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Topic #3

General Equilibrium

Our consumer theory will have a framing premise and three assumptions. A framing premise is something that cant be proven its either accepted or rejected. Our framing premise is that individuals are self-interested. That is, they act to be made as well off as possible under the circumstances. Further, our consumers are rational and goal-directed. We assume that they act in a purposeful manner. This does not mean that our consumers are selfish. Being self-interested does not mean you benefit from depriving others. For example, let Carols ordinal utility be represented by the following equation, U = F + B, where F is footballs and B is books. An indifference curve connects all the consumption bundles that generate the same level of utility. Thus, a consumer is indifferent among the consumption bundles on a particular indifference curve. For example, the following indifference curves represents X units of utility. Higher indifference curves yield more utility. Thus, consumption bundles to the north-east are superior bundles and consumption bundles to the south-west are inferior bundles.
Footballs 36 16 1 4 16 49 Books a d b INFERIOR BUNDLES c Figure 1 SUPERIOR BUNDLES

In addition, our theory has three assumptions: 1. Completeness - the consumer has and can rank in order of preference all consumption items. No flipping of coins or enemeneminemo. 2. Transitivity - preferences are rational and consistent. No rock, paper, scissors. The following indifference map violates the assumption of transitivity. For example, try to rank consumption bundles a, b, and c. Consumption Good Y a c b

Consumption Good X It appears that a>b, a=c, and b=c, which does not make sense. So, we conclude that indifference curves can't intersect. 3. Nonsatiation - more is preferred to less. This means that indifference curves cant be positively sloped and that indifference curves cant be fat. The Marginal Rate of Substitution (MRSYX) is the amount of the consumption good measured on the Y axis that an individual would be willing to give up in order to obtain another unit of the consumption good measured on the X axis. We assume that the marginal rate of substitution is diminishing as we move from left to right along an indifference curve. This makes indifference curves convex. For example MRSFB is the maximum amount of footballs the consumer is willing to give up to obtain another book. Find the MRS between bundles a and b and b and c. Does the MRS increase or decreases as we move from left to right? Suppose consumption bundle e has 49 footballs and 1 book. Calculate the MRS between e and a.
Footballs 36 16 1 16 49 Books a b c Figure 1

Formally, U = MUF(F) + MUB(B). Since utility is constant along an indifference curve, 0 = MUF(F) + MUB(B) when calculating MRS. Thus, MUB/MUF = F/B. To see why the MRS is diminishing, suppose I give you 10 large pizzas (each with 10 slices) and 1 six-pack of coke. What is the maximum number of slices of pizza would you be willing to give up in order to obtain one more six-pack of coke? Suppose instead that I give you 1 large pizza (with 10 slices) and 10 six-packs of coke (60 cokes). What is the maximum number of slices of pizza would you be willing to give up in order to obtain one more six-pack of coke?

Now, is your answer to the first question larger than to the second? If so, then you exhibit a diminishing MRS. Again, this is why indifference curves are convex to the origin. Suppose Bill really likes footballs relative to books and that a nerd really likes books relative to footballs. Draw a set of indifference curves for Bill and a set for the nerd on the same graph that represent the above information about their preferences. If they intersect each other, have we violated an axiom? Footballs Nerd

Bill

Books Thus far, our theory of consumer choice has suggested that to maximize utility, individuals will consume an infinite amount of consumption goods. However, this does not represent the behavior of consumers in the real world because consumers are constrained by scarcity. In particular, consumption goods cost money and consumers have limited resources. Therefore, we must derive a budget constraint that illustrates the consumption bundles that are attainable given a consumers scarce resources. Suppose that a consumer has income of I, consumption good 1 costs p1 per unit, and consumption good 2 costs p2 per unit. The following budget constraint defines what combinations of consumption goods 1 and 2 that are attainable. Good 2 I/p2

I/p1

Good 1

Note that the slope of the budget constraint is p1/p2. In other words, the opportunity cost in terms of good 2 of consuming 1 more unit of good 1 is p1/p2. The slope of the budget constraint is always given by the price of the good measured on the X axis divided by the price of the good measured on the Y axis. Footballs Nice, But Unattainable

b c d Attainable, But Inferior

Books We can rank the consumption bundles as follows: a > c > b = d. But, consumption bundle a is unattainable. So, consumption bundle c maximizes utility. Now consider an economy with only two consumers. Let the consumers have endowment bundles of two goods. Further, let the two consumers trade to achieve the highest possible utility. We depict this with an Edgeworth box. Suppose Mr. Smith and Ms. Jones live on an island with no contact with the outside world. Each owns a part of the island and, with no labor expended, each obtains a positive quantity of both apples and bananas from his/her part of the island. No production is possible. Let endowments be S = ( Sa, Sb) >> 0 and J = ( Ja, Jb) >> 0.
Apples Jones Bananas W W*

Bananas Smith Apples

Mr. Smith and Mrs. Jones will engage in trade only if their MRS are not equal at the initial endowment when that endowment lies in the interior. As drawn, USa/USb > UJa/UJb at W*. For trade to take place, neither trader can be made worse off. Therefore, only points in the eye between the two indifference curves are acceptable. Mutually advantageous trade is possible because Smith can move to a higher indifference curve by trading bananas for apples, and Jones can move to a higher indifference curve by trading apples for bananas: (USa/USb) decreases until it equals (UJa/UJb), which correspondingly increases. Trade will take place only if MRSS doesnt equal MRSJ. If they are equal, such as at point W, then no gains can be had by trading. Suppose one or both of the 2 people have a positive endowment of only one good. The endowment must lie on the boarder of the Edgeworth box. As before, agents will trade if their MRS are not equal. However, we must consider the feasibility of the trades. In certain instances, Pareto improvements will not be feasible.
Apples W2 Bananas W1 W3 Jones

Bananas W4 Smith Apples

At W1 and W2: USa/USb > UJa/UJb. At W3 and W4: USa/USb < UJa/UJb. W1, W2: Smith trades b for a and Jones trades a for b: (USa/USb) decreases until it equals (UJa/UJb), which increases. W3, W4: Smith trades a for b and Jones trades b for a: (USa/USb) increases until it equals (UJa/UJb), which decreases.

