Financa Publike Analiza Normative

Chapter 10/General Equilibrium and Economic Welfare
CHAPTER 10
General Equilibrium and Economic Welfare
MULTIPLE CHOICE
Choose the one alternative that best completes the statement or answers the question.
1) General equilbrium analysis is the study of
A) how an equilibrium is determined in all markets simultaneously.
B) how an equilibrium is determined in all closely related markets.
C) the effects of a change in a market, and all spillover effects in all related markets.
D) All of the above.
Answer: D
Diff: 0
Topic: General Equilibrium
2) Joe and Rita each have some cookies and milk. Joe is willing to trade 2 cookies for an
additional ounce of milk. Rita is willing to trade 4 cookies for an additional ounce of milk.
If trading is possible, which of the following is most likely to occur?
A) Joe will give some milk to Rita in exchange for cookies.
B) Rita will give some milk to Joe in exchange for cookies.
C) No trade will take place since they both prefer to have more milk and fewer cookies.
D) There is not enough information to make any predictions.
Answer: A
Diff: 1
Topic: Trading Between Two People
3) Joe and Rita each have some milk and cookies. Joe's MRS of cookies for milk is 2. Rita's
MRS of cookies for milk is 4. Which of the following statements is TRUE?
A) No gains from trade are possible.
B) Both Rita and Joe can be made better off if Rita gives Joe some cookies in exchange for
milk.
C) Rita and Joe are on the contract curve.
D) Both Rita and Joe can be made better off if Joe gives Rita some cookies in exchange for
milk.
Answer: B
Diff: 1
187
4) Gains from trade can only occur when

A) marginal rates of substitutions differ across people.
B) marginal rates of substitution are equal across people.
C) indifference curves are convex.
D) people find themselves on the contract curve.
Answer: A
Diff: 1
5) Moving away from the contract curve will
A) harm both parties.
B) harm only one of the parties.
C) harm at least one of the parties.
D) harm neither of the parties.
Answer: C
Diff: 1
Figure 10.1
6) Figure 10.1 depicts the Edgeworth box for two individuals, Al and Bruce. The contract curve
can found by connecting points
A) a and b.
B) a and c.
C) b and d.
D) c and d.
Answer: D
Diff: 1
188
7) If only two people are trading their endowments and no production is possible, then
the equilibrium they reach will
A) be on their contract curve.
B) result in unequal marginal rates of substitution for the two people.
C) result in one person being worse off than with his or her endowment.
Answer: A
Diff: 1
8) Figure 10.1 depicts the Edgeworth box for two individuals, Al and Bruce. If the endowment
is at point a and trade is possible, which of the following points are possible equilibria?
A) a and b
B) a and c
C) b and d
D) c and d
Answer: D
Diff: 1
9) Figure 10.1 depicts the Edgeworth box for two individuals, Al and Bruce. Considering only
the labeled points, point c is a possible equilibrium
A) only if it was the endowment.
B) only if point a is the endowment.
C) if either point a or b is the endowment.
D) only if point d is the endowment.
Answer: C
Diff: 1
10) Figure 10.1 depicts the Edgeworth box for two individuals, Al and Bruce. If the endowment
is at point a, and Al has no ability to bargain, the final allocation will be at point
A) a.
B) b.
C) c.
D) d.
Answer: C
Diff: 1
189
11) Figure 10.1 depicts the Edgeworth box for two individuals, Al and Bruce. Point a is not
Pareto efficient because
A) Al's MRS exceeds Bruce's MRS.
B) the point is not near the center of the box.
C) Al's indifference curve is not far enough away from the origin.
Answer: A
Diff: 1
12) Figure 10.1 depicts the Edgeworth Box for two individuals, Al and Bruce. Point c is Pareto
efficient because
A) the MRS's are equal.
B) the indifference curves are tangent.
C) no mutual gains from trade exist.
Answer: D
Diff: 1
13) Gains from trade will be possible as long as
A) people have different endowments.
B) people place different values on some goods.
C) marginal rates of substitution are equal across individuals.
D) excess supply equals excess demand.
Answer: B
Diff: 1
14) Gains from trade will be possible as long as
A) levels of utility differ.
B) utility functions differ.
C) marginal rates of substitution differ.
D) endowments differ.
Answer: C
Diff: 1
190
15) In a competitive marketplace, prices adjust until

