Problem Set 81 (b) Suppose that there are two households with identi-

Microeconomic Theory: A Mathematical Approach (General cal utility uh (x) = log(x1 ) + log(x2 ), h = 1, 2 and
Equilibrium) endowments e1 = (1, 2) and e2 = (2, 1) respectively.
Compute a Walrasian equilibrium and show that it
1. Consider an economy with two consumers (A and B), and is Pareto-optimal. Now assume that agent 1 sets a
a single consumption good (x). A is endowed with 10 units price, agent 2 chooses optimal demand at this price
of x and B is endowed with 20 units of x. For each of the and agent 1 supplies and demands the right amount
following pairs of A and B’s preferences, find the set of so that markets clear. Compute this non-competitive
pareto efficient allocations and competitive equilibria. equilibrium and show that it is not Pareto-optimal.
(a) uA (xA , xB ) = x2A + x2B , uB (xA , xB ) = xA xB (c) Suppose there is the following externality in the econ-
(b) uA (xA , xB ) = 2xA + xB , uB (xA , xB ) = omy. Let x1 = (x11 , x12 ) be household 1’s consump-
min{xA , xB , 10} tion, let x2 = (x21 , x22 ) be household 2’s consumption.
The two households have utility functions
2. Consider an economy with two consumers (1 and 2), and
two consumption goods (x and y). Consumer 1 is endowed u1 (x) = log(x11 + x21 ) + log(x12 )
with 10 units of x and consumer 2 is endowed with 10
units of y. For each of the following pairs of consumers’ and

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preferences, find the set of pareto efficient allocations and
u2 (x) = log(x21 ) + log(x22 )
competitive equilibria.

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(a) u1 (x1 , y1 , x2 , y2 ) = x1 + y1 + x2 + y2 , Suppose endowments are as in (b), but agents be-

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u2 (x1 , y1 , x2 , y2 ) = min{x2 , y2 } + min{x1 , y1 } have competitively. Compute all Pareto-optimal al-
locations and compute one Walrasian equilibrium. Is
(b) u1 (x1 , y1 , x2 , y2 ) = min{x1 + 2y1 , 2x1 + y1 , x2 +

(c) u1 (x1 , y1 , x2 , y2 ) =
ho
2y2 , 2x2 + y2 }, u2 (x1 , y1 , x2 , y2 ) = x2 + 3y2
x1 + y1 − x2 − y2 ,
u2 (x1 , y1 , x2 , y2 ) = max{x1 , y1 , x2 , y2 }
it Pareto-optimal?

5. Consider a two-person (A and B) two-good (x and y) com-

petitive exchange economy with externalities. A has util-
sc
ity function
3. Consider an economy with two agents, A and B, and two
U A = 2 min{xA , y A } − xB
on

commodities: x representing money, and y representing

hours of music played by A. A’s action (e.g. playing
loud music) gives him pleasure but makes the neighbor B B has utility function
unhappy. A’s utility is an increasing function of y, the
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number of hours per day of music played. B’s utility is an U B = 4xB + y B

increasing function of 24 − y (which is the freedom from
loud music being played). Both have the nonnegative quadrant as a consumption
According to a claim (called by some “the Coase Theo- possibility set. A’s initial endowment is 12 units of x and
rem”), with appropriate compensation(s), a Pareto opti- 12 units of y; and B’s initial endowment is 12 units of x
mal outcome will be the same regardless of whether A and no y. Determine the set of Pareto efficient allocations
needs permission from B to pursue the offending activity. and competitive equilibrium.

(a) Is the claim true if both preferences are defined by 6. An economy is made up of two people. The utility func-
quasi-linear utility functions that are linear with re- tions are u1 (x11 , x12 ) = x11 x12 and u2 (x21 , x22 ) = 2x21 +
spect to money (denoted by x)? Thus A’s utility 2x22 − x11 The initial bundles are ω1 = (1, 0), ω2 = (0, 1).
√ Although 2 suffers from l’s consumption of good 1, he can-
function can be written as uA (xA , y) = xA + y. And
B’s utility function can be written as uB (xB , y) = not control it.
p
xB + (24 − y).
(a) Calculate a competitive equilibrium. Draw an Edge-
(b) Is the claim true if both preferences are Cobb- worth box diagram to illustrate your answer.
Douglas, with utility functions uA (xA , y) = xA · y,
(b) Find the locus of interior Pareto optimal points.
and uB (xB , y) = xB · [24 − y], respectively?
(c) Calculate prices p1 and p2 , a per unit subsidy s or tax
4. Possible failures of first welfare theorem t, and lump sum cash transfers T1 and T2 to bring the
economy to the allocation x01 = ( 31 , 12 ), x02 = ( 23 , 21 ).
(a) Suppose that there are two agents and two commodi-
ties. Both agents have differentiable, strictly increas- 7. Imagine a three-person economy in which good 1 is gar-
ing and strictly concave utility, but there is a missing dening services, the consumption of which makes one’s
market for commodity 2. Define Walrasian equilib- yard more beautiful, and good 2 is food. Imagine that
rium and show in an Edgeworth box (or analytically consumers 1 and 2 live in adjacent houses, while consumer
if you prefer) that typically Walrasian equilibria are 3 lives on the other side of a particularly large mountain.
not Pareto-efficient here. Consumption by consumer 3 of gardening services gen-
1 Contact: econschool@[Link] erates no externality for the other consumers, nor does

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consumer 3 care about the gardens of the other two con-
sumers. Each of the other two consumers generates a posi-
tive externality for her neighbor through the consumption
of the gardening services. To be precise, imagine that con-
sumers 1 and 2 have utility functions of the form
√ √
ui (x) = x11 + x21 + xi2

Note that consumers 1 and 2 get just as much utility out

of their neighbor’s yard as they do out of their own, and
their utility is linear in food. Also assume that consumer
3 has a utility function of the form
√
u3 (x) = x31 + x32

Aggregate endowment of gardening services and food is

ω = (ω1 , ω2 )  0.
(a) Suppose the aggregate endowment is allocated evenly

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among the three consumers. What will be the Wal-

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rasian equilibrium (with externalities)?
(b) Characterize the set of pareto efficient allocations of

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the social endowment. Is the equilibrium allocation
in (a) Pareto efficient?

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