University of Exeter

Department of Economics
Pauline Vorjohann
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BEEM101 Microeconomics
Problem Set 5: Exchange Economy
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1. Exercise - Competitive equilibrium

Consider an exchange economy with two individuals, A and B, and two goods, good 1 and good 2.
Let xi1 and xi2 denote individual i’s respective quantities of the two goods. Individual A has initial
A 41 A 34
endowment (ω1A , ω2A ) = (1, 0) and utility function u(xA A
1 , x2 ) = (x1 ) (x2 ) . Individual B has initial
B B B B B B
endowment (ω1 ; ω2 ) = (0, 1) and utility function v(x1 , x2 ) = x1 x2 . Assume the price of good 1
is equal to 1, p1 = 1, so that the price of good 2, p2 , measures its relative price.
a) Compute the set of Pareto optimal allocations, also known as “contract curve”. Which alloca-
tions on this contract curve pareto-dominate the initial allocation?
b) Derive A’s (gross) demand for goods 1 and 2 as a function of p2 .
c) Derive B’s (gross) demand for goods 1 and 2 as a function of p2 .
d) Compute the competitive equilibrium for this exchange economy, meaning the price p2 that
equates demand and supply for both goods; also determine the resulting equilibrium allocation.
e) Draw the Edgeworth box describing this economy, and indicate the initial allocation, the
contract curve, and the equilibrium allocation.

a) The contract curve consists of all feasible allocations where the individuals’ indifference curves
are tangent to each other. Formally, this means that the MRS of A and B are equal. If this
were not the case, then, graphically, there would be a lense between the indifference curves,
and all allocations in this lense would pareto-dominate the original allocation.
Individual A:
1 3
u(xA A
1 ; x2 ) = (xA A 4
1 ) (x2 )
4

  34
∂u 1 xA 2
=
∂xA
1 4 xA 1
 A  14
∂u 3 x1
=
∂xA
2 4 xA 2
xA
MRSA = 2
3xA1

Individual B:

v(xB B
1 ; x2 ) = xB B
1 x2
∂u
= xB
2
∂xB 1
∂u
= xB
1
∂xB 2
xB
MRSB = 2
xB
1

M RS A = M RS B :
xA2 xB
2
=
3xA1 xB
1

1
 We also know by feasibility that xB A B A
2 = 1 − x2 and x1 = 1 − x1 , since there is one unit of each
good in the economy (it cannot be Pareto-optimal to not allocate everything to someone, since
both goods are “goods”).

xA
2 1 − xA
2
=
3xA1 1 − xA
1
xA A A
2 − x2 x1 = 3xA A A
1 − 3x1 x2
xA A A
2 + 2x2 x1 = 3xA
1
xA
2 (1 + 2xA
1) = 3xA
1
3xA
1
xA
2 =
1 + 2xA
1

This equation describes the contract curve. All allocations on this curve are Pareto-optimal.
Since both individuals have a utility of zero at their initial endowments, any interior point on
this line (where xi1 > 0 and xi2 > 0 for both individuals i ∈ {A, B}) will be preferred by both to
the initial allocation.
b) Since u(xA A
1 , x2 ) is a Cobb-Douglas utility function, the demands for goods 1 and 2 are such
that fraction 41 of wealth is spent on good 1 and fraction 14 of wealth is spent on good 2. We
still have to compute A’s wealth, however, which equals the value of her initial endowment at
given prices p1 and p2 : she only has quantity 1 of good 1, and this good’s price equals 1, so her
wealth equals 1.
1
xA∗
1 (p2 ) =
4
3
xA∗
2 (p2 ) =
4p2
1 1
c) The utility function v(xB B B 2 B 2
1 , x2 ) is equivalent to the Cobb-Douglas utility function (x1 ) (x2 )
(take the root of v, which is a positive monotonic transformation). Hence B spends the same
amount of her wealth on both goods (fraction one half ). Her budget equals p2 since she only
has quantity 1 of good 2 whose price is p2 .
p2
xB∗
1 (p2 ) =
2
1
xB∗
2 (p2 ) =
2

d) The competitive equilibrium price p∗2 satisfies that both xA∗ ∗ B∗ ∗ A∗ ∗

1 (p2 ) + x1 (p2 ) = 1 and x2 (p2 ) +
∗
xB∗
2 (p2 ) = 1 (market clearing for both markets). The first equation yields:

1 p∗2
= 1−
4 2
3
p∗2 =
2
1 1 3 1
At this price, xA∗ A∗ B∗ B∗
1 = 4 , x2 = 2 , x1 = 4 , and x2 = 2 . The market for good 2 clears as well
(Walras’ law).

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