1. Suppose there are two consumers, A and B.
The utility functions of each consumer are given by:
UA(X,Y) = X*Y
UB(X,Y) = X*Y3
Therefore:
For consumer A: MUX = Y; MUY = X
For consumer B: MUX = Y3; MUY = 3XY2
The initial endowments are:
A: X = 6; Y = 7
B: X = 14; Y = 13
a) (40 points) Suppose the price of Y, PY = 1. Calculate the price of X, PX that will lead to a
competitive equilibrium.
Answer:
The consumption of two goods in the general equilibrium cannot be greater than total
endowment of two goods i.e.
XeA + XeB = 20 ………….. (1)
YeA+YeB = 20 …………… (2)
Price ratio (Px/Py) = Px/1 = Px
Consumer A:
Consumer A’s utility is maximized when
(MUX/MUY)A = (Px/Py) or
Y/X = Px, implies YA = Px*XA ……….. (3)
Consumer A cannot consume more than the value of its endowment. Suppose price of x is
denoted by Px and price of y is denoted by Py (=1), then given he has endowment: (x, y) = (6, 7),
the value of its endowment is given by: 6Px + 7
So budget constraint for consumer A:
XA*Px + YA = 6Px + 7………………. (4)
Substitute (3) in (4), we get
XA*Px + Px*XA = 6Px + 7 or
2XAPx = 6Px + 7, implies optimal consumption of good X by consumer A i.e. XA*= (6Px+7)/2Px
…… (5)
And optimal consumption of good Y by consumer A i.e. YA* = Px*XA = (6Px+7)/2 ……. (6)
Consumer B:
Consumer B cannot consume more than the value of its endowment. Suppose price of x is
denoted by Px and price of y is denoted by Py (=1), then given he has endowment: (x, y) = (14,
13), the value of its endowment is given by: 14Px + 13
So budget constraint for consumer B:
XB*Px + YB = 14Px + 13………………. (7)
Consumer B’s utility is maximized when
(MUX/MUY)B = (Px/Py) or
Y3/3XY2 = Px or
Y/3X = Px, implies YB = 3XBPx
Substitute this in (7), we get
XBPx + 3XBPx = 14Px + 13, implies optimal consumption of good X by consumer B i.e. X B* =
(14Px+13)/4Px ……………….. (8)
And optimal consumption of good Y by consumer B i.e. X B* = 3XBPx = 3(14Px+13)/4 ………
(9)
We know that the consumption of good X (or good Y) in the general equilibrium cannot be
greater than its total endowment, so we have [using (5) and (8) in (1)]
(6Px+7)/2Px + (14Px+13)/4Px = 20 or
(12Px+14+14Px+13)/4Px = 20 or
26Px+27 = 80Px or
54Px = 27, implies Px = 0.5
This means for general equilibrium Px should be 0.5.
b) (16 points) How much of each good does each consumer demand in equilibrium?
Consumer A’s Demand for X:
Consumer A’s Demand for Y
Consumer B’s demand for X
Consumer B’s demand for Y
Answer:
Substituting the value of Px, in equations (5), (6), (8) and (9), we get different demand values
Consumer A’s Demand for X i.e. XA* = 10
Consumer A’s Demand for Y i.e. YA* = 5
Consumer B’s demand for X i.e. XB* =10
Consumer B’s demand for Y i.e. YB* = 15
c) (8 points) What is the marginal rate of substitution for consumer A at the competitive
equilibrium?
Answer:
At the competitive equilibrium, marginal rate of substitution (MRS) = Px/Py = 0.5/1 = 0.5
2. (20 points) Suppose there are two consumers, A and B.
The utility functions of each consumer are given by:
UA(X,Y) = X + Y
UB(X,Y) = Min(X,Y)
The initial endowments are:
A: X = 2; Y = 4
B: X = 4; Y = 2
Illustrate the initial endowments in and Edgeworth Box. Be sure to label the Edgeworth Box
carefully and accurately, and make sure the dimensions of the box are correct. Also, draw each
consumer’s indifference curve that runs through the initial endowments. Is this initial endowment
Pareto Efficient?
Answer:
Total amount of X available = Xa + Xb = 2+4 = 6
Total amount of Y available = Ya + Yb = 4+2 = 6
The Edge-worth has been represented below. The point ‘E’ in the edge-worth box denotes the
endowment point. At this endowment point, consumer A’s endowment is (2, 4) and consumer B’s
endowment is (4, 2).
The initial endowment (E) is not Pareto efficient. This is because at this point, there is room for
Pareto improvement i.e. utility of consumer B can be increased without reducing the utility for
consumer A. Hence, point E is not a Pareto efficient point.
3. (16 points) For each of the following production functions, determine whether it exhibits
increasing, constant or decreasing returns to scale:
a) Q = K + 4L
Answer:
The function represents constant returns to scale. For example if we increase each input by
proportion ‘λ’, the output would also increase by proportion ‘λ’.
Output when each input is increased by ‘λ’.
Q” = (λK)+4(λL) = λ[K+4L] = λQ
This implies that if each input is increased by proportion ‘λ’, the output would also increase by
proportion ‘λ’. Hence the function represents constant returns to scale.
b) Q = L + L/K
Answer:
If L = 2 and K =2, then Q = 2 + (2/2) = 3
If L = 4 and K = 4, then Q = 4 + (4/4) = 5
So we note that when inputs are doubled, output would be less than double. Therefore this
function represents decreasing returns to scale.
c) Q = Min(K,L)
Answer:
This production function represents constant returns to scale.
If L = 2 and K =2, then Q = min (2, 2) = 2
If L = 4 and K = 4, then Q = min (4, 4) = 4
We note that when inputs are doubled, output has also doubled. Hence the following production
function represents constant returns to scale.
d) Q = L*K
Answer:
This production function represents increasing returns to scale.
If L = 2 and K =2, then Q = 2*2 = 4
If L = 4 and K = 4, then Q = 4*4 = 16
We note that when inputs are doubled, output has more than doubled. Hence the following
production function represents increasing returns to scale.