A) MRS's are equal to zero.
B) excess supply equals excess demand equals zero in all markets.
C) each consumer has maximized utility subject to his budget constraint.
D) all firms earn zero profit.
Answer: B
Diff: 1
Topic: Competitive Exchange
16) A competitive equilibrium is Pareto efficient because at the competitive equilibrium
A) prices have been allowed to adjust.
B) there are no further gains from trade.
C) the final outcome is different from the original inefficient endowment.
D) all members of society can be made better off.
Answer: B
Diff: 2
17) A competitive equilibrium is Pareto efficient because at the competitive equilibrium
A) prices reflect the differences in marginal rates of substitution across individuals.
B) there are no further gains from trade.
C) there is an equal distribution of the goods.
D) everyone has the same level of utility.
Answer: B
Diff: 2
18) Any competitive equilibrium is Pareto efficient because, with a competitive
equilibrium
A) the marginal rates of substitution are equal for all consumers.
B) the price line is the contract curve.
C) mutual gains from trade exist.
D) the slope of the price line equals the ratio of the MRS for all consumers.
Answer: A
Diff: 1
191
19) For a given set of prices, two consumers choose bundles that are off the contract curve. In a
competitive market,
A) prices will adjust until the consumers choose bundles that are on the contract curve.
B) the indifference curves will shift back to the contract curve.
C) the contract curve will shift to connect these bundles.
D) no adjustments need to be made.
Answer: A
Diff: 2
20) In a competitive market, prices adjust until all consumers find themselves
A) maximizing utility.
B) on the contract curve.
C) happy with their original endowment.
D) with many opportunities to gain from additional exchange.
Answer: B
Diff: 1
21) If pizza is measured on the horizontal axis and pretzels are measured on the vertical axis, the
slope of the production possibility frontier at a given combination reflects
A) the total cost of producing that combination.
B) the total cost of producing that quantity of pizza in terms of pretzels.
C) the cost of making the last pizza in terms of pretzels.
D) the cost of making the last pretzel in terms of pizza.
Answer: C
Diff: 1
Topic: Production and Trading
192
Figure 10.2
22) Suppose the production possibilities for two countries, producing either food or clothing, are
shown in Figure 10.2. They can each produce any linear combination as well. Measuring
food on the horizontal axis, the joint production possibility frontier
A) will kink away from the origin at 20 units of food.
B) will kink toward the origin at 20 units of food.
C) will kink toward the origin at 10 units of food.
D) will kink away from the origin at 10 units of food.
Answer: B
Diff: 1
23) Suppose the production possibilities for two countries, producing either food or
clothing, are shown in Figure 10.2. The USA has a comparative advantage in producing
A) food.
B) clothing.
C) food and clothing.
D) neither good.
Answer: A
Diff: 1
193
food on the horizontal axis, the joint production possibility frontier
A) will have a slope of -3/4 over the entire frontier.
B) will have a slope of -2 when less than 20 units of food are produced.
C) will have a slope of -1 when less than 20 units of food are produced.
D) will have a slope of -1/2 when less than 20 units of food are produced.
Answer: D
Diff: 1
shown in Figure 10.2. They can each produce any linear combination as well. Assuming free
trade between these two countries, Canada will produce food
A) as long as any positive amount of food is demanded.
B) as long as more than 10 units of food are demanded.
C) as long as people are willing to give up at least 1 unit of clothing to get a unit of food.
D) as long as people are willing to give up more than 1/2 a unit of clothing to get a unit of
food.
Answer: C
Diff: 2
shown in Figure 10.2. They can each produce any linear combination as well. If production
occurs at the kink on the joint production possibility frontier,
A) the USA will specialize in food and Canada will specialize in clothing.
B) the USA will specialize in clothing and Canada will specialize in food.
C) each country will devote half of its resources to each industry.
D) joint output is minimized.
Answer: A
Diff: 1
194
shown in Figure 10.2. They can each produce any linear combination as well. Suppose each
country is in competitive equilibrium prior to free trade being allowed. Once free trade is
allowed, the price of food will be