All of the above are feasible, so trade can take place.

Apples W6

Jones Bananas

W5

W7

Bananas W8 Smith Apples

At W5 and W6, USa/USb < UJa/UJb. At W7 and W8, USa/USb > UJa/UJb. At W5 and W6, Smith wants to trade a for b but WSa = 0. Jones wants to trade b for a, but WJb = 0. At W7 and W8, Smith wants to trade b for a but WSb = 0. Jones wants to trade a for b, but WJa = 0. Since these are not feasible, trade cannot take place. If the two agents trade, the trade must be feasible and acceptable (neither trader is worse off and the trades are Pareto optimal: within the eye and on the contract curve). The first part says trade to a feasible allocation must make neither agent worse off. The second part says that the trade is Pareto optimal since nobody can be made better off at any other feasible allocation without making the other agent worse off. These conditions narrow the set of trades to the section of the contract curve that lies within the eye. Feasible can be expressed as: xSi + xJi = Si + Ji for i = a and b. Acceptable can be expressed as: US(xs) US( S), UJ(xJ) UJ( J), and for any y x, if US(yS) > US(xS) then UJ(yJ) < UJ(xJ). Now suppose that a ship comes and from then on they are connected to world markets. In world markets, the price of apples is pa and the price of bananas is pb. They can trade freely at world prices. Once connected to world markets, the agents face the price ratio pa/pb. They are now competitive agents unable to affect the terms of the trade between the two

goods. The trades will be the selection of xS and xJ that maximize Ui(xia,xib) such that pa ia + pb ib = paxia + pbxib for i = S and J. The agents are no longer constrained by the feasibility condition defined by the dimensions of the Edgeworth Box. Thus, it is not necessary for trades to take place such that each agents indifference curve is tangent to the budget line at the same point. The first order condition to the maximization problem is Uia/Uib = pa/pb for i = S and J. Again, neither will make a trade that makes them worse off. Note also that the budget line must pass through the endowment. Since Uia/Uib = pa/pb for i = S and J, no further gains can be made by trading between themselves. Given these conditions (trade with the outside world), the two consumers will not trade with the outside world only if world price ratio pa/pb is such that the utility maximizing trade with the outside world are feasible between themselves. Each would equate MRS to pa/pb and the outcome would be a tangency between the agents indifference curves. Pareto Optimal Allocation: an allocation (x*) for which no other allocation (x) exists with the property that the other allocation (x) is preferred to x* by at least one consumer with the other consumer(s) being indifferent between x* and x. Core or Contract Curve: the set of Pareto Optimal Allocations that dominate the initial endowment. Walrasian Equilibrium: an allocation (x*) and a price vector (p*) such that (i) x* maximizes each consumers utility given each consumers budget constraint and (ii) demand equals supply in all markets with x*. Excess demand function: (denoted by z) is the difference in the amount of a good demanded (x*) and the endowment of that good x: z = x* - x. Example 1: Consider the following pure exchange, Edgeworth box economy. There are 2 consumers and 2 goods. Consumer 1 has an endowment of 7 units of good 1 and 3 units of good 2 (i.e. 1 = (7,3)), while consumer 2 has an endowment of 3 units of good 1 and 7 units of good 2 ( 2 = (3,7)). The consumers utility functions are given by: U1 = x11 + x12 and U2 = min{x21,x22} where xi1 is consumption of good 1 by consumer i. a) Find the set of Pareto optimal allocations of this economy. b) Find the core of the economy. c) Find the Walrasian equilibrium. The indifference curves of consumer 1 are straight lines and the indifference curves of consumer 2 are Leontief. The set of Pareto optimal allocations is the 45 degrees line in the Edgeworth Box. That is, the set {x11,x12,x21,x22} such that {x11=x12, x21 = x22, x11 + x21 = 10, x12+x22 = 10}. b) The core is the dark dotted line in the Edgeworth Box. It is the subset of Pareto optimal allocations such that consumer 1 has at least 5 units of each good and consumer 2 has at
a)

least 3 units of each good. That is, the set {x11, x21, x12, x22} such that x11 = x12 5, x21=x22 3, where x11 + x21 = 10 and x12 + x22 = 10}. c) There is a unique Walresian equilibrium: x11* = x21* = x12* = x22* = 5, p1*/p2* = 1. This is found by maximizing utility for consumer 1: max U1 such that p1x11 + p2x12 = p17 + p23, or max(x11, x12): x11 + x12 + { p1x11 + p2x12 - p17 - p23} which gives the following three first order conditions: 1 - p1 = 0 1 - p2 = 0 (which with the 1st first order condition implies that p1/p2 = 1) p1x11 + p2x12 - p17 - p23 = 0 so, x11 = (7p1 + 3p2 p2x12)/p1. We know that with Leontief preferences, x21 = x22 at the optimum. Therefore, (p1 + p2)x11 = 7p1 + 3p2 , x12 = x11 = (7p1+3p2)/(p1+p2) = (7+3)/2 = 5. So, x12 = x11 = 5 and x22 = x21 = 5.
10 Good 1 5 3 Consumer 2 Good 2 5 Core 5

3 Good 2 Consumer 1 Good 1 5 7

7 10

Example 2: Consider the following pure exchange, Edgeworth Box economy. There are 2 consumers and 2 goods. Consumer 1 has an endowment of 8 units of good 1 and 30 units of good 2 ( 1 = (8,30)), while consumer 2 has an endowment of 10 units of each good ( 2 = (10,10)). The consumers utility functions are given by: U1 = x11x12 + 12x11 + 3x12 and U2 = x21x22 + 8x21 + 9x22. a) Determine the excess demand functions for the two consumers. b) Find an equilibrium price ratio for this economy. Sketch the situation in an Edgeworth Box. Consumer 1 maximizes x11x12 + 12x11 + 3x12 such that p1x11 + p2x12 = 8p1 + 30p2. The first order conditions are: x12 + 12 - p1 = 0, x11 + 3 - p2 = 0, and p1x11 + p2x12 - 8p1 - 30p2 = 0

