Microeconomics 2: Problem Set 2

Anastasia Antsygina

Due to: November 30, 3 pm

Problem 1: Pareto Efficiency (15 points)

Take a 2 × 2 pure exchange economy with two individuals (A and B) and two goods (1 and
2). The preferences of A and B can be characterized as follows:

1
1
uA x1A , x2A = ln x1A + ln x2A


2 4
q q
4 3
uB x1B , x2B = 4 x1B · (x2B )

and their endowments are eA = (1, 4) and eB = (4, 1), respectively. For the given economy,
which allocation(s) is Pareto efficient? Consider each allocation separately and explain why
it is Pareto efficient or not.
1. x1A = 5, x2A = 5, x1B = 0, x2B = 0
2. x1A = 2, x2A = 15 , x1B = 3, x2B = 24
5

3. x1A = 1, x2A = 4, x1B = 4, x2B = 1

4. x1A = 3, x2A = 72 , x1B = 2, x2B = 3
2

5. x1A = 3, x2A = 1, x1B = 2, x2B = 4

Problem 2: Welfare Theorems and Non-Standard

Preferences (15 points)
Consider a simple 2 × 2 endowment economy where two individuals, A and B, have the
following preferences over two goods, 1 and 2:

2
2
uA x1A , x2A = − x1A − 4 − x2A − 4

1 2

q
uB xB , xB = 4 x1B x2B

1
and the endowments are:
eA = (2, a) , eB = (b, 1)

where a, b ≥ 0. For which values of a and b do the First and the Second Fundamental Welfare
Theorems always hold? Explain your answer.

Problem 3: Pure Exchange Economy (30 points)

Consider a simple 2 × 2 endowment economy where two individuals, A and B, have the
following preferences over two goods, 1 and 2: q q
uA x1A , x2A = x1A + x2A

√
uB x1B , x2B = 2x1B + x2B

and the endowments are:

eA = (2, 0) , eB = (0, 4)

1. (5 points) Derive the contract curve for this exchange economy. Show it and individual
indifference curves on a graph using the Edgeworth box.
2. (5 points) Derive individual excess demand functions for good 1 and good 2.
3. (5 points) Find a competitive equilibrium and show it graphically using the Edgeworth
box.
4. (5 points) Does the Second Fundamental Welfare Theorem hold for the given pure
exchange economy?
5. (10 points) Find a lump-sum transfer from individual A to individual B which
decentralizes the ((x1A = 1, x2A = 2) , (x1B = 1, x2B = 2)) Pareto efficient allocation as a
competitive equilibrium.

Problem 4: General Equilibrium with Production (40

points)
Robinson Crusoe (RC) is a single inhabitant of a very remote island. In the island economy,
Robinson acts both as a consumer and as a manufacturer. Specifically, he supplies labor

2
inelastically (SL ≡ 1) and establishes a firm to produce two goods, bacon (B) and eggs (E),
according to the following technology:
√
yB (L) = 2 L
yE (L) = 4L

Robinson does not like to kill animals: it makes him feel bad. Nevertheless, the firm must
run the bacon production to help Robinson survive in the island. Robinson’s preferences over
bacon and eggs are:

uRC (xB , xE ) = xB xE − yB

where xB (xE ) denotes consumption of bacon (eggs), and the second utility component reflects
a negative externality the bacon production creates for Robinson.

1. (5 points) Characterize the production possibilities set (P P S) and the production

possibilities frontier (P P F ) for the island economy and show them graphically.

2. (15 points) Define a competitive equilibrium for the island economy and solve for it
(normalize the price of bacon to a unity, i.e. pB ≡ 1). Is this equilibrium unique? (Hint:
do not forget that Robinson solves his utility optimization and profit maximization
programs separately.)

3. (15 points) Robinson Crusoe meets Friday and asks him to act as a social planner.
Specifically, Friday must find a Pareto efficient allocation for the island economy with
one consumer (Robinson) and two goods (bacon and eggs). Compute this allocation.
Does it coincide with the competitive equilibrium? Explain your answer.

4. (5 points) Does the First Fundamental Welfare Theorem hold for the island economy?
Explain your answer.