Exchange 1

1. Consider an economy with two consumers, A and B , and two goods, X and Y. Consumers’ utility
√
functions
are UA (xA , yA ) = ln xA + yA and UB (xB , yB ) = 2 xB + yB . Initial total endowments
are X, Y = (1, 9) .
Find the set of Pareto optimal allocations and plot it in the Edgeworth box.
Interior Pareto optimal allocations:
Conditions for Pareto Optimality

M RS A = M RS B
xA + xB = 1
yA + yB = 9

By combining the first two conditions:

1 1
=√
xA xB
√
⇒xA = xB
⇒x2A = 1 − xA
⇒x2A − 1 + xA = 0

This equation has two different roots, but just one of them is positive.
Therefore: √
5−1
x∗A =
2
Now, by using feasibility and x∗A
√ √
5−1 3− 5
(x∗A , x∗B ) =( , )
2 2
and
∗ ∗
yA + yB =9

Corner Pareto optimal allocations:

√ √
5−1 √ 2 . Besides, 5−1
In any allocation such that xA < 2 the M RS A > if xA < 2 and using
√ q5−1
3− 5
feasibility condition, implies xB > 2 , then M RS B < 3−2√5 .

Hence, any allocation such that xA < x∗A satisfies: M RS B < M RS A . Any additional unit of good
y increases more the welfare of consumer B than A. Therefore, it is efficient yB = 9 and yA = 0
√
5−1
By an analogous argument, if xA > 2 it is satisfied M RS B > M RS A , then in any efficient
allocation yB = 0 and yA = 9
Edgeworth box

1
 XB
9 Individual B

YA YB

Individual A
XA 1
√
2. Now assume that B ’s utility function is instead UB (xB , yB ) = xB + 2 yB and everything else is
as before.
(a) Find and plot the set of Pareto optimal allocations and plot it in the Edgeworth box.
Interior pareto optimal allocations:
Conditions for Pareto Optimality

M RS A = M RS B
xA + xB = 1
yA + yB = 9

By combining the three conditions:

1 √
= yB
xA
 1 2
⇒ = yB
xA
 1 2
⇒ = 9 − yA
xA
 1 2
⇒yA = 9 −
xA

Next, let’s find the corner solutions. From the previous condition, (xA , yA ) = (1/3, 0) and
(xA , yA ) = (1, 8) are points satisfying optimal conditions.
First, assume xA < 1/3 this implies M RS A > 3.
From feasibility condition, yA + yB = 9, then yB ≤ 9 and M RS B ≤ 3.
Next, by combining the previous conditions M RS A > M RS B , then in an efficient allocation
consumer B must consume all the endowment of good y.
Analogously if yA > 8 it is efficient individual A consumes all the endowment of x.
Edgeworth box

2
 XB
9 Individual B

YA YB

Individual A
XA 1
(b) Suppose that the initial endowments are (xA , y A ) = (1, 0) and (xB, y B ) = (0, 9) . Find
Walrasian equilibrium prices and allocation (you can assume that the Walrasian equilibrium
allocation is interior).
Individual A

xy −1 −px py
M RSA (xA , yA ) = = ⇒ x∗A =
xA py px
Budget constraint of individual A

px xA + py yA = px

Next, combine the budget constraint and x∗A

∗ px − py
yA =
py

Individual B

xy √ −px ∗
 p 2
x
M RSB (xB , yB ) = − yB = ⇒ yB =
py py
Budget constraint of individual B

px xA + py yA = 9py

∗
Next, combine the budget constraint and yB

9py px
x∗B = −
px py
Market clearing conditions

xA + xB = 1
yA + yB = 9

3
 ∗ ∗
From yA and yB into the condition yA + yB = 9
px  p 2
x
−1+ =9
py py

Normalize py = 1
p2x + px − 10 = 0
Therefore: √
41 − 1
px =
2
And the equilibrium allocations are:

1 2
x∗A =
=√
px 41 − 1
√
41 − 3
x∗B = 1 − x∗A = √
41 − 1
√
∗ 41 − 3
yA = px − 1 ⇒ yA =
2
√
∗ 21 − 41
yB = 9 − yA =
2

Exchange 2
1. Consider an economy with two consumers, A and B , and two goods, X and Y. Consumers’ utility
√
functions
are UA (xA , yA ) = ln xA + yA and UB (xB , yB ) = 2 xB + yB . Initial total endowments
are X, Y = (9, 1) .
Find the set of Pareto optimal allocations and plot it in the Edgeworth box.
Interior Pareto optimal allocations:
Conditions for Pareto Optimality

M RS A = M RS B
xA + xB = 9
yA + yB = 1

By combining the first two conditions:

1 1
=√
xA xB
√
⇒xA = xB
⇒x2A = 9 − xA
⇒x2A − 9 + xA = 0

The previous equation has two different roots, but just one of them is positive. Therefore:
√
∗ 37 − 1
xA =
2

Now, by using feasibility and x∗A

√ √
37 − 1 19 − 37
(x∗A , x∗B ) =( , )
2 2
and
∗ ∗
yA + yB =1

4
 Corner Pareto optimal allocations:
√ √
37−1 2 37−1
In any allocation such that xA < 2 the M RS A > √37−1 . Besides, if xA < 2 and the
√ q
19− 37
feasibility condition implies xB > 2 , and M RS B < 19−2√37 .

Hence, any allocation such that xA < x∗A satisfies: M RS B < M RS A . Any additional unit of good
y increases more the welfare of consumer B than A. Therefore, it is efficient yB = 1 and yA = 0
√
37−1
By an analogous argument, if xA > 2 it is satisfied M RS B > M RS A , then in any efficient
allocation yB = 0 and yA = 1
Edgeworth box
XB
1 Individual B

YA YB

Individual A
XA 9
√
2. Now assume that B ’s utility function is instead UB (xB , yB ) = xB + 2 yB and everything else is
as before.
(a) Find and plot the set of Pareto optimal allocations and plot it in the Edgeworth box.
Interior pareto optimal allocations:
Conditions for Pareto Optimality

M RS A = M RS B
xA + xB = 9
yA + yB = 1

By combining the three conditions:

1 √
= yB
xA
 1 2
⇒ = yB
xA
 1 2
⇒ = 1 − yA
xA
 1 2
⇒yA = 1 −
xA

Next, let’s find the corner solutions. From the previous condition, (xA , yA ) = (1, 0) and
(xA , yA ) = (9, 80
81 ) are points satisfying optimal conditions, and in the sides of the box. Next
is finding which conditions must be satisfied for a optimal solution on the sides of the box
First, assume xA < 1 this implies M RS A > 1.
From feasibility condition, yA + yB = 1, then yB ≤ 1 from which M RS B ≤ 1.
Next, by combining the previous conditions M RS A > M RS B , then in an efficient allocation
consumer B must consume all the endowment of good y.
80
Analogously if yA > 81 it is efficient individual A consumes all the endowment of x.
Edgeworth box
XB
1 Individual B
A
Y YB
Individual A
XA 9

5
(b) Suppose that the initial endowments are (xA , y A ) = (9, 0) and (xB, y B ) = (0, 1) . Find
Walrasian equilibrium prices and allocation (you can assume that the Walrasian equilibrium
allocation is interior).
Individual A

xy −1 −px py
M RSA (xA , yA ) = = ⇒ x∗A =
xA py px
Budget constraint of individual A

px xA + py yA = 9px

Next, combine the budget constraint and x∗A

∗ 9px − py
yA =
py

Individual B

xy √ −px ∗
 p 2
x
M RSB (xB , yB ) = − yB = ⇒ yB =
py py
Budget constraint of individual B

px xA + py yA = py

∗
Next, combine the budget constraint and yB
py px
x∗B = −
px py
Market clearing conditions

xA + xB = 9
yA + yB = 1

From x∗A and x∗B into the condition xA + xB = 9

px  p 2
x
9 −1+ =1
py py

Normalize py = 1
p2x + 9px − 2 = 0
Therefore: √
89 − 9
px =
2
And the equilibrium allocations are:

1 2
x∗A = =√
px 89 − 9
√
∗ ∗ 9 89 − 83
xB = 9 − xA = √
89 − 9
√
∗ 9 89 − 1
yA = 9px − 1 ⇒ yA =
2
√
∗ 83 − 9 89
yB = 1 − yA =
2

6
 Exchange 3
1. Consider an economy with two consumers, A and B , and two goods, X and Y. Consumers’ utility
√
functions are UA (xA , yA ) = xA + ln yA and UB (xB , yB ) = xB + 2 yB . Initial total endowments


are X, Y = (9, 1) .
Find the set of Pareto optimal allocations and plot it in the Edgeworth box.
Interior Pareto optimal allocations:
Conditions for Pareto Optimality

M RS A = M RS B
xA + xB = 9
yA + yB = 1

By combining the first two conditions:

√
yA = yB

2
⇒yA = 1 − yA
2
⇒yA − 1 + yA = 0

The previous equation has two different roots, but just one of them is positive. Therefore:
√
∗ 5−1
yA =
2

Now, by using feasibility and x∗A

√ √
∗ ∗ 5−1 3− 5
(yA , yB )=( , )
2 2
and
x∗A + x∗B = 9

Corner Pareto optimal allocations:

√ √ √
5−1
In any allocation such that yA < 2 the M RS A < 5−1 . Besides, if yA < 5−1
and the
√ q 2√ 2
3− 5 B 3− 5
feasibility condition implies yB > 2 , and M RS > 2 .
∗
Hence, any allocation such that yA < yA satisfies: M RS A < M RS B . Any additional unit of good
x increases more the welfare of consumer B than A. Therefore, it is efficient xB = 9 and xA = 0
√
5−1
By an analogous argument, if yA > 2 it is satisfied M RS B > M RS A , then in any efficient
allocation xB = 0 and xA = 9
Edgeworth box
XB
1 Individual B

YA YB

Individual A
XA 9
√
2. Now assume that B ’s utility function is instead UB (xB , yB ) = 2 xB + yB and everything else is
as before.

7
(a) Find and plot the set of Pareto optimal allocations and plot it in the Edgeworth box.
Interior pareto optimal allocations:
Conditions for Pareto Optimality

M RS A = M RS B
xA + xB = 9
yA + yB = 1

By combining the three conditions:

1
yA = √
xB
1
⇒yA = √
9 − xA

Next, let’s find the corner solutions. From the previous condition, (xA , yA ) = (0, 1/3) and
(xA , yA ) = (8, 1) are points satisfying optimal conditions, and in the sides of the box. Next is
finding which conditions must be satisfied for a optimal solution on the sides of the box
First, assume yA < 1/3 this implies M RS A < 1/3.
From feasibility condition, xA + xB = 9, then xB ≤ 9 from which M RS B ≥ 1/3.
Next, by combining the previous conditions M RS A < M RS B , then in an efficient allocation
consumer B must consume all the endowment of good x.
Analogously if xA > 8 it is efficient individual A consumes all the endowment of y.
Edgeworth box
XB
1 Individual B
A
Y YB
Individual A
XA 9

(b) Suppose that the initial endowments are (xA , y A ) = (0, 1) and (xB, y B ) = (9, 0) . Find
Walrasian equilibrium prices and allocation (you can assume that the Walrasian equilibrium
allocation is interior).
Individual A

xy −px ∗ px
M RSA (xA , yA ) = −yA = ⇒ yA =
py py
Budget constraint of individual A

px xA + py yA = py

Next, combine the budget constraint and x∗A

py − px
x∗A =
px

Individual B

xy 1 −px  p 2
y
M RSB (xB , yB ) = − √ = ⇒ x∗B =
xB py px
Budget constraint of individual B

px xA + py yA = 9px

Next, combine the budget constraint and x∗B

∗ 9px py
yB = −
py px

8
 Market clearing conditions

xA + xB = 9
yA + yB = 1

From x∗A and x∗B into the condition xA + xB = 9

py  p 2
y
−1+ =9
px px
Normalize px = 1
p2y + py − 10 = 0
Therefore: √
41 − 1
py =
2
And the equilibrium allocations are:

∗ 1 2
yA = =√
py 41 − 1
√
∗ ∗ 41 − 3
yB = 1 − yA = √
41 − 1
√
∗ 41 − 3
xA = py − 1 ⇒ xA =
2
√
21 − 41
xB = 9 − x∗A =
2

Production 1
1. Consider an economy with two consumption goods, X and Y , two factors of production,
1 1
K and L , two firms, X and Y , with production functions xX = fX (kX , lX ) = kX lX ,
2 2

1 1

yY = fY (kY , lY ) = 2kY lY . Total initial endowments are K, L = (1, 1) . Find and plot the
2 2

production possibilities frontier.

In order to find the PPF, I will use technological efficiency conditions

M RT Sx = M RT Sy (1)
kx + ky = 1 (2)
lx + ly = 1 (3)
1 1
x X = k X lX2 2
(4)
1 1
yY = 2kY lY 2 2
(5)

From condition (1):

1 1
1 −2 2 −1 1

2 k x lx 2 12 ky 2 ly2
1 1 = 1
− 12
1 2 −2
2 kx lx 2 12 ky2 ly
lx ly
⇒ =
kx ky
By using condition (2) and (3):
lx = kx and ly = ky

In addition, by using equations (4) and (5)

9
 xX = kx
yY = 2ky

Therefore, by using condition (2)

yY
xX + =1
2
The production possibilities frontier is:

yY = 2 − 2xX

1.5

1
y

0.5

0
0 0.2 0.4 0.6 0.8 1
x
2. Assume now firm Y ’s production function is instead yY = fY (lY ) = 2lY and everything
else is unchanged. Find and plot the production possibilities frontier. Suppose that there is
one consumer, A , who owns total initial endowments of K and L and who has with utility
function UA (xA , yA ) = 3xA + yA .
i. Find the Pareto optimal allocation.
In a Pareto optimal allocation kY must be equal to zero, therefore the previous problem
is equivalent to work with
yY = fY (lY ) = 2lY
and 1
xX = lX
2

Applying the feasibility condition, and the conditional factor demand of both firms:
y
lX + lY = 1 ⇒ x 2 + =1
2
Therefore, the PPF is:
y = 2 − 2x2

10
 2

1.5

1
y

0.5

0
0 0.2 0.4 0.6 0.8 1
x
ii. Find Walrasian equilibrium prices and allocation.
Let UA = 3xA + yA
Pareto optimal allocation satisfies that in an interior solution:
A
M RTx,y = M RSx,y
∂y A
⇒ = M RSx,y
∂x
⇒ −4xA = −3
3
⇒ xA =
4
From the PPF y = 2 − 2x2 . Therefore, yA = 78
Now, by using the production functions of both firms, and the fact that y = 78 and x = 43 ,
implies:
7 9
ly = 16 , lX = 16 kx = 1, and ky = 0
Walrasian equilibrium:
From the first welfare theorem, we know that the Walrasian equilibrium must be a Pareto
Optimal allocation. In the previous part, we get there is a unique Pareto Optimal alloca-
tion that must be the allocation in the Walrasian equilibrium, i.e. (x∗ , y ∗ , kx∗ , ky∗ , lx∗ , ly∗ ) =
( 34 , 78 , 1, 0, 16
9 7
, 16 )
Therefore, we have missing only the equilibrium prices.
First,
px
M RS(x∗ , y ∗ ) =
py
px
⇒ =3
py
The firm y has constant returns to scale, therefore in equilibrium profits must be equal
to zero
πy∗ = 0 ⇒ py ∗ 2ly∗ = wly∗
Therefore,
w
=2
py
Finally,
r
M RT S =
w
lx r
=
kx 2
9
r=
8
Finally, by normalizing py = 1
9
(px , py , w, r) = (3, 1, 2, )
8

