TA Session 3

Microeconomics 2 - LMEC - a.y. 2021/2022

Professor: Paolo Vanin
Teaching Assistant: Nektaria Glynia

10 December 2021

1 Cobb-Douglas Pure-Exchange Economy (PEE)

Consider a pure-exchange economy with two rational consumers, Ms. A and Mr. B, and two goods x1
and x2 . Preferences are described by Cobb-Douglas utility functions of the form:
2 1
uA (xA A A 3 A 3
1 , x2 ) = (x1 ) (x2 )
1 2
uB (xB B B 3 B 3
1 , x2 ) = (x1 ) (x2 )

Let wA = (2; 4) and wB = (4; 2) be the initial endowments of the two consumers, also let w = (wA ; wB ).
1.1 Draw the Edgeworth box labelling axes and the initial endowment w.
1.2 Compute and draw the set of Pareto-optimal allocations and show the contract curve in the box.
1.3 Find the Walrasian demands, Walrasian prices and equilibrium allocations.

Answer

1.1

2/3 A
1/3
U A xA = xA wA = (2; 4)


1 x2

1/3 B
2/3
U B xB = xB wA = (4; 2)


1 x2

X2A
4 0
X1B
Initial Endowment

(2,4)
4 2

X1A
0 2
X2B

1
1.2

Pareto optimal allocations

At every interior solution we have
P1 P1
M RS A = and M RS B = ⇒ M RS A = M RS B
P2 P2

Pareto set is characterised by: 

A B
M RS = M RS

xA B
1 + x1 = w1

 A
x2 + xB
2 = w2

where

2

−1/3
1/3
xA
1 xA2 2xA
M RS = A 3

2/3 −2/3
= A2
1 x1


3 xA
1 xA
2

1

−2/3
2/3
B 3 xB
1 xB2 xB
2
M RS = =
−1/3 2xB
2

1/3

3 xB
1 xB
2 1

Therefore:  2xA xB

 xA
2
= 2
2xB
(i)

 1 1



 xA B B A
1 + x1 = 6 → x1 = 6 − x1 (ii)





 A
x2 + xB B A
2 = 6 → x2 = 6 − x2 (iii)
Plug in (ii) and (iii) in (i) and solve for xA
2

2xA2 6 − xA2 2xA1

= ⇒ xA
2 =
xA
2 2(6 − xA1) 8 − xA1

The Pareto set is a convex curve since xA A

2 (0) = 0 and x2 (6) = 6. Notice that:

A 1 B
M RSw A = 4 6= = M RSw B
4
cannot be in the Pareto set.
− A values good 1 much more the B (ready to give up 4 units of good 2 for 1 unit of good 1, while
B only 1/4 units. Thus trade will occur. A exchanges good 2 for good 1)

Contact curve / Core

Core (in a 2 agent economy), is the subset of the Pareto set that is preferred by both agents with respect
to their endowments.
That is: 
2xA

 xA2 = 8−xA
1
1







2/3 A
1/3
 xA1 x2 ≥ 2.52 = U A (wA )





 xB
1/3 xB
2/3 ≥ 2.52 = U B (wB )

1 2

One way to characterize the core is to find the intersection between the Pareto set and the indifferent
curves passing through the initial endowments. This is given by:

A 2/3


1/3
 x1

 xA
2 ≥ 2.52 (i)

2xA


 xA =
 1
(ii)
2 8−xA1

2
Solving equation (i) above for xA2 and plugging in equation (ii) yield a 3rd order polynomial with one
real root. The solution to the system then is xA A
2 = 3.34; x2 = 1.43

→ Intersection between U B (wB ) and the Pareto set: Convert the Pareto set form B’s ”point of view”
using the feasibility constraints xA B A
2 = 6 − x2 ; x1 = 6 − x1
B


B 1/3


2/3
 x1

 xB
2 ≥ 2.52 (i)

2−(6−xB
1 )

6 − x B =

(ii)
2 8−(6−xB
1

xB A
1 = 1.165 → x1 = 4.835

xB A
2 = 2.35 → x2 = 3.05

X2A
4 0
X1B
Initial Endowment
2X1A
X2A = 8−X1A
(2,4)
4 2

(4.835, 3.05)
Core

(4, 2)

(3.34 , 1.43)

X1A
0 2
X2B

1.3

Walrasian demands
Solve the Utility Maximisation Problem for the 2 agents separately.