Solve for x11 and x12: x11 = 5/2 + 21p2/p1 (demand function of good 1 by consumer 1) and x12 = 9 + 11p1/2p2 (demand function for good 2 by consumer 1). Thus, the excess demand functions of consumer 1 are: z11 = 5/2 + 21p2/p1 8 = 21p2/p1 11/2 and z12 = 9 + 11p1/2p2 30 = 11p1/2p2 21. Consumer 2 maximizes x21x22 + 8x21 + 9x22 such that p1x21 + p2x22 = 10p1 + 10p2. The first order conditions are: x22 + 8 - p1 = 0, x21 + 9 - p2 = 0, and p1x21 + p2x22 - 10p1 - 10p2 = 0 Solve for x21 and x22 to get x21 = + 9p2/p1 (demand function for good 1 by consumer 2) and x22 = 1 + 19p1/2p2 (demand function for good 2 by consumer 2). The excess demand functions are: z21 = + 9p2/p1 10 = 9p2/p1 19/2 and z22 = 1 + 19p1/2p2 10 = 19p1/2p2-9. At equilibrium, z11 + z21 = z12 + z22 = 0. So, z11 + z21 = 21p2/p1 11/2 + 9p2/p1 19/2 = 30 p2/p1 15. Hence, p2/p1 = or p1/p2 = 2 is an equilibrium price ratio and it is unique. Therefore, x11 = 13, x12 = 20, x21 = 5, and x22 = 20.
10 5 Good 1 Consumer 2 Good 2 30 W* 20 20 10

Good 2 Consumer 1 8 13 Good 1

Example 3: Consider the following pure exchange, Edgeworth box economy. There are 2 consumers and 2 goods. Consumer 1 has an endowment of 1 unit of good 1 and 2 units of good 2 (i.e. 1 = (1,2)), while consumer 2 has an endowment of 2 units of good 1 and 1 unit of good 2 ( 2 = (2,1)). The consumers utility functions are given by: U1 = ln(x11) + (1-)ln(x12) and U2 = ln(x21) + (1-)ln(x22) where xi1 is consumption of good 1 by consumer i, i = 1, 2. Find the Walrasian equilibrium.

The Legrangian for consumer 1 is Maxx11,x12: ln(x11) + (1-)ln(x12) + (p1x11+p2x12-p1-2p2). The first order conditions are: (1/x11) + p1 = 0 (1-)(1/x12) + p2 = 0 and p1x11 + p2x12 p1 2p2 = 0 From the first order conditions, x11 = (p1+2p2)/p1 and x12 = (1-)(p1+2p2)/p2. We can do the same for consumer 2 to get x21 = (2p1+p2)/p1 and x22 = (1-)(2p1+p2)/p2. To find the Walrasian equilibrium, set supply equal to demand: x11 + x21 = 11 + 21, or (p1 + 2p2)/p1 + (2p1+ p2)/p1 = 1 + 2 3p1 + 3p2 = 3p1 p2 = (1-)p1 so p1/p2 = /(1-). Now, plug the price vector back into the demand functions to get x11 = 2-, x12 = 2-, x21=1+, and x22 = 1+. Example 4: Consider a two-period economy with n individuals and a single good in each period. The n individuals have identical preferences given by the utility function U(c0, c1) = ln(c0) + ln(c1) where c0 denotes the individuals period 0 consumption and c1 denotes period 1 consumption. Each individual has an endowment of one unit of period 0 good and zero units of period 1 good. Each individual has an equal share in the economys only firm, which has production function x1 = (x0)1/2, where x1 denotes production of period 1 good and x0 denotes the input of period 0 good. In period 0, the firm purchases the period 0 good to use as an input in the production of the period 1 good which it sells in period 1. In period 0, each individual decides how much of the endowment to consume and how much to sell to the firm. In period 1, the individual purchases period 1 good from the firm. Let p0 and p1 denote the period 0 and period 1 prices. Set up and solve the firms profit maximization problem taking prices as given. b) First, find a representative individuals demand functions for period 0 and period 1 consumption, taking prices as given. Then, find the market demand functions. c) Define Walrasian equilibrium for this economy. Normalize prices by taking p0 = 1. Solve for the equilibrium price in period 1.
a) a)

The profit function is = p1(x0)1/2 p0x0. The first order condition is 0.5p1(x)-1/2 = p0. So, x0 = (0.5p1/p0)2 and x1 = 0.5p12/p0. Corresponding profits are = p1(x0)1/2 p0x0
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b)

p1((0.5p1/p0)2)1/2 p0(0.5p1/p0)2 2p122/4p0 p122/4p0 = p122/4p0. Profits for each consumer are /n = p122/4np0. The utility maximization equation is L(x0, x1, ): ln(c0) + ln(c1) + (p0 p0c0 p1c1 + p122/4np0). The first order conditions are 1/c0 p0 = 0 /c1 p1 = 0 and p0 p0c0 p1c1 + p122/4np0. From the first two first order conditions, (1/c0)/(/c1) = p0/p1 c1/c0 = p0/p1 c1 = (p0/p1)c0. Subbing this into the third first order condition, p0 p0c0 p1((p0/p1)c0) + p122/4np0 = 0 p0 p0c0 p0c0 + p122/4np0 = 0 p0 + p12 2/4np0 = c0(1+ )p0 c0 = [p0 + (p12 2/4np0)] / (1+)p0 c0 = p0/(1+ )p0 + p12 2/n4p0(1+ )p0 c0 = 1/(1+ ) + p12 2/4p02(1+ )n c0 = (n4p02 + p12 2)/n4(1+ )p02. c1 = (p0/p1)c0 = (p0/p1) [n4p02 + p12 2)/n4(1+ )p02] = (p0/p1)(/(1+)) + p12/(4n(1+)p0) = p122/(4n(1+)p0p1) + (p02/p1)(/(1+))(4n/4np0) Thus, solving for c0 gives c0 = (n4p02 + p122)/4n(1+)p02 and c1 = (p122 + p024n)/(p1p0(1+)4n.

