General Equilibrium

Econ 301: Week 8 Handout Solutions March 11th, 2011

1 Standard Edgeworth Box

Consider an economy with apples and oranges. Andy is initially endowed with wA = (0, 50) and Bobs endowment is wB = (50, 0). The utility function of both Andy and Bob is the same and given by U (x1 , x2 ) = 3lnx1 + 3lnx2 a) Plot the Edgeworth box and mark the allocation representing the initial endowment. ANSWER: The total endowment of the economy is w = (50, 50).

b) Provide general denition of Pareto efciency. ANSWER: An economic allocation is called Pareto efcient if there is no way to make any person better off without hurting anybody else. c) Prove, that an allocation is Pareto efcient if and only in such allocation satises MRSA = MRSB : Start with necessity by showing that if the MRS condition does not hold then allocation is not Pareto efcient. Then proceed to sufciency by showing that if the condition MRS is satised then indeed allocation is efcient (use a graph and write two sentences for each of the two conditions). ANSWER: If MRSA = MRSB (indifference curves are not tangent), then allocation is not Pareto efcient.

As in the graph, at point C the indifference curves are not tangent. If Andy and Bot switch from point C to point D, both of them become better off. Thus point C is not Pareto optimal. If MRSA = MRSB , then allocation is not Pareto efcient.

As in the graph, at point C the indifference curves are tangent. There is no point which can make both Andy and Bot become better off. (Consider point D,E,F and G). Thus point C is Pareto optimal. d) Find analytically a collection of all Pareto efcient allocations (contract curve) and depict it in the graph. ANSWER: As in part c), in Pareto efcient allocation, the slopes of indifference curves must coincide. Therefore MRSA = MRSB or
A B x2 x2 = B A x1 x1

B = 50 xA , xB = 50 xA . Therefore, we can write Note that x1 1 2 2 A A x2 50 x2 = A A x1 50 x1 A (50 xA ) gives Multiplying both sides by x1 1 A A A A (50 x1 )x2 = x1 (50 x2 )

which can be reduced to

A x2 50 =1 = A 50 x1

All the points on the offer curve satisfy

A B x2 x2 = B =1 A x1 x1

e) Find the competitive equilibrium. A , xA ), (xB , xB ) and prices ( p , p ) such that ANSWER: Equilibrium is an allocation (x1 1 2 2 1 2 i i 1) for each consumer (x1 , x2 ) is optimal given prices ( p1 , p2 ) 2) ( p1 , p2 ) are such that markets clear Since the equilibrium determines only a relative price, we can normalize p2 = 1. Given ( p1 , p2 ), Andys income is mA = 0 p1 + 50 1 = 50. Given ( p1 , p2 ), Bobs income is mB = 50 p1 + 0 1 = 50 p1 . With Cobb-Douglas utility fuctions, we nd optimal choices using the magic formula as the following,
A x1 =

3 mA 1 50 25 = = 3 + 3 p1 2 p1 p1

B x1 =

3 mB 1 50 p1 = = 25 3 + 3 p1 2 p1

By Walras law once market for good 1 clears, market for good 2 will clear automatically. Thus we have
A B x1 + x1 = 50

25 + 25 = 50 p1 this gives p1 = 1 At such prices the optimal consumption is

A x1 =

25 = 25 1

B = 25 x1

A x2 =

3 mA 1 50 = = 25 3 + 3 p2 2 1

B x2 =

3 mB 1 50 p1 = = 25 3 + 3 p2 2 1

Hence allocation xA = (25, 25),xB = (25, 25) and prices ( p1 , p2 ) = (1, 1) is an equilibrium. f) Give some other prices that are consistent with competitive equilibrium (give two numbers). ANSWER: Any price system that is associated with the relative price equal to 1 supports the same allocation as an equilibrium. For example ( p1 , p2 ) = (10, 10). g) Using MRS condition verify that equilibrium allocation is Pareto efcient and hence an invisible hand of a free (and competitive) market guides selsh Andy and Bob to a socially optimal outcome. ANSWER: At the equilibrium allocation, MRSA = MRSB =
A x2 =1 A x1 B x2 B =1 x1

and hence their indifference curves are tangent, so the allocation is Pareto efcient. h) Find geometrically (in the Edgeworth box) the equilibrium consumption and prices of both commodities for the new utility (perfect substitutes) given by: U (x1 , x2 ) = 3x1 + 3x2 ANSWER: NOTE: In this case all allocations in Edgeworth box are Pareto efcient. Equilibrium: For any relative price p1 < MRSi = 1 p2 both trader spend their total income on x1 and no income on x2 . This results in excess demand for x1 . For any relative price 4

p1 > MRSi = 1 p2 both trader spend their total income on x2 and no income on x1 . This results in excess demand for x2 . Therefore markets can clear only for relative price p1 = MRSi = 1 p2 But then all allocations on the budget set are optimal for each trader therefore any of them is an equilibrium allocation.

2 Edgeworth box, determination of interest rate

Andy is a manager with income "when young" and "when old" given by mA = (600, 0) and sportsman and Bob, given interest rate? ANSWER: Given r = 100%, Andy saves 600-400=200 today. Tomorrow he gets 200 (1 + r) = 200 2 = 400. Bob borrows 200 today. Tomorrow he pays back 200 (1 + r) = 200 2 = 400. Therefore he consumes 600-400=200 tomorrow.Bob has income mB = (0, 600). The utility function of both Andy and Bob is the same and given by U (x1 , x2 ) = lnx1 + lnx2 where the discount rate is = a) Plot the Edgeworth box and mark the allocation representing the initial endowment. Is the allocation of initial endowments Pareto efcient? ANSWER:The total endowment of the economy is w = (600, 600).
1 2

0 2 No, the initial allocation is not Pareto efcient as MRSA = MRSB . MRSA = x A = 1/2600 =

xA

0,MRSB
p1 p2 )

= = . = b) Find the equilibrium interest rate and depict the equilibrium in the Edgeworth box. (Hint: 1 + r =

B x2 x B 1

1600 /20

ANSWER: Since the equilibrium determines only a relative price, we can normalize p2 = 1. Given ( p1 , p2 ), Andys income is mA = 600 p1 + 0 1 = 600 p1 . Given ( p1 , p2 ), Bobs income is mB = 0 p1 + 600 1 = 600. With Cobb-Douglas utility fuctions, we the optimal demand for consumption "today" using the magic formula as the following,
A x1 =

1 mA 2 600 p1 = = 400 1 + 1/2 p1 3 p1 1 mB 2 600 400 = = 1 + 1/2 p1 3 p1 p1

B x1 =

By Walras law once market for consumption today clears, market for consumption tomorrow will clear automatically. Thus we have
A B x1 + x1 = 600

400 + this gives

400 = 600 p1

p1 = 2 At such prices the optimal consumption is

A x1 = 400

B x1 =

400 = 400/2 = 200 p1

A x2 =

1/2 mA 1 600 p1 = = 400 1 + 1/2 p2 3 1 1/2 mB 1 600 = = 200 1 + 1/2 p2 3 1

B x2 =

Hence allocation xA = (400, 400),xB = (200, 200) and prices ( p1 , p2 ) = (2, 1) is an equilibrium. The interest rate is 1+r = p1 =2 p2

hence r = 100%. c) What are the savings/borrowing strategies of Andy and Bob, given interest rate? ANSWER: Given r = 100%, Andy saves 600-400=200 today. Tomorrow he gets 200 (1 + r) = 200 2 = 400. Bob borrows 200 today. Tomorrow he pays back 200 (1 + r) = 200 2 = 400. Therefore he consumes 600-400=200 tomorrow.