ECO 503 Problem Set 5 Solutions
1. Here,
U A (xA
1 , x2 ) = 2x1 + x2
A A A
U B (xB
1 , x2 ) = ωx1 + x2
B B B
First, let’s consider for any price ratio, what bundles would consumers A and B choose to maximize their
utilities. We can see that for A,
M U1A
M RS A = =2
M U2A
So for any price ratio p1
p2 < 2, A would demand only good 1 and spend all of her wealth on buying good 1.
For p1
p2 > 2, A would demand only good 2 and spend all of her wealth on buying good 2. For p1
p2 = 2, she’s
indi!erent between consuming good 1 and good 2, so any mixed bundle that exhausts her budget would do.
Similarly, M RS B = ω. So for any price ratio p1
p2 < ω, B would demand only good 1 and spend all of his wealth
on buying good 1. For p1
p2 > ω, B would demand only good 2 and spend all of his wealth on buying good 2.
For p1
p2 = ω, he’s indi!erent between consuming good 1 and good 2, so any mixed bundle that exhausts his
budget would do.
Now, to make life a little easier, let’s normalize p1 = p and p2 = 1, so the price ratio equals p.
We also know that total available amount of each good in the economy is the same, so x¯1 = x¯2 = x̄. Let’s say
x̄ is the amount available for each good, so consumption of either good above the amount of x̄ is not feasible.
! x̄1 "
Then given each consumer has endowments 2 , x̄22 , both of their wealths (measured in monetary units) is
x¯2
p x̄21 + 2 .
1
(a) ω = 2
We think about what prices might constitute equilibrium prices. If p→ < 12 , then both consumers would
only demand good 1 so obviously there would be excess supply of good 2. If p→ > 2, then both would
demand only good 2, so there would be excess supply of good 1.
1 1 A 1 x¯1 x¯2
At p→ = 2, consumer A would spend all her wealth on good 1. This means 2 x1 = 2 2 + 2 , so
1
x¯1
1 =
xA 2 + 2 x¯22 = 32 x̄, which is not feasible.
x¯1 x¯2 3
At p→ = 2, consumer B would spend all his wealth on good 2. This means xB 2 = 2 2 + 2 = 2 x̄, which
! "
again is not feasible. So we must look for price p→ → 12 , 2 .
! " → x¯1 x¯2
At any p→ → 12 , 2 , consumer A would spend all her wealth on good 1. This means p→ xA
1 = p 2 + 2 ,
x¯1 1 x¯2
so xA
1 = 2 + p→ 2
If p→ < 1, that leads to xA
1 > x̄, which is infeasible. If p > 1, consumer B would spend all his wealth on
→
→ x¯1 x¯2
good 2. This means xB
2 =p 2 + 2 > x̄, which again is not feasible.
So we must have p→ = 1, and xA
1 = x¯1 , x2 = 0; x1 = 0, x2 = x¯2 . So consumer A trades all of her
A B B
endowed good 2 for good 1, and A consumes all of the available good 1, B consumes all of the available
good 2.
In this case, the Pareto-optimal allocations are all bundles in the south border and the east border. The
equilibrium allocation is the point on the south-east corner, which is Pareto-optimal.
(b) ω = 4
If p→ > 4, both would demand only good 2. If p→ < 2, both would only demand good 1. So we must have
p→ → [2, 4].
→ x¯1 x¯2
At any p→ → (2, 4), consumer A only demands good 2. So, xA
2 = p 2 + 2 > x̄, so we can’t have
p→ → (2, 4).
x¯1 x¯2 3
At p→ = 2, consumer B would spend all his wealth on good 1. This means 2xB
1 = 2 2 + 2 , so x1 = 4 x¯1 ,
B
which is feasible.
1
We still have to check A’s demand for each good at p→ = 2 satisfies market-clearing. We need xA
1 = 4 x¯1
and xA
2 = x¯2 . Is this A’s demand at p = 2?
→
A is indi!erent between any mix as long as it exhausts her budget. Let’s check if it does.
A’s wealth is 2 x̄2 + x¯22 = 32 x̄.
! "
2 14 x¯1 + x¯2 = 12 x¯1 + x¯2 = 3
2 x̄. So we do have what we wanted, and p→ = 2, xA
1 =
1
4 x¯1 , 2 = x¯2 ;
xA
3
1 = 4 x¯1 , x2 = 0 is a Walrasian equilibrium.
xB B
In this case, the Pareto-optimal allocations are all bundles in the west border and the north border. The
equilibrium allocation is a point on the north border, which is Pareto-optimal.
