Charlie Nusbaum T4 Selected Solutions

Econ 100B: General Equilibrium Selected Solutions

E. Charlie Nusbaum

August 13, 2016

Charlie Nusbaum T4 Selected Solutions

3) In an exchange economy, there are two people (A and B), and two goods (X and Y).
2 1 3 1
The utility functions of A and B are given by UA = xa3 ya3 and UB = xb4 yb4 . There are
10 units of X and 10 units of Y in total. Which of the following gives a condition for
Pareto optimality?

Here, we are effectively looking for our contract curve in terms of person A’s de-
mands. Because we have smooth indifference curves, we can use our tangency condition.

M RSa = M RSb
−1 1
−1 1
2/3xa 3 ya3 3/4xb 4 yb4
⇔ 2
−2
= 3
− 43
1/3xa ya 3
3
1/4xb4 yb
2ya 3yb
⇔ =
xa xb

Now, recall our feasibility conditions: xa + xb = 10 and ya + yb = 10. From these, we

can substitute out person B’s demands.

2ya 3(10 − ya )
⇒ =
xa 10 − xa
⇔ 20ya − 2xa ya = 30xa − 3xa ya
30xa
⇔ ya =
20 + xa
Charlie Nusbaum T4 Selected Solutions

4) (Continued from previous question) Suppose person A is originally endowed with all
10 units of good X and person B is originally endowed with all 10 units of good Y. Let
p be the price of good X and let the price of good Y be 1. What is the competitive
equilibrium value of p?

max Ua s.t. px xa + ya = 10px max Ub s.t. px xb + yb = 10

px px
⇒ M RSa = M RSb =
1 1
2ya 3yb
⇔ = px = px
xa xb
px px
⇔ y a = xa yb = xb
2 3

Plugging these expressions into our budget constraints will yield our demand functions.

3 4
⇒ px xa = 10px px xb = 10
2 3
20 15
⇔ xa = xb =
3 2px

From here, we could also solve for ya and yb . Instead, let’s use our feasibility condition
for x to find our market clearing price (xa + xb = 10).

20 15
10 = +
3 2px
9
⇔ px =
4
Charlie Nusbaum T4 Selected Solutions

20) Consider an exchange economy consisting of two people, A and B, endowed with
two goods, 1 and 2. Person A is initially endowed with ωA = (4, 8) and person B is
initially endowed with ωB = (4, 0).Their preferences are given by UA (x1 , x2 ) = x1 x2
and UB (x1 , x2 ) = x21 x22 .

a) Write the equation of the contract curve (express xA A

2 as a function of x1 ).

As with problem 3, we begin with our tangency condition because we have

“smooth” utility functions.

xA
2 xB
2
A
=
x1 xB
1

We can again substitute from our feasibility conditions: xA B A B

1 +x1 = 8 and x2 +x2 =

8.

xA
2 8 − xA2
⇒ =
xA
1 8 − x A
1

⇔ xA A
2 = x1

b) Let p2 = 1. Find the competitive equilibrium price, p1 , and allocations, xA =

(xA A B B B
1 , x2 ) and x = (x1 , x2 ).

As before, we solve each individual’s maximization problem.

xA
2 xB
2
= px = px
xA
1 xB
1

⇔ xA a
2 = p x x1 ⇔ xB B
2 = p x x1
Charlie Nusbaum T4 Selected Solutions

Now, we can substitute these equalities into each person’s budget constraint.

⇒ 2px xA
1 = 4px + 8 ⇒ 2px xB
1 = 4px
4px + 8
⇔ xA
1 = ⇔ xB
1 = 2
2px

Again, we can use our feasibility conditions to find our market clearing price.

4px + 8
⇒8=2+
2px
⇔ 8px = 4px + 4

⇔ px = 1

Plugging into our demand functions yields:

x∗A = (6, 6) x∗B = (2, 2)

Note that there are a number of ways to approach these problems. I find the
above to be the most formulaic, though not always the fastest solution method,
because it relies on two things that you should all be comfortable with: utility
maximization and market clearing. Alternatively, you could appeal to the First
Fundamental Welfare theorem (i.e. all competitive equilibrium are P.O.) and
plug our contract curve equation into our M RS = px equation. Subsequently, you
could use the budget and feasibility constraints to solve for equilibrium quantities.
I tend not to use this trick because the contract curve equation can sometimes be
nasty.
Charlie Nusbaum T4 Selected Solutions

c) Now suppose that person B’s preferences are instead given by UB = min{xB B
1 , x2 }.
1
Given a price of p1 = 3
(and assuming p2 = 1), what Pareto-optimal allocation
will result from trade between the two people?

Notice that in this case, we do not in fact have “smooth” utility functions; person
B’s utility function is now L-shaped (i.e. perfect compliments). As a result, we
cannot set the marginal rates of substitution for each person equal to one another.
Drawing our Edgeworth Box diagram, however, it should be evident that the
points at which there are no additional Pareto improving trades are the points
where the corners of person B’s indifference curves just touch the indifference
curves of person A. But this is simply the definition of Pareto optimality. Hence
the line connecting the corners of person B’s indifference curves must be the
contract curve. (WOW!)

We have just derived our contract curve to be xB B

1 = x2 . Let’s plug this into our

budget constraint directly.

1 4
⇒ xB B
1 +x2 =
3 3
1 B B 4
⇔ x1 +x1 =
3 3
⇔ xB
1 = 1 ⇒ xB
2 = 1

Now, we can use our feasibility conditions to find person A’s quantities.

⇒ xA = (7, 7)
Charlie Nusbaum T4 Selected Solutions

d) Briefly explain why this price and allocation combination are not competitive
equilibrium.

Notice that if we solved person A’s utility optimization problem, we would obtain
xA
the following condition: xA
2 =
1
3
. From here, we should already be able to see
that this equality does not hold at (7,7); person A’s would like to sell more good
2 and buy more of good 1 at this prices. As a result, the market does not clear at
these prices. At first glance, it may seem that this violates our welfare theorems.
Let’s recall what these theorems say. The First Welfare theorem states (under
minor assumptions) that all competitive equilibrium are P.O, not the other way
around. The Second Welfare theorem states (under additional assumptions) that
any P.O. allocation can be supported by SOME prices after appropriate transfers
are made; it does not say that P.O. allocations are supported by ANY price sys-
tem. Clearly, then, we have not violated our welfare theorems.

e) Let p2 = 1. Find the actual competitive equilibrium price, p1 , and allocations,

xA = (xA A B B
1 , x2 ) and xB = (x1 , x2 ).

From part c, we know that xB B

1 = x2 because of perfect complimentarity for person

B. Recall that person A’s optimization problem yields xA A

2 = p x x1 .

⇒ 4px + 8 = px xA A
1 + x2 ⇒ 4px = px xB B
1 + x2
4px + 8 4px
⇔ xA
1 = ⇔ xB
1 =
2px px + 1
4px + 8 4px
⇒ + =8
2px px + 1
⇔ p2x +px − 2 = 0

⇔ px = 1, −2
Charlie Nusbaum T4 Selected Solutions

Because price cannot be negative, we take px = 1. Furthermore, this price im-

plies equilibrium quantities of xA = (6, 6) and xB = (2, 2). A clever individual
could skip all of this algebra by noticing that our solution to part b satisfied the
optimality conditions of persons A and B.