c)

To solve for the equilibrium, set nc1 = x1 (demand equals supply in the output market) or n(1-c0) = x0 (demand equals supply in the input market). Either will generate an equilibrium price of p1 = 2(n)1/2/(+2)1/2. For example, let nc1 = x1. n(1 [(4np02 + p122)/4n(1+)p02] = (p1/2p0)2 + n n [(n4p02 + p122)/ 4(1+)p02] = p122/4p02 4np02(1+) n4p02 p122 = (1+)p122 4np02 + 4np02 4np02 p122 = p122 + p122 4np02 = p122 + 2p122 4np02 = (2 + 22)p02 p12/p02 = 4n/(2 + 22) p1/p0 = 2(n)1/2/(+2)1/2.

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Example 5: There is an economy in which there are two goods, two types of consumers, and no production. Let px denote the price of the first good and py the price of the second. The consumers of type i ( i = 1,2) have the following utility functions and endowments: U1 = x1y1; U2 = x2y22 ; 1= ( x1 , y1 ) and 2= ( x 2 , y 2 ) a) Derive each consumers demand function for each good. b) Suppose that the number of type 1 and type 2 consumers is the same, that the endowment of each type 1 consumer is (15,30), and the endowment of each type 2 consumer is (45,30). Find the competitive equilibrium for this economy. c) For an economy having total resources (60,60), as in part b, can you characterize the set of endowments for which the economy will have the same equilibrium as in part b? d) Suppose the endowments are (7.5,35) for the type 1 consumers and (52.5,25) for the type 2 consumers. Find the competitive equilibrium. e) Now suppose that there are m consumers of type 2 and 100m consumers of type 1. Endowments are (7.5,35) for the type 1 consumers and (5250,2500) for the type 2 consumers. Find the competitive equilibrium. f) Now assume that m = 1. In other words, there are 100 type 1 consumers and only 1 type 2 consumer. The type 2 consumer is in a monopoly position and can choose px/py, the term of trade between the two goods. Assume that the type 1 consumers are competitive and cannot affect price. Also, assume that the lone type 2 consumer is a price chooser. Find the equilibrium for the model. g) Can you tell whether the equilibrium in part f is Pareto optimal? How? Can you characterize the Pareto optimal allocations for the economy?

a)

Maxxy x1y1 such that pxx1 + pyy1 = px x1 + py y1 . Maxx x1[( x1 px+ y1 py -pxx1)/py] gives x1 = ( x1 px+ y1 py)/2px. y1 = ( x1 px + y1 py px[( x1 px+py)/2px] ) / py so y1 = ( x1 px+ y1 py) /2py. Similarly, x2 = 1/3 [( x 2 px + y 2 py)/px] and y2 = 2/3[( x 2 px+ y 2 py)/py] The number of type 1 consumers = the number of type 2 consumers = n and 1(15,30) and 2(45,30). Find the competitive equilibrium, px* and py*, such that supply equals demand, S = D. S = (60n,60n) and D = [n( x1 px+ y1 py)/2px + n( x 2 px+ y 2 py)/3px, n( x1 px+ y1 py)/2py + 2n( x 2 px+ y 2 py)/3py ] which equals and D = [n(15px+30py)/2px + n(45px+30py)/3px, n(15px+30py)/2py + 2n(px45+30py)/3py]. 60 = (45px + 90py + 90px + 60py)/6px which gives px = 150py/225 or px/py = 2/3. Competitive equilibrium is a price vector and an allocation: (px*, py*) = (.4, .6), x1* = 30, y1* = 20, x2* = 30, and y2* = 40.
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b)

c)

Total resources = (60, 60). Characterize the set of endowments for which the economy will have the same equilibrium as in b. Feasibility: 1 = ( x1 , y1 ) , 2 = ( x 2 , y 2 ) implies x1 + x 2 = 60 = x1+ x2 and y1 + y 2 = 60= y1+y2. To have the same equilibrium, agents will maximize utility subject to the budget constraint and have allocations (30, 20) and (30, 40). This implies that the budget constraints are given by: .4 x1 + .6 y1 = 30(.4) + 20(.6) and .4 x 2 + .6 y 2 = 30(.4) + 40(.6). Solve the budget constraint for y1 in terms of x1 : y1 = 40 x1 2/3. Solve the budget constraint for y 2 in terms of x 2 : y 2 = 60 - x 2 2/3. This implies that e1 = ( x1 , 40- x1 2/3) and e2 = (60 x1 , 20 + x1 2/3).

d)

e1 = (7.5, 35) and e2 = (52.5, 25). From part c: y1 = 35, x 2 = 52.5, y 2 = 25. Thus, this satisfies the conditions on endowments for which the economy will have the same equilibrium as in part b. (px*, py*) = (.4, .6) and allocations (30, 20) and (30, 40).

e)

There are m type 2 consumers with e2(5250, 2500) and 100m type 1 consumers with e1(7.5, 35). As in part 1, each agent will maximize utility subject to the budget constraint, thus yielding the same demand functions. Feasibility: 100m(7.5) + m(5250) = 100 m((7.5px+35py)/2px) + m ((5250px+2500)/3px) 6000 = (2250px + 10,500py + 10,500px + 5000py) / 6px. So, px = 2/3py and well have allocations of (30,20) and (3000,4000).

f)