A) two times the price of clothing.
B) equal to the price of clothing.
C) one-half the price of clothing.
D) somewhere between one-half the price of clothing and the price of clothing, depending
upon the relative bargaining power of the two countries.
Answer: D
Diff: 1
shown in Figure 10.2. They can each produce any linear combination as well. Once free trade
is allowed, Canada will produce
A) no clothing.
B) 10 units of clothing.
C) 20 units of clothing.
D) 5 units of clothing.
Answer: B
Diff: 1
shown in Figure 10.2. They can each produce any linear combination as well. Assuming that
consumers place equal value on both of these goods and that free trade between these two
countries is possible, gains from trade
A) are not possible.
B) exist because food is more expensive to produce in Canada than in the USA.
C) exist because food is more expensive to produce in the USA than in Canada.
D) do not exist because the consumers in each country have set their marginal rate of
substitution equal to their country's marginal rate of transformation.
Answer: B
Diff: 2
195
food on the horizontal axis, the joint production possibility frontier has a horizontal intercept
of
A) 10.
B) 20.
C) 30.
D) 50.
Answer: C
Diff: 1
food on the horizontal axis, the joint production possibility frontier has a vertical intercept of
A) 10.
B) 20.
C) 30.
D) 50.
Answer: B
Diff: 1
food on the horizontal axis, the joint production possibility frontier will have a slope of -1
A) only when 20 - 30 units of food are produced.
B) only when 10 - 20 units of food are produced.
C) only when 10 - 20 units of clothing are produced.
D) throughout the entire PPF.
Answer: A
Diff: 1
196
food on the horizontal axis, the joint production possibility frontier has a kink because
A) each country has a constant marginal rate of transformation that differs from the other
country.
B) each country has a marginal rate of transformation that varies with the product mix.
C) all production possibility frontiers have kinks.
D) the two countries have the same marginal rate of transformation.
Answer: A
Diff: 1
34) Competition results in the efficient product mix because
A) producers are setting MRT equal to minus the price ratio while consumers are setting
MRS equal to minus the price ratio ensuring that MRT will equal MRS.
B) consumers are on the contract curve.
C) the slope of the production possibility frontier will equal the slope of the contract curve.
D) the distribution of the final output is Pareto efficient.
Answer: A
Diff: 1
35) By saying that MRS = MRT, an economist means that
A) for all goods, the value that society places on the last unit produced equals the cost of
making that unit.
B) for all goods, the value that a consumer places on the last unit consumed equals the value
that all consumers would place on that unit.
C) society is able to produce more output of one good without reducing the output of any
other good.
D) no other output mix is technically feasible.
Answer: A
Diff: 2
197
36) A cake is to be shared by two people. Both desire the largest piece possible. One of the two
will cut the cake. Under which of the following situations will the cutter adopt a Rawlsian
social welfare function?
A) The person cutting the cake chooses the first piece.
B) The person not cutting the cake chooses the first piece.
C) The two individuals will bid for the right to cut the cake and choose first.
D) The two individuals will toss a coin for the right to cut the cake and choose first.
Answer: B
Diff: 2
Topic: Efficiency and Equity
37) Suppose in a democratic society, all voters prefer choice G over choice B; however, when the
two choices are presented along with a third choice, R, B wins the election. This violates the
assumption of
A) transitivity.
B) non-dictatorship.
C) independence of irrelevant alternatives.
D) completeness.
Answer: C
Diff: 1
38) If everyone's utility is given equal weight and a change in resource allocation results in one
person's gain exceeding another person's loss, we can say that the new allocation
A) is Pareto superior to the original one.
B) increases social welfare.
C) decreases social welfare.
D) is efficient.
Answer: B
Diff: 1
39) If a society only cares about efficiency and not equity, then
A) all points on the contract curve yield the same level of social welfare.
B) it will not rely on competitive markets to allocate goods.
C) it will maximize the utility of its worst-off member.
D) an equitable outcome is impossible.
Answer: A
Diff: 1
198
40) If a society relies on competitive markets to allocate goods, then

