Problem Set 3 - Graduate Microeconomics II

Prof. Leandro Arozamena

2017

Exercise 1 (M.W.G. 15.B.2)A

Consider an Edgeworth box economy in which the consumers have the Cobb-Douglas utility functions
u1 (x1 1 , x2 1 ) = xα 1−α
1 1 x2 1 and u2 (x1 2 , x2 2 ) = xβ1 2 x1−β
2 2 . Consumer i's endowments are (ω1 i , ω2 i ) >> 0,
for i = 1, 2. Solve for the equilibrium price ratio and allocation. How do these change with a dierential
change in ω1 1 .

Exercise 2 (M.W.G. 15.B.9)B

Suppose that in a pure exchange economy (i.e., an economy without production), we have two consumers,
Alphanse and Betatrix, and two goods, Perrier and Brie. Alphanse and Betatrix have the utility functions:
uα = min {xp α , xb α } and uβ = min {xp β , xb β }
(where xp α is Alphanse's consumption of Perrir, and so on). Alphanse starts with an endowment of 30
units of Perrier (and none of Brie); Betatrix starts with 20 units of Brie (and none of Perrier). Neither can
consume negative amounts of a good. If the two consumers behave as price takers, what is the equilibrium?

Suppose instead that Alphanse begins with only 5 units of Perrier while Betatrix's initial endowment remains
20 units of Brie, 0 units of Perrier. What happens now?

Exercise 3 (M.W.G. 17.C.6)B

Let L = 2. Consider conditions (i), (iii) and (iv) of Proposition 17.B.2. Exhibit four examples such that in
each of the examples only one condition fails and yet the system of equations z (p) = 0 has no solution. Why
is condition (ii) not included in the list?

Proposition 17.B.2: Suppose that, for every

and strongly monotone. Suppose also that i ωi >> 0. Then the aggregate excess demand function z (p),
dened for all price vectors p >> 0, satises the properties:

(i) z (·) is continuous.

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 (ii) z (·) is homogeneous of degree zero.
(iii) pz (p) = 0 for all p (Walras' law).
(iv) There is an s > 0 such that z` (p) > −s for every commodity ` and all p.
(v) If pn → p, where p 6= 0 and p` = 0 for some `, then max {z1 (pn ) , . . . , zL (pn )} → ∞.

Exercise 4 (M.W.G. 17.C.4)A

Consider a pure exchange economy. The only novelty is that a progressive tax system is instituted according
to the following rule: individual wealth is no longer pωi ; instead, anyone with wealth above the mean of the
population must contribute half of the excess over the mean into a fund, and those below the mean receive
a contribution from the fund in proportion to their deciency below the mean.

(a) For a two-consumer society with endowments ω1 = (1, 2) and ω2 = (2, 1), write the after-tax wealths
of the two consumers as a function of prices.
(b) If the consumer preferences are continuous, strictly convex, and strongly monotone, will the excess
demand functions satisfy the conditions required for existence in Proposition 17.C.1 given that wealth
is being distributed in this way?

Proposition 17.C.1: Suppose that z (p) is a function dened for all strictly positive price vectors p ∈ RL++
and satisfying conditions (i) to (v) of Proposition 17.B.2. Then the system of equationsP z (p) = 0 has a
solution. Hence, a Walrasian equilibrium exists in any pure exchange economy in which i ωi >> 0 and
every consumer has continuous, strictly convex, and strongly monotone preferences.

Exercise 5 (M.W.G. 17.C.3)B

Consider an exchange economy in which every consumer i has continuous, strongly monotone, strictly convex
preferences and ωi >> 0. The peculiarity of the equilibrium problem to be considered is that the consumer
will now pay a type of tax on his gross consumption; moreover, this tax can dier across commodities and
consumers. We will also assume that total tax recepits are rebated equally across consumers and in a limp-
sum fashion. Specically, for every i there is a vector of given tax rates t̄i = (t1 i , . . . , tL i ) ≥ 0 and for every
price vector p >> 0 the budget set of consumer i is:
( )
X
Bi (p, wi ) = xi ∈ RL
+ : (1 + t` i ) p` x` i ≤ wi
`

An equilibrium with taxes is then a price vector and an allocation (x?1 , . . . , x?I ) with x?1 =
P P
 p >> 0 P  i i ωi
such that every i maximizes preferences in Bi p, p ωi + ` i `Ii ` ` i .
t p x

(a) Illustrate the notion of an equlibrium with taxes in an Edgeworth box. Verify that an equilibrium with
taxes need not be a Pareto optimum.
(b) Apply Proposition 17.C.1 to show that an equilibrium with taxes exists.

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(c) As formulated here, the taxes are on gross consumptions. If they were imposed instead on net con-
sumptions, that is, on amounts purchased or sold, then (assuming the same rate for buying or selling)
the budget set would be:
( )
X
Bi (p, Ti ) = x i ∈ RL
+ : p (xi − ωi ) + t` |p` i (xi − ωi )| ≤ Ti
`

where the Ti are the lump-sum rebates. In what way does this budget set dier from that described
previously for the case of taxes on gross consumptions? Represent graphically. Notice the kinks.
(d) Write down a budget set for the situation similar to (c) except that the tax rates for amounts bought
or sold may be dierent.
(e) (More advanced) How would you approach the existence issue for the modication described in (c)?