100 type 1 consumers and 1 type 2 consumer (a monopolist who sets px/py). Maximize utility such that x2+100x1 = 6000 and y2 + 100y1 = 6000. Maxp/q x2y22 such that 6000 100x1 = x2 and 6000 100y1 = y2. Maxp/q (6000 100 [(7.5px + 35py) / 2px] (6000 100[(7.5px + 35py)/2py)2 Let k = px/py: Maxk (5625 1750/k) (4250 375k)2

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=(1750/k2) (4250-275k)2 + (5625 1750/k) 2(4250 375k) (-375) = 0 = (4250-375k) [ 4218750k2 656250k 7437500] = 0 = [656250 +/- [ (656250)2 + 4(4218750) (7437500) ]1/2 ]/ 2(4218750). The roots are 11.333, 1.40782, and 1.2522644. The root 1.40782 yields the highest utility. So, px* = .585 and the allocation for consumers of type one is (16.18, 22.78), and py* = .415 and the allocation for consumer type 2 is (4382, 3722). The equilibrium is not Pareto optimal since MRS1 MRS2. That is, y1/x1 y2/2x2 and y1/x1 = px/py = 1.407 but y2/2x2 = .425 px/py. The MRS of the type 2 consumer does not equal the MRS of the type one player, so additional trade could benefit both. Pareto optimality would have type 1 trade x1 for y1 and type 2 trade y2 for x2. To characterize Pareto optimal allocations, set y1/x1 = y2/2x2 and solve for y1, y2, x2 in terms of x1. This gives y2/2x2 = (6000-100y1)/ (12000 200x1) = (60- y1)/(120-2x1) which gives (60- y1) / (120 2x1) = y1/x1 so y1 = 60x1/(120-x1). y2 = 6000 100(60x1/(120-x1)) = (720,000 6000x1 6000x1)/ (120-x1) so y2 = 12000(60-x1)/(120-x1) and x2 = 6000 100x1. Therefore, the type one allocation is (x1, 60x1/(120-x1)) and the type 2 allocation is (6000 100x1, 12000(60-x1)/(120-x1)).

g)

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Problem Set #3
1.

General Equilibrium

Consider the following pure exchange, Edgeworth box economy. There are 2 consumers and 2 goods. Consumer 1 has an endowment of 7 units of good 1 and 3 units of good 2 (i.e. 1 = (7,3)), while consumer 2 has an endowment of 3 units of good 1 and 7 units of good 2 ( 2 = (3,7)). The consumers utility functions are given by: U1 = x11 + x12 and U2 = min{x21,x22} where xi1 is consumption of good 1 by consumer i.
a)

b)
c)

d)
e)

f)
2.

Define Pareto Optimal Allocations. Find the set of Pareto optimal allocations of this economy. Define Core or Contract Curve. Find the core of the economy. Define Walrasian Equilibrium. Find the Walrasian equilibrium. Consider the following pure exchange, Edgeworth Box economy. There are 2 consumers and 2 goods. Consumer 1 has an endowment of 8 units of good 1 and 30 units of good 2 ( 1 = (8,30)), while consumer 2 has an endowment of 10 units of each good ( 2 = (10,10)). The consumers utility functions are given by:

U1 = x11x12 + 12x11 + 3x12 and U2 = x21x22 + 8x21 + 9x22. a) Determine the excess demand functions for the two consumers. b) Find an equilibrium price ratio for this economy. Sketch the situation in an Edgeworth Box.
3.

a)

b) c) d) e)

There is an economy in which there are two goods, two types of consumers, and no production. Let px denote the price of the first good and py the price of the second. The consumers of type i ( i = 1,2) have the following utility functions and endowments: U1 = x1y1; U2 = x2y22 ; 1= ( x1 , y1 ) and 2= ( x 2 , y 2 ) Derive each consumers demand function for each good. Suppose that the number of type 1 and type 2 consumers is the same, that the endowment of each type 1 consumer is (15,30), and the endowment of each type 2 consumer is (45,30). Find the competitive equilibrium for this economy. For an economy having total resources (60,60), as in part b, can you characterize the set of endowments for which the economy will have the same equilibrium as in part b? Suppose the endowments are (7.5,35) for the type 1 consumers and (52.5,25) for the type 2 consumers. Find the competitive equilibrium. Now suppose that there are m consumers of type 2 and 100m consumers of type 1. Endowments are (7.5,35) for the type 1 consumers and (5250,2500) for the type 2 consumers. Find the competitive equilibrium.

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Now assume that m = 1. In other words, there are 100 type 1 consumers and only 1 type 2 consumer. The type 2 consumer is in a monopoly position and can choose px/py, the term of trade between the two goods. Assume that the type 1 consumers are competitive and cannot affect price. Also, assume that the lone type 2 consumer is a price chooser. Find the equilibrium for the model. g) Can you tell whether the equilibrium in part f is Pareto optimal? How? Can you characterize the Pareto optimal allocations for the economy?
f) 4.

Consider a simple exchange economy with two individuals, Fred and Sally, and two goods, X and Y. The economys endowment of each good is positive and the total endowment of goods X and Y is denoted (X*,Y*). Freds preferences are represented by the utility function Uf where Uf(xf,yf) = xfyf and xf and yf denote Freds consumption of goods X and Y, respectively. Sallys preferences are represented by the utility function US where US(xs, ys, xf) = xsys Axf, xs and ys denote Sallys consumption of goods X and Y, respectively, and A is a positive parameter.

a) Determine the Pareto optimal allocations for this economy. Recall that one way of describing a Pareto optimal allocation when there are two persons is that the allocation maximizes the utility of person 1 given a fixed utility level for person 2. Use that in deriving the Pareto optimal allocations. b) Suppose that the economy has a total of 2n persons with n of them being exact clones of Fred and the remaining n being exact clones of Sally, that both Fred and Sally have nonnegative endowments of the two goods, denoted (xf*, yf*) and (xs*, ys*), respectively, with xf* + xs* = X* and yf* + ys* = Y*, and that each Sally type of consumer has preferences given by US(xs,ysxf) = xsys Axf where xf is the mean X consumption of the Fred type consumers. Determine the competitive equilibrium allocations and the corresponding equilibrium prices. c) Determine whether the competitive equilibrium of the economy in part a is Pareto optimal. Offer a verbal explanation for your finding.
5.