11
 Production 2
1. Consider an economy with two consumption goods, X and Y , two factors of production,
1 1
K and L , two firms, X and Y , with production functions xX = fX (kX , lX ) = 2kX lX ,
2 2

1 1

yY = fY (kY , lY ) = kY lY . Total initial endowments are K, L = (1, 1) . Find and plot the
2 2

production possibilities frontier.

In order to find the PPF, I will use technological efficiency conditions

M RT Sx = M RT Sy (1)
kx + ky = 1 (2)
lx + ly = 1 (3)
1 1
xX = 2kX lX 2 2
(4)
1 1
yY = kY lY
2 2
(5)

From condition (1):

−1 1
1 −2 2
1 1
2 12 kx 2 lx2 2 k y ly
1
− 12
= 1 1
1 2 −2
2 12 kx2 lx 2 ky ly
lx ly
⇒ =
kx ky
By using condition (2) and (3):
lx = kx and ly = ky
In addition, by using equations (4) and (5)

xX = 2kx
yY = k y

Therefore, by using condition (2)

xX
+ yY = 1
2
The production possibilities frontier is:
xX
yY = 1 −
2

0.8

0.6
y

0.4

0.2

0
0 0.5 1 1.5 2
x

12
2. Assume now firm Y ’s production function is instead yY = fY (kY ) = kY and everything
else is unchanged. Find and plot the production possibilities frontier. Suppose that there is
one consumer, A , who owns total initial endowments of K and L and who has with utility
function UA (xA , yA ) = xA + 2yA .
i. Find the Pareto optimal allocation.
In a Pareto optimal allocation lY must be equal to zero, therefore the previous problem
is equivalent to work with
yY = fY (kY ) = kY
and 1
xX = 2kX
2

Applying the feasibility condition, and the conditional factor demand of both firms:

x2
kX + kY = 1 ⇒ +y =1
4
Therefore, the PPF is:
x2
y =1−
4
1

0.8

0.6
y

0.4

0.2

0
0 0.5 1 1.5 2
x
ii. Find Walrasian equilibrium prices and allocation.
Let UA = xA + 2yA
Pareto optimal allocation satisfies that in an interior solution:
A
M RTx,y = M RSx,y
∂y A
⇒ = M RSx,y
∂x
−1 −1
⇒ xA =
2 2
⇒ xA = 1
2
From the PPF y = 1 − x4 . Therefore, yA = 4−1 4 = 4
3

Nox, by using the production functions of both firms, and the fact that y = 34 and x = 1,
implies:
ky = 43 , kX = 41 lx = 1, and ly = 0
Walrasian equilibrium:
From the first welfare theorem, we know that the Walrasian equilibrium must be a Pareto
Optimal allocation. In the previous part, we get there is a unique Pareto Optimal alloca-
tion that must be the allocation in the Walrasian equilibrium, i.e. (x∗ , y ∗ , kx∗ , ky∗ , lx∗ , ly∗ ) =
(1, 34 , 14 , 1, 0)
Therefore, we have missing only the equilibrium prices.

13
 First,
px
M RSA (x∗ , y ∗ ) =
py
px
⇒ =3
py
The firm y has constant returns to scale, therefore in equilibrium profits must be equal
to zero
πy∗ = 0 ⇒ py ∗ ky∗ = rky∗
Therefore,
r
=1
py
Finally, from the profit maximization of firm x we have
1 1
max px ∗ 2kX lX − wlX − rkX
2 2

FOC: 1
−1
pX kX
2
lX 2 − w = 0
1
2 −2
1 w
⇒ kX lX =
px
r
w 1 1
⇒ = =
px 4 2
Finally, by normalizing py = 1
1 1
(px , py , w, r) = ( , 1, , 1)
2 4

Production 3
1. Consider an economy with two consumption goods, X and Y , two factors of production,
1 1
K and L , two firms, X and Y , with production functions xX = fX (kX , lX ) = kX lX ,
2 2

1 1

yY = fY (kY , lY ) = 2kY lY . Total initial endowments are K, L = (1, 1) . Find and plot the
2 2

production possibilities frontier.

