ECON 4160: Public Sector Economics

FALL 2015
Hennadige N. Thenuwara
Homework 2
Due on Sep 8, 2015
Warning: Completion of this Homework may take time. Start early.
1. Consider two consumers, 1 and 2. The utility function of the consumer 1 is
U1=10.X.4Y.6, and the utility function of consumer 2 is U2=5.X.6Y.4.
a. What is the marginal rate of substitution (MRS) of consumer 1?
b. What is the MRS of consumer 2?
2. Assume that a social planner allocates 20 units of X and 16 units of Y
between Consumers 1 and 2.
a. If Consumer 1 receives the bundle (8,12) and Consumer 2 receives the
rest, what are the MRSs of the two consumers?
b. What are their utility levels?
c. Show this allocation in an Edgeworth Box.
d. Is this Pareto Efficient (PE)? Why?
e. If not, show a PE allocation, and prove it is PE using MRSs. (Hint:
allocate Consumer 1 some units of X, and workout other allocations)
f. What are the new utility levels?
3. Now consider that both consumers enter a competitive market and face
prices of Px and Py, i.e. price of X is Px and price of Y is Py. Consumer 1 has
money income of M1 and consumer 2 has money income of M2.
a. Write down consumers problems (for 1 and 2 separately).
b. What are the utility maximizing conditions in terms of MRS and
prices?
c. If Px = o.8, and Py=1, and Consumer 1s income is 16 how much will be
demanded of X and Y?
d. If Consumer 2 faces same prices and has an income of 16 what are
his/her demands of X and Y?
e. Is this competitive equilibrium Pareto Efficient? Why?
4. Consumers earn income by selling factors (labor and capital) to firms. Firms
produce the goods X and Y using those factors.
a. Show isoquants of a firm.
b. Define Marginal Rate of Technical Substitution.
c. What is the condition for Pareto Efficient production of X and Y?
d. Show that a competitive market can yield a Pareto Efficient allocation.
e. Illustrate the production possibility frontier (PPF).

f. Define Marginal Rate of Transformation.

g. Choose a point on PPF and show a Pareto Efficient distribution of
goods using Edgeworth Box diagram.
h. What is the condition for Pareto Efficiency?