The FOCs are:


A P1 P1
M RS =
 P2 → 2xA A
2 x1 = P2
A

P1 x A A A A
1 + P2 x2 = P1 w1 + P2 w2 → P1 x A A
1 + P2 x 2 = P1 2 + P2 4


You can solve the system or recognize that for the Cobb-Douglas we have
2 2P1 + 4P2
xA
1 (p) =
3 P1
1 2P1 + 4P2
xA
2 (p) =
3 P2

Similarly:
1 4P1 + 2P2
xB
1 (p) =
3 P1
2 4P 1 + 2P2
xB
2 (p) =
3 P2

3
 Walrasian prices:
P1
Since excess demands are homogeneous of degree zero we can normalise prices i.e P2 = 1; P1 = P2 =P

By Walras law if N − 1 of the N markets are in equilibrium (excess demand is 0), also the N th market
will clear. Take for example good 1:

xA B
1 (p) + x1 (p) − w1 = 0

2 2P + 4 1 4P + 2
+ −6=0 → P =1
3 P 3 P

Equilibrium allocation:
xA A
1 (1; 1) = 4 → x2 (1; 1) = 2

xB B
1 (1; 1) = 2 → x2 (1; 1) = 4

2 Quasi-Linear PEE
Consider a pure-exchange economy with two rational consumers, Ms. A and Mr. B, and two goods x1
and x2 . Preferences are described by quasi-linear utility functions of the form:
1
uA (xA A A A 2
1 , x2 ) = (x1 ) + 2(x2 )

1
uB (xB B B B 2
1 , x2 ) = (x1 ) + (x2 )

Let wA = (4; 1) and wB = (1; 4) be the initial endowments of the two consumers, also let w = (wA ; wB ).
2.1 Draw the Edgeworth box labelling axes and the initial endowment w.
2.2 Compute and draw the set of Pareto-optimal allocations.
2.3 Find the Walrasian demands, Walrasian prices and equilibrium allocations.

Answer

2.1-2.2

A 1/2
U A xA = xA wA = (4; 1)



1 + 2 x2

B 1/2
U B xB = xB wA = (1; 4)



1 + x2

• Pareto set is characterised by:


12
1/2


 xA
2 = 2 xB
2




xA B
1 + x1 = 5






xA B
2 + x2 = 5


n
12
1/2
xA
2 = 2 5 − xA
2 ⇒ xA A
2 = 20 − 4x2 ⇒ xA
2 =4

4
 Pareto Set
4 1
(2.5, 4)

(4, 1)
G

So the Pareto set is a straight line since MRS does not depend on x1 . However think of point G.
(

xA A
1 = 0; x2 = 2
A=

xB B
1 = 5; x2 = 3

M RS A ≡ 1.4 6= 3.38 ≡ M RS B

B values more good x1 , he wants more of it but he has all of it so trade cannot occur. However, there is
no way to make the agents better off.

2.3
Walrasian demands:
P1
Let P2 = 1; P1 = P2 =P

1
A 2 P1
 x2
 = P2 → xA
2 (P ) = P
2

A
4P +1−P 2

P1 x A A A
1 + P2 x2 = P1 4 + P2 1 → x1 (P ) =

P


1
B 2 P1 P2
2 x2
 = P2 → xB
2 (P ) = 4
B
4P +16−P 2

P1 x B B B
1 + P2 x2 = P1 1 + P2 4 → x1 (P ) =

4P

Walrasian prices
Take the market for good 2:

P2
P2 + −5=0 → P =2
4

xA A B B



1 = 2.5; x2 = 4 ; x1 = 2.5; x2 = 1

5
3 Kinked Preferences in PEE
Consider a pure-exchange economy with two rational consumers, Ms. A and Mr. B, and two goods x1
and x2 . Preferences are kinked and are described by the following utility function:
p p
i 1 i i i
 x1 + 2 x2 if x1 ≤ x2

ui (xi1 , xi2 ) =
1p i p i

2 x1 + x2 if xi1 > xi2

where i ∈ {1, 2}. Moreover, let wi = (w1i ; w2i ) be the initial endowment of the two consumers.
3.1 Find the excess demand functions.
3.2 For each of the following cases find the Walrasian prices:
a) wA = wB = (4, 4);
b) wA = (5, 3) and wB = (3, 5);
c) wA = (8, 2) and wB = (3, 5).