A) an equitable distribution is assured.
B) an equitable distribution is certain to not occur.
C) the competitive equilibrium will be Pareto superior to any other.
D) social welfare as measured by consumer surplus plus producer surplus will equal zero.
Answer: C
Diff: 1
41) A dictator is most likely to
A) adopt a Rawlsian social welfare function.
B) maximize her own utility.
C) place equal weight on everyone's utility function.
D) have nontransitive preferences.
Answer: B
Diff: 1
42) If society were to maximize the utility of its worst-off member, the final allocation would
most likely be
A) relatively egalitarian.
C) Pareto efficient.
D) one in which one person gets everything.
Answer: A
Diff: 1
43) If society were to maximize the utility of its best-off member, the final allocation would be
A) perfect equity.
C) Pareto efficient.
D) one in which one person gets everything.
Answer: D
Diff: 1
199
44) For most commonly used social welfare functions, an efficient allocation is
A) always preferred over any inefficient allocation.
B) not possible.
C) usually preferred.
D) never preferred.
Answer: C
Diff: 1
TRUE/FALSE/EXPLAIN
1) Any point on the contract curve is Pareto efficient regardless of the initial endowment.
Answer: True. Efficiency requires that no gains from trade are possible. This true along the
contract curve.
Diff: 1
2) If two grade-school children willingly trade their lunches with one another, we can conclude
that at least one of them preferred the other's lunch to his own.
Answer: True. Either one or both preferred the other's. If only one preferred the other's, then
the other must have been indifferent between the two lunches.
Diff: 1
3) A competitive equilibrium is not Pareto efficient if some members of society are unable to
afford a necessary good.
Answer: False. The competitive equilibrium described is efficient since all consumers set
MRS equal to the price ratio. The problem with the described equilibrium is one of
distributive justice not efficiency.
Diff: 1
4) If MRS's are equal across all consumers, then the efficient product mix has been achieved.
Answer: False. Consumption efficiency has been achieved for the given product mix, but the
given product mix is efficient only if MRT equals the MRS for all pairs of goods.
Diff: 1
200
5) At a given point in time, the Rawlsian welfare function gives equal weight to each
individual's utility.
Answer: False. The Rawlsian welfare function gives a weight of 1 to the utility of the worstoff person and a weight of zero to the utilities of all others.
Diff: 2
PROBLEMS
1) Employing a general equilibrium approach, describe the effect of a new law that prohibits
steel imports.
Answer: The initial effect is that the supply curve for steel shifts leftward. This raises the
price of steel. The largest users of steel are the automobile industry, the construction industry
and the appliance industry. The increased cost of inputs will raise the price of the goods
produced by these industries. Given time, these industries will look to substitute plastic or
aluminum in place of steel, raising the prices of these materials.
Diff: 0
Figure 10.3
2) Suppose that the minimum wage covers all sectors of the economy; however, for unionized
laborers, the minimum wage is ineffective. That is, the union wage is already above the
minimum wage. Analyze the impact of an increase in the minimum wage on both the
unionized and non-unionized labor markets. (Assume that the higher minimum wage is still
ineffective in the unionized sector and that union and nonunion labor are substitutable.)
Answer: See Figure 10.3. The higher minimum wage from min1 to min2 reduces the quantity
demanded of nonunion labor from L1 to L2. This causes a rightward shift of the demand curve
for union labor from D1 to D2. The equilibrium union wage rises from w1 to w2. This explains
201
why unions typically support increases in the minimum wage even though it does not directly
affect their members.
Diff: 0
3) Explain why having different marginal rates of substitution is necessary for trade to
occur.
Answer: The marginal rate of substitution is the rate at which a person is willing to trade one
good for another. If these rates are not equal for all people, trade can occur. With different
marginal rates of substitution at least one person gains by trading. When the marginal rates
of substitution are the same for everyone, everyone is willing to trade goods at the same rate,
so no one can gain by trading.
Diff: 1
4) Explain why Robin Hoods practice of stealing from the rich to give to the poor is never
Pareto-efficient.
Answer: When Robin steals from the rich, those people are made worse off. This cannot be
Pareto-efficient.
Diff; 1
5) Consider a society consisting of just a farmer and a tailor. The farmer has 10 units of food
but no clothing. The tailor has 20 units of clothing but no food. Suppose each has the utility
function U = F * C. Derive the contract curve.
Answer: Let F and C denote the farmers final allotment of food and clothing. Setting MRS's
equal yields F/C = (10 - F)/(20 - C) or F/C = 1/2. The contract curve is a ray from the origin
with a slope of 1/2 (assuming food is on the vertical axis).
Diff: 2
202
Figure 10.4
6) Robinson starts out with 10 lobsters and 5 coconuts. Friday starts out with 10 lobsters and 15
coconuts. After trading, Robinson ends up with 8 lobsters and 10 coconuts. Robinson feels
neither better nor worse off than when he started but cannot get Friday to agree to any more
trades. Friday feels better off than when he started. Draw the Edgeworth box consistent with
this story.
Answer: See Figure 10.4
Diff: 2
7) Consider a society consisting of just a farmer and a tailor. The farmer has 10 units of food
but no clothing. The tailor has 20 units of clothing but no food. Suppose each has the utility
