.1 Consumer theory . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.1.1 Duality . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.1.2 Aggregate demand . . . . . . . . . . . . . . . . . . . . 11
2.2 Producer theory . . . . . . . . . . . . . . . . . . . . . . . . . . 12

3 Arrow-Debreu exchange economies 17

3.1 The economy . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.2 Pareto e ciency . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.3 Competitive equilibrium . . . . . . . . . . . . . . . . . . . . . 19
3.3.1 Uniqueness . . . . . . . . . . . . . . . . . . . . . . . . 23
3.3.2 Local uniqueness . . . . . . . . . . . . . . . . . . . . . 23
3.3.3 Dierentiable approach: A rough primer . . . . . . . . 25
3.3.4 Competitive equilibrium in production economies . . . 31
3.4 Mathematical appendix . . . . . . . . . . . . . . . . . . . . . . 31
3.4.1 References . . . . . . . . . . . . . . . . . . . . . . . . . 34
3.5 Strategic foundations . . . . . . . . . . . . . . . . . . . . . . . 34

4 Two-period economies 35
4.1 Arrow-Debreu economies . . . . . . . . . . . . . . . . . . . . . 35
4.2 Financial market economies . . . . . . . . . . . . . . . . . . . 38
4.2.1 The stochastic discount factor . . . . . . . . . . . . . . 42
4.2.2 Arrow theorem . . . . . . . . . . . . . . . . . . . . . . 44
4.2.3 Existence . . . . . . . . . . . . . . . . . . . . . . . . . 46
4.2.4 Constrained Pareto optimality . . . . . . . . . . . . . . 47
4.2.5 Aggregation . . . . . . . . . . . . . . . . . . . . . . . . 54

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4.2.6 Asset pricing . . . . . . . . . . . . . . . . . . . . . . . 63

4.2.7 Some classic representation of asset pricing . . . . . . . 63
4.2.8 Production . . . . . . . . . . . . . . . . . . . . . . . . 68

5 Asymmetric information 79
5.1 A simple insurance economy . . . . . . . . . . . . . . . . . . . 80
5.1.1 The Symmetric information benchmark . . . . . . . . . 81
5.2 The moral hazard economy . . . . . . . . . . . . . . . . . . . . 82
5.3 The adverse selection economy . . . . . . . . . . . . . . . . . . 85
5.4 Information revealed by prices . . . . . . . . . . . . . . . . . . 86
5.4.1 References . . . . . . . . . . . . . . . . . . . . . . . . . 90

6 Innite-horizon economies 93
6.1 Asset pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
6.1.1 Arrow-Debreu economy . . . . . . . . . . . . . . . . . . 94
6.1.2 Financial markets economy . . . . . . . . . . . . . . . 94
6.1.3 Conditional asset pricing . . . . . . . . . . . . . . . . . 95
6.1.4 Predictability or returns . . . . . . . . . . . . . . . . . 97
6.1.5 Fundamentals-driven asset prices . . . . . . . . . . . . 98
6.2 Bubbles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
6.2.1 (Famous) Theoretical Examples of Bubbles . . . . . . . 106
6.3 Double Innity . . . . . . . . . . . . . . . . . . . . . . . . . . 108
6.3.1 Overlapping generations economies . . . . . . . . . . . 111
6.4 Default . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

7 To add 123
Chapter 1

Introduction

These notes constitute the material for the second half of the Micro I (rst
year) graduate course at NYU. They owe much to the brilliant TAs I had,
Sevgi Yuksel and (somewhat in expectations) Bernard Herskovic. The topic
of this section of the course is general equilibrium theory (the other section,
decision theory, is taught by Ariel Rubinstein).
The standard approach to graduate teaching of general equilibrium the-
ory involves introducing a series of theorems on existence, characterization,
and welfare properties of competitive equilibria under weaker and weaker
assumptions in larger and larger commodity spaces. Such an approach intro-
duces the students to precise rigorous mathematical analysis and invariably
impresses them with the elegance of the theory. Various textbooks take this
approach, in some form or another:

A. Mas-Colell, M. Whinston, and J. Green (1995): Microeconomic Theory,

Oxford University Press, Part 4, is the main reference; it also contains
a short introduction to two-period economies.

L. McKenzie (2002), Classical General Equilibrium Theory, MIT Press, is a

beautiful modern treatment of the classical theory.

K. Arrow and F. Hahn (1971): General Competitive Analysis, North Hol-

land, is the classical treatment of the classical theory.1
1
And so is G. Debreu (1972), Theory of Value: An Axiomatic Analysis of Economic
Equilibrium, Cowles Foundation Monographs Series, Yale University Press, an invaluable
little book for several generations of theorists.