4
(c) ω = 3
4
Let’s try p→ = 3. At this price, consumer A would spend all her wealth on good 1. This means
4 A 4 x¯1 x¯2 x¯1 3 x¯2
3 x1 = 3 2 + 2 or xA
1 = 2 + 4 2 = 78 x¯1 , which is feasible.
Consumer B is indi!erent between any mix of good 1 and good 2. For market-clearing, we need xB
1 =
1
8 x¯1 , x2 = x¯2 . Does this exhaust B’s budget?
B
4 x¯1 x¯2
B’s wealth is 3 2 + 2 = 76 x̄
With the proposed bundle, B’s expenditure is
2
41
3 8 x¯1 + x¯2 = 16 x¯1 + x¯2 = 76 x̄. Exactly what we needed.
In this case, the Pareto-optimal allocations are all bundles in the south border and the east border. The
equilibrium allocation is a point on the south border, which is Pareto-optimal.
2. In equilibrium where they choose simultaneously:
max 23 ln (xA + xB ) + ln (24 ↑ xA )
xA
FOC:
23 1
+ (↑1) = 0
xA + xB 24 ↑ xA
23 1
=
xA + xB 24 ↑ xA
xA + xB = (23) (24) ↑ 23xA
24xA = (23) (24) ↑ xB
xB
xA = 23 ↑
24
Similarly,
xA
xB = 23 ↑
24
1 # xB $
= 23 ↑ 23 ↑
24 24
23 xB
= 23 ↑ +
24 (24)2
% &
1 (23) (24) ↑ 23
xB 1 ↑ 2 =
24 24
% 2 &
24 ↑ 1 232
xB =
242 24
232 242
x→B =
24 242 ↑ 1
232 ↓ 24 23
= = ↓ 24 = 92% ↓ 24
25 ↓ 23 25
↭ x→A = x→B = 92% ↓ 24 = 22.08
Instead, if maximizing social surplus:
max 46 ln (xA + xB ) + ln (24 ↑ xA ) + ln (24 ↑ xB )
xA ,xB
3
FOC:
46 1
+ (↑1) = 0
xA + xB 24 ↑ xA
xA + xB = (46) (24) ↑ 46xA
47xA = (46) (24) ↑ xB
47xA = (46) (24) ↑ xA
48xA = (46) (24)
xeA = 23
xeB = 23
3. Consumer 1’s utility maximization problem in this question is:
! 1 "ω ! 1 "1↑ω
max
1 1
x1 x2
x1 ,x2
s. to p1 x11 + p2 x12 ↔ p1 ε11 + p2 ε22
! "ω ! 1 "1↑ω '! " ! "(
The Lagrangian is L1 = x11 x2 ↑ ϑ p1 x11 + p2 x12 ↑ p1 ε11 + p2 ε22
By taking the FOC w.r.t. x11 and x12 we get the equations:
% &1↑ω
x12
ω = ϑp1
x11
% 1 &ω
x1
(1 ↑ ω) = ϑp2
x12
Dividing the first equation by the second, we get:
ω x12 p1
=
1 ↑ ω x11 p2
Reorganizing a bit, this gives us:
% &
ω
p2 x12 = p1 x11
1↑ω
Taking the FOC of the Lagrangian now w.r.t. ϑ of course tells us that the budget constraint holds with
equality:
p1 x11 + p2 x12 = p1 ε11 + p2 ε22
4
Plugging in the expression from the line just above into the budget constraint, we get:
% &
ω
p2 x12 + p2 x12 = p1 ε11 + p2 ε22
1↑ω
This allows us to solve for consumer 1’s optimal choice x12 (p, ε), and to also get x11 (p, ε) from the budget
→ →
constraint. Exactly the same calculations give us the optimal choices (Marshallian demands) as functions of
p and ε for consumer 2. We collect them all and write them here:
p1 ε11 + p2 ε21
x11 (p, ε) = ω
→
p1
p1 ε11 + p2 ε21
x12 (p, ε) = (1 ↑ ω)
→
p2
p1 ε1 + p2 ε22
2
x21 (p, ε) = ϖ
→
p1
p1 ε12 + p2 ε22
x22 (p, ε) = (1 ↑ ϖ)
→
p2
Now, based on the Cobb-Douglas form of utility, we can say that marginal utility for both goods, to either
consumer, is always positive. This means in equilibrium, all available amount of both goods in the economy
will be consumed. Which means, for commodity 2,
p1 ε11 + p2 ε21 p1 ε12 + p2 ε22
x12 + x22 = (1 ↑ ω) + (1 ↑ ϖ) = ε21 + ε22
→ →
p2 p2
Rearranging, we get:
p1 ' (
(1 ↑ ω)ε11 + (1 ↑ ϖ)ε12 = ωε21 + ϖε22
p2
p→ ωε21 + ϖε22
↭ equilibrium price ratio, p→ = 1→ =
p2 (1 ↑ ω)ε11 + (1 ↑ ϖ)ε12
Next, we get to the comparative statics question. How does each of p→ , x11 , x12 , x21 , x22 change in response
→ → → →
to a change of ε11 (If there is some new injection of good 1 in the economy, which is given to consumer 1)?