Answer

3.1
p p
1
i
 x1 + 2 x2
 i if xi1 ≤ xi2
i
xi1 ; x2i


U =
1p
 p
2 xi1 + xi2 if xi1 > xi2

Utility is not differentiable at the kink. Notice that we can rule out boundary solutions since:
!
∂U i (.) 1
lim = p = +∞
xi1 →0 ∂xi1 2 xi1

!
∂U i (.) 1
lim i
= p = +∞
xi2 →0 ∂x2 2 xi2

P2
Walrasian demand Normalise P1 = 1; P2 = P1 =P

p p
Case I: xi1 > xi2 > 0 → U i = 12 xi1 + xi2
 q i
1 x2


 M RS i
= 2 xi1
= P1 P >2 since xi1 > xi2
Ui xi1 ; xi2 =



xi + P xi = wi + P wi

1 2 1 2

Consumer will consume higher amount of good 1 than good 2 only if good 2 is more than twice as
expensive as good 1. Solve the first equation for xi2 to get
 2
2
xi2 = xi1
P
Plug it in the budget constraint so that:
4 i
xi1 + P x = w1i + P w2i
P2 1

6
 w1i + P w2i w1i P + P 2 w2i
xi1 (P ) = =
1 + P4 P +4

w1i P + P 2 w2i 4w1i + 4P w2i

 
4
xi2 (P ) = 2 =
P P +4 4P + P 2

p p
Case II: 0 < xi1 < xi2 ⇒ U i = xi1 + 12 xi2
 q i
x2


 M RS i
= 2 xi
= P1 P < 1
2 since xi2 > xi1
1


xi + P xi = wi + P wi

1 2 1 2

The agents consume higher amount of good 2 than good 1 only if good 1 is more than twice as
expensive. As before solve for xi2 and plug it in the budget constraint:

4w1i P + 4P 2 w2i
xi1 (P ) =
4P + 1

w1i + P w2i
xi2 (P ) =
P + 4P 2

Case III: xi1 = xi2 ⇒ P ∈ [ 12 ; 2]


i i
x1 = x2



 i
x1 + P xi2 = w1i + P w2i

w1i P + P 2 w2i
xi1 (P ) =
1+P

w1i P + P 2 w2i
xi2 (P ) =
1+P

Excess demand can be found by substracting the relevant initial endowment from the Walrasian
demand: e.g z1i (p) = xi1 − w1i
 P 2 wi −4wi 4wi −P 2 wi
 4+P ; 4P +P 2 P >2
2 1 1 2






P 2 w2i −P w1i w1i −w2i
z i (p) = z1i (p); z2i (p)


; 1+P P ∈ [ 21 ; 2]
 1+P




 4P 2 wi −wi
 w1i −4P 2 w2i 1
2
4P +1
1
; 4P +P P < 2

3.2
- Now assume wA = wB = (4; 4)

1. The Box is square

2. The Pareto set is the 45 degree line

7
 3. Multiple Equilibria/ Price indeterminacy

x21

8 O2

Pareto Optimal Allocations

IC1
x12 w x22

IC2

O1 8

x11

- Now assume wA = (5; 3); wB = (3; 5). Find for which prices the aggregate excess demand in one of
the markets is equal to 0. Take good 1:

P 2 ×3−4×5 P 2 ×5−4×3 8P 2 −32

• For P > 2 → z1A + z1B = 4+P + 4+P = 4+P

5P −3P 3P −5P 8P 2 −32

• For P ∈ [1; 12 ] → z1A + z1B = 1+P + 1+P =0= 4+P

1 32P 2 −8
• For P < 2 → z1A + z1B = 4P +1 <0
- Again there are infinitely many equilibrium prices. However both agents will consume on the 45
degree line. Notice that in this and the previous example the multiplicity of equilibria was mainly driven
by the kink.

x21

8 O2

x12 x22

O1 8

x11

Now assume wA = (8; 2) and wB = (3; 5) and compute excess demand as before:

8
 q
7P 2 −44
• for P > 2 then 4+P 0 if P ∗ = 44
7 = 2.5
−4P
• for P ∈ [1; 2] then 1+P <0
28P 2 −11
• for P < 1/2 then 4P + <0

∗ ∗ ∗ ∗
xA A B B



1 (P ) = 5; x2 (P ) = 3.2 ; x1 (P ) = 6; x2 (P ) = 3.8

x21
7 O2

x12 x22
E
IC2 IC1

O1 11
x11