Consider a two-period economy with 2 individuals and a single good in each period. The 2 individuals have identical preferences given by the utility function U(c0, c1) = ln(c0) + ln(c1) where c0 denotes the individuals period 0 consumption and c1 denotes period 1 consumption. Individual 1 has an endowment of two units of period 0 good and individual 2 has an endowment of one unit of period 0 good. Both individuals have zero units of period 1 good. Each individual also has a firm. Individual 1s firm has production function x1 = 2(x0)1/2, where x1 denotes production of period 1 good and x0 denotes the input of period 0 good. Individual 2s firm has production function x1 = 4(x0)1/2. In period 0, the firms purchase the period 0 good to use as an input in the production of the period 1 good, which is sold in period 1. In period 0, each individual decides how much of the endowment to consume, how much to use in production, and how much to sell to the other firm. In period 1, the individuals purchase period 1 good from the firms at market price. Let the discount rate be zero (r = 0).

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p0 and p1 denote the period 0 and period 1 prices. Set up and solve the firms profit maximization problem taking prices as given. b) Find individual 1s demand functions for period 0 and period 1 consumption, taking prices as given. Do the same for individual 2. c) Find the market demand functions for the two goods. d) Define Walrasian equilibrium for this economy. Normalize prices by taking p1 = 1. Solve for the equilibrium price in period 0.
a)

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Answer Key #3
Answer to question 1:

General Equilibrium

The indifference curves of consumer 1 are straight lines and the indifference curves of consumer 2 are Leontief.
a)

b)

c) d)

e)

f)

A Pareto Optimal Allocation is an allocation (x*) for which no other allocation (x) exists with the property that the other allocation (x) is preferred to x* by at least one consumer with the other consumer(s) being indifferent between x* and x. The set of Pareto optimal allocations is the 45 degrees line in the Edgeworth Box. That is, the set {x11,x12,x21,x22} such that {x11=x12, x21 = x22, x11 + x21 = 10, x12+x22 = 10}. The Core or Contract Curve is the set of Pareto Optimal Allocations that dominate the initial endowment. The core is the dark dotted line in the Edgeworth Box. It is the subset of Pareto optimal allocations such that consumer 1 has at least 5 units of each good and consumer 2 has at least 3 units of each good. That is, the set {x11, x21, x12, x22} such that x11 = x12 5, x21=x22 3, where x11 + x21 = 10 and x12 + x22 = 10}. A Walresian Equilibrium is an allocation (x*) and a price vector (p*) such that (i) x* maximizes each consumers utility given each consumers budget constraint and (ii) demand equals supply in all markets with x*. There is a unique Walresian equilibrium: x11* = x21* = x12* = x22* = 5, p1*/p2* = 1. This is found by maximizing utility for consumer 1: max U1 such that p1x11 + p2x12 = p17 + p23, or max(x11, x12): x11 + x12 + { p1x11 + p2x12 - p17 - p23} which gives the following three first order conditions: 1 - p1 = 0 1 - p2 = 0 (which with the 1st first order condition implies that p1/p2 = 1) p1x11 + p2x12 - p17 - p23 = 0

so, x11 = (7p1 + 3p2 p2x12)/p1. We know that with Leontief preferences, x21 = x22 at the optimum. Therefore, (p1 + p2)x11 = 7p1 + 3p2 , x12 = x11 = (7p1+3p2)/(p1+p2) = (7+3)/2 = 5. So, x12 = x11 = 5 and x22 = x21 = 5.
10 Good 1 5 3 Consumer 2 Good 2 5 Core 5

3 Good 2

Consumer 1

Good 1

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Answer to question 2: Consumer 1 maximizes x11x12 + 12x11 + 3x12 such that p1x11 + p2x12 = 8p1 + 30p2. The first order conditions are: x12 + 12 - p1 = 0, x11 + 3 - p2 = 0, and p1x11 + p2x12 - 8p1 - 30p2 = 0 Solve for x11 and x12: x11 = 5/2 + 21p2/p1 (demand function of good 1 by consumer 1) and x12 = 9 + 11p1/2p2 (demand function for good 2 by consumer 1). Thus, the excess demand functions of consumer 1 are: z11 = 5/2 + 21p2/p1 8 = 21p2/p1 11/2 and z12 = 9 + 11p1/2p2 30 = 11p1/2p2 21. Consumer 2 maximizes x21x22 + 8x21 + 9x22 such that p1x21 + p2x22 = 10p1 + 10p2. The first order conditions are: x22 + 8 - p1 = 0, x21 + 9 - p2 = 0, and p1x21 + p2x22 - 10p1 - 10p2 = 0 Solve for x21 and x22 to get x21 = + 9p2/p1 (demand function for good 1 by consumer 2) and x22 = 1 + 19p1/2p2 (demand function for good 2 by consumer 2). The excess demand functions are: z21 = + 9p2/p1 10 = 9p2/p1 19/2 and z22 = 1 + 19p1/2p2 10 = 19p1/2p2-9. At equilibrium, z11 + z21 = z12 + z22 = 0. So z11 + z21 = 21p2/p1 11/2 + 9p2/p1 19/2 = 30 p2/p1 15. Hence, p2/p1 = or p1/p2 = 2 is an equilibrium price ratio and it is unique. Therefore, x11 = 13, x12 = 20, x21 = 5, and x22 = 20.
10 5 Good 1 Consumer 2 Good 2 30 W* 20 20 10

Good 2 Consumer 1 8 13 Good 1

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Answer to question 3:
h)