In order to find the PPF, I will use technological efficiency conditions

M RT Sx = M RT Sy (1)
kx + ky = 1 (2)
lx + ly = 1 (3)
1 1
x X = k X lX
2 2
(4)
1 1
yY = 2kY lY 2 2
(5)

From condition (1):

1 1
1 −2 2 −1 1

2 k x lx 2 12 ky 2 ly2
1 1 = 1
− 12
1 2 −2
2 kx lx 2 12 ky2 ly
lx ly
⇒ =
kx ky
By using condition (2) and (3):
lx = kx and ly = ky

In addition, by using equations (4) and (5)

14
 xX = kx
yY = 2ky

Therefore, by using condition (2)

yY
xX + =1
2
The production possibilities frontier is:

yY = 2 − 2xX

1.5

1
y

0.5

0
0 0.2 0.4 0.6 0.8 1
x
2. Assume now firm Y ’s production function is instead yY = fY (kY ) = 2kY and everything
else is unchanged. Find and plot the production possibilities frontier. Suppose that there is
one consumer, A , who owns total initial endowments of K and L and who has with utility
function UA (xA , yA ) = min{xA , yA }.
i. Find the Pareto optimal allocation.
In a Pareto optimal allocation lY must be equal to zero, therefore the previous problem
is equivalent to work with
yY = fY (kY ) = 2kY
and 1
xX = kX
2

Applying the feasibility condition, and the conditional factor demand of both firms:
y
kX + kY = 1 ⇒ x2 + =1
2
Therefore, the PPF is:
y = 2 − 2x2

15
 2

1.5

1
y

0.5

0
0 0.2 0.4 0.6 0.8 1
x
ii. Find Walrasian equilibrium prices and allocation.
Let UA = min{xA , 2yA }
Pareto optimal allocation satisfies that in an interior solution:

y = 2 − 2x2 and x = 2y
The second condition, from optimality of the consumer’s problem. Then,

y − 2 + 8y 2 = 0
√ √
65−1 65−1
Therefore, yA = 16 and xA = 8
√
65 − 1
y
ky = =
232
√
33 − 65
kx = 1 − ky =
32
ly = 0 and lx = 1
Walrasian equilibrium:
From the first welfare theorem, we know that the Walrasian equilibrium must be a Pareto
Optimal allocation. In the previous part, we get there is a unique Pareto Optimal alloca-
tion that must be the allocation in the Walrasian equilibrium, i.e. (x∗ , y ∗ , kx∗ , ky∗ , lx∗ , ly∗ ) =
√ √ √ √
( 65−1
8 , 65−1
16 ,
33− 65
32 , 65−1
32 , 1, 0)
Therefore, we have missing only the equilibrium prices.
First,
px
M RT (x∗ , y ∗ ) = −
py
√
px 65 − 1
⇒ =6∗
py 8
√
px 3 65 − 3
⇒ = ≈ 0.66
py 32
The firm y has constant returns to scale, therefore in equilibrium profits must be equal
to zero
πy∗ = 0 ⇒ py ∗ 2ky∗ = rky∗
Therefore,
r
=2
py
Finally, from the profit maximization of firm x we have
1 1
max px ∗ kX lX − wlX − rkX
2 2

16
FOC: 1
−1
pX kX
2
lX 2
−w =0
2
px p
⇒ kX = w
2
Normalizing py = 1 we get
q √ √
⇒ w∗ = 1/256 1/2(33 − 65)(3 65 − 3) ≈ 0.29

√ !
65 − 1
(px , py , w, r) = 3 , 1, w∗ , 2
32
with w∗ from above.

17