function U = F * C. The price of clothing is always $1. If the price of food is $3, does a
competitive equilibrium exist? If not, what will happen to the price of food?
Answer: The farmer will have $30. His budget line is 30 = 3F + C. His budget line is tangent
to an indifference curve when C/F =3. Substituting yields 30 = 6F or F = 5 and C =15. The
tailor's budget line is 20 = 3F + C. His budget line is tangent to an indifference curve when
C/F =3. Substituting yields 20 = 6F or F = 3.33 and C = 10. In total 8.33 units of food and 25
units of clothing are demanded. There is excess demand for clothing and excess supply of
food. The price of food will fall. When the price of food is $2, both markets clear.
Diff: 2
203
Figure 10.1
8) Figure 10.1 depicts the Edgeworth box for two consumers, Al and Bruce. Explain why point
"a" cannot be a competitive equilibrium.
Answer: Point "a" cannot be a competitive equilibrium because at point "a", Al and Bruce
each have a different marginal rate of substitution. Since they both face the same prices in a
competitive market, at least one of them is not in equilibrium.
Diff: 2
9) Explain how it is possible for one of two people in a two-good economy to have an
absolute advantage in producing both goods, but trade can still benefit both people.
Answer: One person, when she spends all of her time producing one good or the other, can
produce more of either good than the other person. This person has an absolute advantage in
producing both goods. However, gains from trade exist when the opportunity costs
associated with each good are different for both people. If the costs of producing one good in
terms of the forgone production of the other good differ for the two people, then they can
gain from trade.
Diff: 1
10) Suppose a society's PPF for food (F) and clothing (C) can be written as 25 = F2 + C2. If all
consumers have the same endowment and the same utility function Ui = Fi*Ci, what is the
efficient product mix of food and clothing?
Answer: The marginal rate of substitution of food for clothing (dF/dC) equals F/C. The
marginal rate of transformation of food for clothing (dF/dC) equals C/F. The efficient product
mix occurs when F/C = C/F or C = F. Given the PPF, food and clothing will both equal
sqrt(12.5).
Diff: 2
204
11) Can consumption efficiency be achieved even if the efficient product mix is not achieved?
Answer: Efficiency in consumption implies that all consumers have the same MRS. This can
be achieved with any product mix. Thus, consumers can be as well off as possible for any
given product mix. If the product mix is inefficient, consumers can still make the best of it
even though a different product mix could make them even better off.
Diff: 2
12) How does competition ensure that the efficient product mix is attained?
Answer: In a competitive market, producers choose an output level where marginal cost
equals price. Thus, Px/Py = MCx/MCy. Each consumer maximizes her own utility subject to
the given prices by setting MUx/MUy = px/py. Even though each is acting independently and
in her own interest, the final outcome is that px/py = MRS = MRT, which is the condition for
efficient product mix.
Diff: 2
Figure 10.5
13) Figure 10.5 shows a production possibility frontier for a society with two members, Al and
Bruce. If point "a" is the efficient product mix, draw a possible Edgeworth box and
indifference curves.
Answer: The Edgeworth box has 0,0 as the southwest corner and point "a" as the northwest
corner. The indifference curves must be tangent where their slopes equal the slope of the PPF
at point "a".
Diff: 2
205
14) Suppose the USA can produce 10 units of food and 5 units of clothing (or any linear
combination) and Canada can produce 6 units of food and 3 units of clothing (or any linear
combination). What type of trade will occur between these two countries? Explain.
Answer: In both countries, 2 units of food must be sacrificed to produce a unit of clothing.
Since each country has the same MRT, there are no gains from trade to be made.
Diff: 2
15) If a market is controlled by one perfect price discriminator who is able to charge each
consumer the highest price that consumer is willing to pay, the seller will produce output
until the price paid by the last consumer is equal to the marginal cost of making the good.
That is, the price of the last good equals the marginal cost of making the good. If welfare is
measured as consumer surplus plus producer surplus, compare this market structure to a
competitive market in terms of efficiency and equity.
Answer: A perfect price discriminator is Pareto efficient. Producer surplus plus consumer
surplus is the same as in a competitive market. From an equity standpoint, however, there is
much less equity than in a competitive market. A perfect price discriminator can capture all
of the consumer surplus for herself, leaving consumer surplus equal to zero.
Diff: 2
16) Explain why a government may select an inefficient allocation.
Answer: A government may decide the equity of an allocation makes it preferable to all
possible efficient allocations
Diff: 1
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Chapter 10/General Equilibrium and Economic Welfare

General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

4) Gains from trade can only occur when

Chapter 10/General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

15) In a competitive marketplace, prices adjust until

Chapter 10/General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

40) If a society relies on competitive markets to allocate goods, then

Chapter 10/General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

Chapter 10/General Equilibrium and Economic Welfare

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