Sub: Economics

Topic: Micro Economics

Question: Deriving the contract curve in two goods two persons economy and also finding out the core allocation and equilibrium allocation with the given endowments and
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price ratio
April has a utility function UA (x,y) = xy and initial endowment of ωA = (4, 0). Bob has a utility function UB (x,y) = √x + √y and initial endowment of ωB = (0, 4). Suppose that px is the price for good x and py is the price for good y. (a) Find the Contract curve. (b) Check whether the allocation ((2, 2), (2, 2)) is a core allocation or not. (c) For what price ratio, Px/Py can the allocation ((1, 1), (3, 3)) be supported as an equilibrium allocation? (d) Can the allocation ((1, 2), (3, 2)) be supported as an equilibrium with some prices px and py? If so, find Px/Py.

Solution:
(a) The Contract Curve highlights all points within an Edgeworth Box that can serve as Exchange Equilibria, i.e., all points for which the MRS of both people are equal or all points for which the indifference curves of both people are tangent to one another. Exchange equilibrium where there is equality in the Marginal Rates of Substitution, i.e., MRS of consumer April = MRS of consumer Bob UA= (X,Y)
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Sub: Economics

Topic: Micro Economics

MRSA= MUx/ MUy=Y/X UB= X1/2 + Y1/2 MRS B = Y1/2/ X1/2 Thus the contract curve is, MRSA = MRS B = Y/X = Y1/2/ X1/2 Y=X (b) The allocation (2,2), (2,2) are core allocation This is a core allocation because xA1=xA2, xB1 = xB2, xA1 + xB1 = 4, xA2+xB2 = 4

(c) Let the price ratio be Px/Py The contract curve is Y=X The allocation for both April and Bob are satisfying this condition. Thus it is supported as equilibrium condition. MRS for April = Y/X It must be equal to the price ratio Y/X= Px/Py=1/1=1 Thus the required price ratio is 1 d) The allocation (1,2) and ( 3,2) are not supported as an equilibrium Plugging the values in the MRS for April we get, Y/X= 2/1=2

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Sub: Economics

Topic: Micro Economics

Plugging the values in the MRS for Bob we get, 2/3=2/3 MRs for two individuals are NOT equal . So it cannot be considered as equilibrium. ** End of the Solution **
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*The Homework solutions from ClassOf1 are intended to help the student understand the approach to solving the problem and not for
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