Maxxy x1y1 such that pxx1 + pyy1 = px x1 + py y1 . Maxx x1[( x1 px+ y1 py -pxx1)/py] gives x1 = ( x1 px+ y1 py)/2px. y1 = ( x1 px + y1 py px[( x1 px+py)/2px] ) / py so y1 = ( x1 px+ y1 py) /2py. Similarly, x2 = 1/3 [( x 2 px + y 2 py)/px] and y2 = 2/3[( x 2 px+ y 2 py)/py] The number of type 1 consumers = the number of type 2 consumers = n and 1(15,30) and 2(45,30). Find the competitive equilibrium, px* and py*, such that supply equals demand, S = D. S = (60n,60n) and D = [n( x1 px+ y1 py)/2px + n( x 2 px+ y 2 py)/3px, n( x1 px+ y1 py)/2py + 2n( x 2 px+ y 2 py)/3py ] which equals and D = [n(15px+30py)/2px + n(45px+30py)/3px, n(15px+30py)/2py + 2n(px45+30py)/3py]. 60 = (45px + 90py + 90px + 60py)/6px which gives px = 150py/225 or px/py = 2/3. Competitive equilibrium is a price vector and an allocation: (px*, py*) = (.4, .6), x1* = 30, y1* = 20, x2* = 30, and y2* = 40.

i)

j)

Total resources = (60, 60). Characterize the set of endowments for which the economy will have the same equilibrium as in b. Feasibility: 1 = ( x1 , y1 ) , 2 = ( x 2 , y 2 ) implies x1 + x 2 = 60 = x1+ x2 and y1 + y 2 = 60= y1+y2. To have the same equilibrium, agents will maximize utility subject to the budget constraint and have allocations (30, 20) and (30, 40). This implies that the budget constraints are given by: .4 x1 + .6 y1 = 30(.4) + 20(.6) and .4 x 2 + .6 y 2 = 30(.4) + 40(.6). Solve the budget constraint for y1 in terms of x1 : y1 = 40 x1 2/3. Solve the budget constraint for y 2 in terms of x 2 : y 2 = 60 - x 2 2/3. This implies that e1 = ( x1 , 40- x1 2/3) and e2 = (60 x1 , 20 + x1 2/3).

k)

e1 = (7.5, 35) and e2 = (52.5, 25). From part c: y1 = 35, x 2 = 52.5, y 2 = 25.

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Thus, this satisfies the conditions on endowments for which the economy will have the same equilibrium as in part b. (px*, py*) = (.4, .6) and allocations (30, 20) and (30, 40).
l)

There are m type 2 consumers with e2(5250, 2500) and 100m type 1 consumers with e1(7.5, 35). As in part 1, each agent will maximize utility subject to the budget constraint, thus yielding the same demand functions. Feasibility: 100m(7.5) + m(5250) = 100 m((7.5px+35py)/2px) + m ((5250px+2500)/3px) 6000 = (2250px + 10,500py + 10,500px + 5000py) / 6px. So, px = 2/3py and allocations (30,20) and (3000,4000)

m)

100 type 1 consumers and 1 type 2 consumer (a monopolist who sets px/py). Maximize utility such that x2+100x1 = 6000 and y2 + 100y1 = 6000. Maxp/q x2y22 such that 6000 100x1 = x2 and 6000 100y1 = y2. Maxp/q (6000 100 [(7.5px + 35py) / 2px] (6000 100[(7.5px + 35py)/2py)2 Let k = px/py: Maxk (5625 1750/k) (4250 375k)2 =(1750/k2) (4250-275k)2 + (5625 1750/k) 2(4250 375k) (-375) = 0 = (4250-375k) [ 4218750k2 656250k 7437500] = 0 = [656250 +/- [ (656250)2 + 4(4218750) (2437500) ]1/2 ]/ 2(4218750) roots are 11.333, 1.40782, and 1.2522644. 1.40782 yields the highest utility. px* = .585 and allocation (16.18, 22.78), py* = .415, and allocation (4382, 3722). The equilibrium is not Pareto optimal since MRS1 MRS2. That is, y1/x1 y2/2x2 and y1/x1 = px/py = 1.407 but y2/2x2 = .425 px/py. The MRS of the type 2 consumer does not equal the MRS of the type one player, so additional trade could benefit both. Pareto optimality would have type 1 trade x1 for y1 and type 2 trade y2 for x2. To characterize Pareto optimal allocations, set y1/x1 = y2/2x2 and solve for y1, y2, x2 in terms of x1. This gives y2/2x2 = (6000-100y1)/ (12000 200x1) = (60- y1)/(120-2x1)

n)

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which gives (60- y1) / (120 2x1) = y1/x1 so y1 = 60x1/(120-x1). y2 = 6000 100(60x1/(120-x1)) = (720,000 6000x1 6000x1)/ (120-x1) so y2 = 12000(60-x1)/(120-x1) and x2 = 6000 100x1. Therefore, type one allocation is (x1, 60x1/(120-x1)) and type 2 allocation is (6000 100x1, 12000(60-x1)/(120-x1)).

Answer to question 4:
a)

maxxs,ys xsys A(X*-xs) + [ Uf (X*-xs) (Y*-ys)]

first order conditions: Lxs: ys + A + (Y*-ys) = 0 Lys: xs + (X* -xs) = 0 L: Uf (X*-xs) (Y*-ys) = 0 Dividing the first condition by the second gives xs = (ys + A)X*/(Y*+A). Substituting that into the third condition yields: Uf (Y*-ys)2 X* /(Y*+A) = 0. So (Y*-ys) = yf = [Uf(Y*+A)/X*]1/2 ys = Y* - yf Uf = xfyf equals Uf/yf = xf which gives xf = [UfX*/(Y*+A)]1/2 and xs = X*-xf.
b)

Competitive equilibrium: Maxxs,ys US = xsys Axf such that pxs + qys = pxs* + qys*

