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Topic: Micro Economics

Question: Pareto efficiency in two persons two goods economy with given initial endowment for both of them

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Consider the following two person- two good pure exchange economy: Alfred’s utility function is UA(X, Y) = min {X, Y} and Bob’s utility function is UB(X, Y) = max{X, Y}. a) Suppose that Alfred’s initial endowment is ωA = (2, 8) and Bob’s initial endowment is ωB = (8, 2). If there is any, given an example to an allocation which is feasible but NOT Pareto Efficient. Explain why it is not Pareto Efficient. b) Suppose now that Alfred’s initial endowment is ωA = (8, 2) and Bob’s initial endowment is ωB = (2, 3). If there is any, given an example to an allocation which is feasible but NOT Pareto Efficient. (HINT: No calculation is necessary. Just use the definition of Pareto Optimality and properties of the utility functions.)

Solution:

a)PARETO OPTIMALITY Pareto efficient allocation is one where: There is no way to make some individual better off without making someone worse off There are no mutually beneficial exchanges as all gains from trade have been exhausted

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Sub: Economics

Topic: Micro Economics

If there is a way to make a people better off without making anybody worse off, we have a Pareto Improvement. If an allocation allows Pareto improvement, it is called Pareto inefficient and if an allocation is no such Pareto improvements are possible, it is called Pareto efficient. The given utility functions are

The first one is Alfred’s Utility function and the Second one is Bob’s Utility function The initial endowment for Alfred is WA= ( 2,8) and the initial endowment for Bob is ( 8,2) The indifference curves of Bob are convex to the origin and the indifference curves of Alfred 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 {xA1=xA2, xB1 = xB2, xA1 + xB1 = 10, xA2+xB2 = 10}. One feasible allocation is x11=5, and x12=5 Such that Alfred can trade 3 units of good 2 to Bob and can have 3 units of good X from Bob So that again xA1 + xB1 = 5+5=10, xA2+xB2 = 5+5=10

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Sub: Economics

Topic: Micro Economics

With this allocation no such Pareto improvements are possible. Nobody becomes worse off or nobody becomes better off. Thus this allocation is feasible but it cannot be considered as the Pareto efficient. b) Now the initial endowment for Alfred is WA= ( 8,2) and Bob’s initial endowment is WB= (2,3) xA1 + xB1 = 10, xA2+xB2 = 5 Another allocation is feasible if Alfred trade 3 units of good X to Bob and get 1 units of good y from Bob. Then the endowment for Alfred will be, ( 5,3) The endowment for Bob will be ( 5,2) With this allocation also the conditions are satisfied xA1 + xB1 =5+5= 10, xA2+xB2 = 3+2=5 With this allocation no such Pareto improvements are possible. Nobody becomes worse off or nobody becomes better off. Thus this allocation is feasible but it cannot be considered as the Pareto efficient. ** End of the Solution **

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