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Econ 201

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costs 1 dollar per unit) and leisure l. She can supply labor L up to an endowment of 12 hours a day at a wage w = 10 dollars per hour. She has an additional endowment of 180 dollars. The consumers preferences over consumption and labor are the following: u(c, L) = 0.8log (c) + 0.2log (12 L) where log (x) represents the natural logarithm of x. a) Set up the consumers UMP with respect to c and l with all the appropriate constraints. Derive the feasibility and the tangency conditions of an interior solution (label each condition explicitly and clearly to receive the full credit). b) Solve for the Marshallian demands for c and l and for labor supply. Graphically illustrate the budget constraint and the optimally chosen bundle. Now, allow the consumers wage to increase to w = 20 dollars per hour. c) Solve for the Marshallian demands for consumption and leisure and for labor supply. Graphically illustrate the budget constraint and the optimally chosen bundle. d) Calculate the substitution eect from this wage change. Explain what would allow you to establish the sign of the substitution eect if you had not solved for it. e) Calculate the income eect from this wage change. f) Is there any other eect that you have to compute to explain how the consumers demand for leisure changes when the wage changes? Relate this discussion to the Slutsky equation. g) If the consumer had no additional income, what would her labor supply be? Explain the economic intuition behind this result. Problem 2 The income of a risk-averse farmer is uncertain because of the weather shocks the farm is exposed to. In the good state of nature, which happens with 20% probability, her yield will be worth $10,000, in the bad state of nature, her yield will be worth $5,000. The farmer is oered to purchase an insurance product which will give her $5,000 in the bad state of nature. She has no other insurance mechanism available. The farmers utility function is u(c) = log (c). 1

a) Set up the farmers UMP in the absence of the insurance product. Calculate the farmers expected utility in the absence of insurance. b) What is the certain equivalent of the farmers uncertain income? c) Set up the farmers UMP if she buys the insurance product at a price P , where P is the total price of the whole insurance product which pays $5,000 in the bad state of nature. What is the farmers expected utility if she buys insurance for the generic price P ? d) What is the actuarially fair price of this insurance product? Explain how you calculate it. e) Would the farmer buy the product if it costed $3,500? Why? f) Assume now that the farmers utility function is linear, i.e. u(c) = c. Is she risk averse, risk neutral or risk-loving? Would she buy the product if it costed $4,500? Why? Problem 3 Calculate the equilibrium relative prices in an economy composed of two individuals, Wilbur (W ) and Zaira (Z ), which have the following preferences

W W 0 .3 0.7 uW (xW ( xW 1 , x2 ) = (x1 ) 2 ) , Z Z 0.7 0.3 uZ (xZ (xZ 1 , x2 ) = (x1 ) 2) .

a) Calculate the equilibrium price good 1 relative to good 2 and the equilibrium allocations. b) Draw the Edgeworth box associated with this problem (you can provide a qualitative representation of the indierence curves). c) Suppose that both Wilburs and Zairas endowments of good 2 double, while the rest of the problem stays the same. Without solving for equilibrium explicitly, can you say what would happen to the equilibrium relative price of good 1 compared to the initial case (i.e. would it be higher or lower)? Why? d) Suppose that you now learn that Wilbur and Zaira have new preferences, while the rest of the problem stays the same:

W W 0 .2 0.8 uW (xW ( xW 1 , x2 ) = (x1 ) 2 ) , Z Z 0.6 0.4 uZ (xZ (xZ 1 , x2 ) = (x1 ) 2) .

Without solving for equilibrium explicitly, can you say what would happen to the equilibrium relative price of good 1 compared to the initial case (i.e. would it be higher or lower)? Why? e) Is the equilibrium allocation that you have calculated in (a) Pareto ecient? Why? 2

f) Assume that good 1 is listening to music, and when one person listens to music, that benets the other person who can also hear. For example, that could imply that Wilburs preferences are now

W W 0.25 0.65 0.1 uW (xW (xW (xZ 1 , x2 ) = (x1 ) 2 ) 1)

and similarly for Zaira. Is competitive equilibrium is Pareto ecient in this case? Justify your answer. Problem 4 Indicate whether the statements below are true or false. Explain your reasoning and always relate it precisely to the concepts you have learned in this class. The points will only be credited solely based on your justication. You can use gures to clarify your argument. a) Strong separability of consumption over time is an assumption that can straightforwardly be applied to the behavior of all consumers in all circumstances because it imposes little restrictions on the consumers preferences. b) A wage increase always raises labor supply. c) Imagine an economy with two goods and two agents which has a unique competitive equilibrium. You observe this economy with two dierent sets of prices, rst (p1 , p2 ) = (3, 4) and second (p1 , p2 ) = (9, 12). Then, because the equilibrium is unique, you know that at least one of these prices must not be the equilibrium prices. d) When preferences are convex, any Pareto ecient allocation is a competitive equilibrium for some prices. e) The certain equivalent of a given lottery is decreasing in the consumers risk aversion.

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