L(xs,ys, ) = xsys Axf + [ pxs* + qys* - pxs qys] Lxs = ys - p = 0

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Lys = xs - q = 0 L = pxs* + qys* - pxs qys = 0. Dividing the first and second conditions gives ys = pxs/q. Subbing that into the third condition gives xs = (pxs* + qys*) / 2p. This gives ys = (p/q) (pxs* + qys*)/2p = (pxs* + qys*) / 2q. Maxxf,yf Uf = xfyf such that pxf + qyf = pxf* + qyf* L(xf,yf, ) = xfyf + [pxf* + qyf* - pxf qyf] Lxf = yf - p = 0 Lyf = xf - q = 0 L = pxf* + qyf* - pxf qyf = 0. This gives xf = (pxf* + qyf*) / 2p and yf = (pxf* + qyf*) / 2q. Markets clear: xs + xf = X*. Find q and p. (pxs* + qys* + pxf* + qyf*) / 2p = X* X* = (pX* + qY*) / 2p gives qY* = pX* which gives q=pX*/Y*. In simplex form, p + q = 1 so p = 1-q. q = (1-q)X*/Y* which gives q = X*/(Y*+X*) and p = Y*/(X*+Y*). Plug prices into the demand functions: xs = [ xs* + X*ys*/Y*] and ys = [ys* + xs*Y*/X*] and xf = [ xf* + X*yf*/ Y*] and yf = [yf* + xf*Y*/X*] c) At the competitive equilibrium: MRSf = Ufxf/Ufyf = yf/xf = [yf* + xf*Y*/X*] / [xf* + X*yf*/Y*] = Y*/X* At Pareto optimum, take account of the externality. MRSf = Ufxf / Ufyf = yf/xf = Y*+A/X*.

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Since they are not equal, the competitive equilibrium is not Pareto optimal. This results because the impact of the externality is ignored by private optimizing agents. Uf/xf / Uf/yf = [ (US/xs + US/xf xf/xs) / US/ ys ] at the Pareto optimal outcome. So, yf/xf = (ys+A)/xs since US/xf = -A and xf/xs = -1. Consuming xs by Sally has a direct effect on US through U/xs and an indirect effect on US by changing xf (xf = X* - xs). Answer to question 5:
a)

Consumer 1s firms profit function is = p12(x0)1/2 p0x0. The first order condition is p1(x0)-1/2 = p0. So, x0 = (p1/p0)2 and x1 = 2p1/p0. Corresponding profits are = p12(p1/p0) p0(p1/p0)2 2p12/p0 p12/p0 = p12/p0. Profit for consumer 1 is p12/p0. Consumer 2s firms profit function is = p14(x0)1/2 p0x0. The first order condition is p12(x0)-1/2 = p0. So, x0 = (2p1/p0)2 and x1 = 8p1/p0. Corresponding profits are = p14(2p1/p0) p0(2p1/p0)2 8p12/p0 4p12/p0 = 4p12/p0. Profit for consumer 2 is 4p12/p0.

b) The utility maximization equation for consumer 1 is L(x0, x1, ): ln(c0) + ln(c1) + (p02 p0c0 p1c1 + p12/p0). The first order conditions are 1/c0 p0 = 0 1/c1 p1 = 0 and p02 p0c0 p1c1 + p12/p0. From the first two first order conditions, (1/c0)/(1/c1) = p0/p1 c1/c0 = p0/p1 c1 = (p0/p1)c0. Subbing this into the third first order condition, p02 p0c0 p1(p0/p1)c0 + p12/p0 = 0 2p0c0 = p02 + p12/p0 c0 = (p02 + p12/p0) / 2p0 c0 = 1 + p12/2p02

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c0 = (2p02 + p12) / 2p02 c1 = (2p02 + p12)/2p1p0 The utility maximization equation for consumer 2 is L(x0, x1, ): ln(c0) + ln(c1) + (p0 p0c0 p1c1 + 4p12/p0). The first order conditions are 1/c0 p0 = 0 1/c1 p1 = 0 and p0 p0c0 p1c1 + 4p12/p0. From the first two first order conditions, (1/c0)/(1/c1) = p0/p1 c1/c0 = p0/p1 c1 = (p0/p1)c0. Subbing this into the third first order condition, p0 p0c0 p1(p0/p1)c0 + 4p12/p0 = 0 2p0c0 = p0 + 4p12/p0 c0 = (p0 + 4p12/p0) / 2p0 c0 = + 4p12/2p02 c0 = (p02 + 4p12) / 2p02 c1 = (p02 + 4p12)/2p1p0 c) To find the Walrasian Equilibrium, essentially set supply equal to demand.

In the market for good 0: 3 = (p1/p0)2 + (2p1/p0)2 + (2p02 + p12) / 2p02 + (p02 + 4p12) / 2p02 3 = 5p12/p02 + (3p02+5p12)/2p02 3 = 10p12/2p02 + 3p02/2p02 + 5p12/2p02 3 = 15p12/2p02 + 3/2 3/2 = 15p12/2p02 3/2 = 15/2p02 since p1 is normalized to be 1. 1/5 = 1/p02 5 = p02 p0 = (5)1/2 = 2.23. Notice that the same answer can be found by setting supply equal to demand for good 1: (p02 + 4p12)/2p1p0 + (2p02 + p12)/2p1p0 = 8p1/p0 + 2p1/p0

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(3p02 + 5p12)/2p1p0 = 10p1/p0 (3p02 + 5p12)/p1p0 = 20p1/p0 3p02/p1p0 + 5p12/p1p0 = 20p1/p0 3p02/p0 + 5/p0 = 20/p0 because p1 is assumed to be normalized to be 1. 3p02 + 5 = 20 3p02 = 15 p02 = 5 p0 = (5)1/2 = $2.23. So, for consumer 1, x0 = 0.201, x1 = 0.896, profits = $0.448, c0 = 1.1, c1 = 2.466, and utility = 0.997. and for consumer 2, x0 = 0.804, x1 = 3.587, profits = $1.793, c0 = 0.90, c1 = 2.017, and utility = 0.596.

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