Taking the values of ε21 , ε12 , ε22 values as given parameters, we can write down the change in p→ caused by a
di!erential change in ε11 as:
% &
ϱp→ ϱ ωε21 + ϖε22
=
ϱε11 ϱε11 (1 ↑ ω)ε11 + (1 ↑ ϖ)ε12
! " ε ' (
↑ ωε21 + ϖε22 εϑ 1 (1 ↑ ω)ε11 + (1 ↑ ϖ)ε12
= 1
2
{(1 ↑ ω)ε11 + (1 ↑ ϖ)ε12 }
! 1 "
↑ ωε2 + ϖε22 (1 ↑ ω)
= 2
{(1 ↑ ω)ε11 + (1 ↑ ϖ)ε12 }
5
p→
It’s easy to see this term is negative. So 1
p→ decreases with an increase in ε11 , which is what we expect, as the
2
amount of good 1 in the economy increases, it makes good 1 relatively cheaper compared to good 2.
Next, we look at x11 (p, ε). As ε11 changes, it has a direct e!ect on x11 , as well as an indirect e!ect through
→ →
p→ . The total e!ect is:
<0 <0 >0
) *+ , )*+, ) *+ ,
dx11 (p, ε) ϱx1 ϱp→ ϱx11
1→
→ →
= +
dε11 ϱp ϱε11 ϱε11
+ ,) *
>0
The indirect e!ect is the substitution e!ect. Increasing ε11 makes good 1 relatively cheaper, so optimally the
consumer switches to consuming more of good 1. The direct e!ect is the income (or wealth) e!ect. Because
the consumer now has more, she can consume more of good 1.
>0
<0 >0
) *+ , )*+, ) *+ ,
1
dx2 (p, ε) ϱx2 ϱp→ ϱx12
1→
→ →
= +
dε11 ϱp ϱε11 ϱε11
+ ,) *
???
Here the substitution e!ect means consumer 1 switches away from good 2 as it has become relatively more
expensive. On the other hand, she has more wealth so that e!ect pushes toward more consumption of good
p→
2. Which of these opposing e!ects is larger? We could plug in in the expression of x12 and then do all the
→
1
p→
2
algebra after taking the derivative to find out, but for now let’s just leave this as a mystery.1
<0<0 =0
) *+ , )*+, ) *+ ,
dx21 (p, ε) ϱx21 ϱp→ ϱx21
→ → →
= +
dε11 ϱp ϱε11 ϱε11
+ ,) *
>0
This one’s simple, consumer 2 only has a substitution e!ect. Nothing changed on his endowment, so he does
not have a wealth e!ect. He consumes more of good 1 because it has become relatively cheaper.
>0 <0 =0
) *+ , )*+, ) *+ ,
dx22 (p, ε) ϱx2 ϱp→ ϱx22
2→
→ →
= +
dε11 ϱp ϱε11 ϱε11
+ ,) *
<0
Consumer 2 eats less of good 2 because it became more expensive. This, however, tells us what happened to
x12 . Because the total endowment of good 2 in the economy hasn’t changed, if consumer 2 consumes less of
→
→
dx12 (p,ϑ)
good 2, that means consumer 1 must be consuming more of good 2. So now we can say that dϑ11
> 0.
1 I seem to remember from my childhood days some saying like “the income e!ect dominates the substitution e!ect”, but I’m not
sure whether that’s only a feature of Cobb-Douglas utility or holds for general preferences.