Market failures, Institutions, and Economic Policy

Coen Teulings
Assignment 1: Correction
Coase theorem: when does a change in property rights not lead to a shift in demand?
This Assignment addresses the issue as to what is the proper shape of a utility function such that a
change in the property rights does not lead to a shift in demand for a particular good.
We consider a simple world with 2 commodities: apples x and other consumption goods y and with 2
consumers i=1,2, each with a standard utility function Ui(xi,yi) of which first derivatives are positive
and second derivatives either zero or negative. Each consumer starts with a money budget Bi. Both
apples and other consumption goods can be bought on the outside market for a price of 1 Euro.
Answer shortly. Each item carries equal weight.
a. Derive the budget-constraint and the first order conditions for apples and for other
consumption.
b. Consider a change of property rights that transfers an amount C<B1 of the budget of consumer
1 to consumer 2. When would that shift not affect the demand for apples of either consumer 1
or consumer 2? (hint: in general, the first derivative of a function Ui(xi,yi) depends on xi and yi.
When does it not?).
c. How does the demand for other consumption change for each of the two consumers? Explain
why this is the case.
d. What are the income effects on the consumption of both commodities?
e. What is the limitation of a model with this type of income effects? When would this limitation
be binding? When the value share of apples in total consumption is low or high?