General Equilibrium Analysis

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    What is a contract curve? What are the characteristics of allocations of a contract curve ?


    Contract curve is the locus of all Pareto optimal allocations in a general equilibrium model. The allocations which are Pareto optimal for both consumer A and B can be found on the points where their indifference curves are tangent to each other. This implies that at the points of contract curve the indifference curves of consumer A and B must have same slope or in terms of economics, for Pareto optimal allocations, the marginal rate of substitution for A and B should be equal.
    For Pareto optimal allocations:
    To be points on contract curves the allocations should also be feasible. Thus, we also require the feasibility condition, which states that the sum of allocation of good i with A and B must be equal to the sum of endowment of good i with both A and B

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    In economics, a contract curve refers to the set of allocations of goods or resources that are considered efficient and feasible within a given economic system. It is a fundamental concept in the study of microeconomics, particularly in the context of exchange economies and Pareto efficiency.

    Characteristics of allocations on a contract curve:

    1. Pareto Efficiency: All allocations on the contract curve are Pareto efficient, meaning that it is impossible to reallocate goods in a way that makes at least one individual better off without making anyone else worse off. In other words, the resources are allocated in a manner where no individual can be made better off without harming someone else.

    2. Feasibility: All allocations on the contract curve must be feasible, meaning that they can be achieved given the available resources and technology. Feasibility ensures that the allocations are practical and can be realized within the existing economic constraints.

    3. No Wastage: The contract curve represents allocations where all available resources are fully utilized, and there is no wastage or unused capacity. In other words, there is no potential for making anyone better off without reducing the well-being of someone else.

    4. Preference Independence: The contract curve is independent of individual preferences. It is solely determined by the production technology and the initial endowment of resources. It does not depend on the specific preferences or utility functions of individuals in the economy.

    5. No Externalities: The contract curve assumes that there are no externalities, meaning that the actions of one individual do not affect the well-being of others beyond the direct exchange of goods. In reality, externalities can exist and may affect the efficiency of market outcomes.

    The contract curve is an important concept in the study of welfare economics and provides a benchmark for evaluating market outcomes. In competitive markets, prices and quantities tend to converge toward the contract curve as individuals optimize their utility or profit-maximizing behavior. However, in the presence of market failures or externalities, the actual market outcomes may not reach the contract curve, leading to potential inefficiencies.

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