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Practical Class (up to II)

Advanced Microeconomics Prof. Maria do Carmo Seabra TA: Joao Silva, Paulo Fagandini

Spring 2014
Nova SBE

1.

Consumer with endowments, Pareto Criteria, Social Welfare functions

1.1 Consider an economy of two people who consume just two goods X and Y. Person 1 has an endowment of X1 =30 and Y1 =120. Person 2 has an endowment of X2 =180 and Y2 =90. Their utility functions are, respectively:

U1 ( X 1; Y1 ) = X 1Y1 U 2 ( X 2 ; Y2 ) = X 2Y2
a) Graph the Edgeworth box corresponding to this economy. b) What are the equations for the indifference curves of persons 1 and 2 that go through the initial endowment? Plot the curves. c) Shade the locus of points that are Pareto-superior to the initial endowments. d) What is the equation of the contract curve in this economy? Graph it. e) Identify the boundaries of the points on the contract curve that are Pareto-superior to the initial endowments. f) Suppose a secretary of the market announces that all trading must take place at PX = 1 and PY = 2. Furthermore, the secretary takes away each persons initial endowment and replaces it with its cash value. The secretary instructs each person to order the quantities of X and Y that maximize utility subject to the budget constraint. (1) What quantities will persons 1 and 2 order? (2) Can the secretary fill these orders with the endowments collected? Go through the same exercise with PX =2 and explain why the outcome is feasible and efficient.

1.2 Bert has initial endowment consisting of 10 units of food and 10 units of clothing. Ernies initial endowment consists of 10 units of food and 20 units of clothing.

a) Represent these initial endowments in an Edgeworth box. b) Bert regards food and clothing as perfect 1-for-1 substitutes. Ernie regards them as perfect complements, always wanting 3 units of clothing for every 2 units of food. Describe the set of allocations that are Pareto preferred to initial endowment.

c) Describe the contract curve for that allocation. d) What price ratio will be required to sustain an allocation on the contract curve? e) How will your answers differ if 5 units of Ernies clothing endowment are given to Bert? 1.3 Consider an economy with two agents, A and B, whose utility functions and endowments are, respectively: W A = WB = (1,1)
/ 2 1/ 2 1/ 3 2 / 3 U A = 4X 1 A Y A , U B = X B YB

a) Determine the excess demand curves for each agent b) Find the competitive equilibrium. c) Determine the contract curve. d) Verify if the competitive equilibrium is pareto efficient.

1.4

In a pure exchange economy, Ollie's utility function is U(x, y) = 3x + y and Fawn's

utility function is U(x, y) = xy. Ollie's initial allocation is 1x and no y's. Fawn's initial allocation is no x's and 2y's. Draw an Edgeworth box for Fawn and Ollie. Put x on the horizontal axis and y on the vertical axis. Measure goods for Ollie from the lower left and goods for Fawn from the upper right. a) b) c) Mark the initial allocation with the letter W. Draw the indifference curves that go through the initial endowments. Find the contract curve.

1.5

There are two consumers, A and B, and two goods, 1 and 2. The utility function

for A is U A = x A y A , and for B is U B = x B y B . The economy has reached a general


p / p =1 equilibrium at x A = 9, y A = 9, x B = 1, y B = 1 and prices x y . First lets figure out the

social welfare of this allocation using a few measures of social welfare. a) If we were to calculate social welfare using the utilitarian social welfare function what would social welfare be? b) If we were to calculate social welfare using the Rawlsian social welfare function what would social welfare be? c) If we use a new Cobb-Douglas style social welfare function, what would social welfare be?

An economist comes along and points out that there exists another general equilibrium at

x A = 5, y A = 5, x B = 5, y B = 5 and some prices p x / p y = 1 .


d) According to the second welfare theorem, what can the social planner do to implement the new general equilibrium? e) Is the new proposal a Pareto improvement over the original general equilibrium? Why or why not? f) Is the new proposal a social welfare improvement over the original general equilibrium under any of the three social welfare functions in a), b) and c)? Under which social welfare measures is it an improvement? Under which is it not an improvement?

1.6

Consider an economy with two agents who consume just two goods X and Y.

Steven has an endowment of XS =10 and YS =10. Monica has an endowment of XM =10 and YM =10. Their utility functions are, respectively, given by: a) Graph the Edgeworth box corresponding to this economy. b) What is the equation of the contract curve in this economy? Graph it. c) Determine the utility possibility set. Graph it. Now consider a social planner who maximizes: 1. a Rawlsian social welfare utility function 2. a utilitarian social welfare utility function 3. a middle-of-the-way social welfare utility function d) For each welfare function, give an example of an allocation that the social planner would choose.