EC4003 quiz #2 solutions

1. (9 points) Consider an exchange economy with two goods, x1 and x2, and two consumers, A and B.
A’s utility function is u A ( x1A , x2A ) = ln( x1A ) + ln( x2A ) and her endowment is eA = (2,8). B’s utility
function is uB ( x1B , x2B ) = ln( x1B ) + ln( x2B ) and his endowment is eB = (8, 2).

Draw an Edgeworth box to characterise this economy. Be sure to label both consumers’ origins, the
endowment point e, both consumers’ indifference curves through e, the contract curve, the set of
individually rational outcomes, and the core. You don’t need to calculate the exact values of any of
these – just give an accurate indication of where they are located in the Edgeworth box. (This part of
the quiz is a set-up for some easy points. Don’t waste them.)

An Edgeworth box is shown here.

2. (5 points) Consider an exchange economy with two goods, x and y, and three consumers, A, B and
C. A’s utility function is u A ( x, y ) = ln( x A ) + 2 ⋅ ln( y A ); B’s is uB ( x, y ) = min{xB , 2 ⋅ yB }; and C’s is
uC ( x, y ) = xC + 2 ⋅ yC . The consumers’ endowments are eA = (12,16), eB = (8, 20), and eC = (10, 24).
Let z = ( z A , z B , zC ) (with zi = ( xi , yi ) for i = A, B, C) be a feasible allocation in which each consumer
receives a strictly positive amount of both goods.

Suppose z is a general equilibrium allocation for this economy; that is, suppose there exists a vector
p = ( px , p y ) of prices so that (z, p) is a general equilibrium. What must be true of p in this case?
Explain why (i.e., if p does not have this property, how does one know z cannot be a general
equilibrium allocation).

We know that for any consumer whose MRS is defined everywhere, it must be equal to the price ratio
u 1 p 1
at a general equilibrium allocation. For consumer C, MRS = x = , so we must have x = , i.e.,
uy 2 py 2
p y = 2 px .
3. (6 points) Consider a general exchange economy with K goods and I consumers. Suppose all
consumers have preferences that are complete, transitive, continuous, strictly monotonic and strictly
convex, and let ei be consumer i’s endowment. Let (x, p) be a general equilibrium, where p is the
vector of prices. Briefly describe why the two facts below must be true – i.e., if the fact is not true,
explain why (x, p) cannot be a general equilibrium. (If you understand this material, you should be
able to do each in 2-4 sentences.)

a. (3 points) All goods must have non-negative prices.

If this is not true – i.e., if some good has a negative price – a consumer (say, consumer i) could have
“bought” additional units of that good (thereby increasing the amount of income available to spend on
other goods), and bought additional units of all other goods, without violating her budget constraint.
By strict monotonicity, this would have been preferred to the bundle (xi) this consumer has in x. So, xi
cannot be i’s utility maximising bundle given p and e, contradicting the definition of general
equilibrium.

b. (3 points) At least one good must have a non-zero price.

If this is not true – i.e., if all goods have a zero price – then a consumer (say, consumer i) could have
bought additional units of all goods, without violating her budget constraint. By strict monotonicity,
this would have been preferred to the bundle (xi) this consumer has in x. So, xi cannot be i’s utility
maximising bundle given p and e, contradicting the definition of general equilibrium.