Microeconomics II

Solutions to problem set 1

Mario Tirelli

December 2009
 Solution to Problem 1

1) The Edgeworth box represents all the possible distributions of the avail-
able, total resources of two commodities between two agents. We restrict
attention to non-wasteful allocations, namely those allocations which ex-
haust total resources.
Let the two commodities and their quantities be x and y, the two consumers
be A and B, the total resources by (ω x , ω y ). The diagram of the box can
be drawn starting from determining both its width and its height. The box
width is
Width = ω x = 5

The box height is

Height = ω y = 10
The endowment allocation is a point in the box (hence feasible). In our

Figure 1: The Edgeworth box (Panel I) and the endowment point (Panel II)
.

case this point is:

ω A = (ωxA ; ωyA )T = (2; 1)T

ω B = (ωxB ; ωyB )T = (3; 9)T

which is shown in (Figure 1 Panel II).

2) In our economy, the set of Pareto efficient allocations (or contract curve)
is the locus of points, in the box, such that indifference curves of the two
agents are tangent (the golden line in (Figure (2)). Why? because the
indifference curves are just regular hyperbolas, hence (Inada conditions ap-
ply, implying indifference curves of i never intersect the hedges of the box
which would correspond to either x or y being equal to zero for i) efficient

1
allocations are interior, (x, y)  0:
ū
ū = xi y i ⇒ yi = ū ∈ R i = A, B
xi
The part of the set of Pareto efficient allocations where both consumers do

Figure 2: The set of Pareto efficient allocations (or contract curve) and the
core of the economy.

at least as well as at their initial endowment is called the core (the red line).

Let us now define the set of Pareto efficient allocation of our economy. To
do so just consider the allocations x which exhaust total resources and
equalize the marginal rates of substitutions.

i U Mxi yi
SM Sx,y = =
U Myi xi

con U Mxi = ∂ui /∂xi = y i , U Myi = ∂ui /∂y i = xi . Hence,

yA yB
=
xA xB
Finally, impose the restriction that resources must be exhausted at x:

yA 10 − y A
=
xA 5 − xA

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The latest condition is equivalent to

5 − xA 10 − y A
=
xA yA

and it is satisfied when y A = 2xA , implying SM S A = 2. Finally, the set

of Pareto efficient allocation is
 A A B B
x , y , x , y : 0 ≤ xA ≤ 5, y A = 2xA , xB = 5 − xA , y B = 2xB

3a) The offer curve of the i-th agent (OC i (p)) is locus of commodity bundles
demanded by i, as relative prices change. Because preferences are strictly
monotone and satisfy Inada, every demand allocation is interior and lies on
the budget line. Therefore, offer curves can be characterized considering
allocations which are at the tangency points between the i-th agent’s indif-
ference curves and the budget line, as the relative price changes. The OC
is then a function of relative price only, which passes through the endow-
ment point and is tangent to the consumer’s indifference curve though the
endowment point.

Mathematically, the OC i (p) is the solution of the following maximization

problem:
(
max(xi ; y i ) ui (xi ; y i ) = xi y i i = A, B
[Problem I] i i i
(1)
subject to w = px x + py y

by imposing the wealth condition:

(WC) wi = p · ω i i = A, B

Indeed, the wealth of i-th agent must be equal to the market value of own
endowment. Solving [Problem I] we obtain the Walrasian’s demands:

wi wi
xix (p; wi ) = xiy (p; wi ) =
2p1 2p2
Imposing the (WC), we get the offer curves for the agent A and B:
2px + py 2px + py T py px 1 T
OC A (p) = ( ; ) = (1 + ; + ) (2)
2px 2py 2px py 2
3(px + 3py ) 3(px + 3py ) T 3 9py 3px 9 T
OC B (p) = ( ; ) =( + ; + ) (3)
2px 2py 2 2px 2py 2

3b) The Walrasian equilibrium is a price vector for the two commodities
which satisfies aggregate demand equal total resources in each of the two
markets. Geometrically, it is the point where the OC intersect. Because
Walras law holds here, it suffices to find the price that clears one of the two

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markets, say that of x.
total demand of good x
z }| {
OC A for commodity x OC B for commodity x
z }| { z }| { total supply of good x
2p∗x + p∗y 3(p∗x + 3p∗y ) z}|{
+ = 5
2p∗x 2p∗x
p∗y 3 9p∗y
⇒ 1+ ∗ + + ∗ =5
2px 2 2px
5p∗y 5 p∗x
⇒ ∗
= ⇒ =2 (4)
px 2 p∗y

This is the Walrasian equilibrium price ratio. At (p∗x /p∗y ) the market for
good y clears too [you should check this]. By substituting the equilibrium
relative price into the offer curves (Equation (2) & (3)), we obtain the Wal-
rasian equilibrium allocations:
p∗y p∗x 1 T 1 1 5 5
OC A (p∗ ) = (1 + ; + ) = (1 + ; 2 + )T = ( ; )T = (1.25 ; 2.5)T
2p∗x py∗ 2 4 2 4 2
3 9p∗y 3p∗x 9 T 3 9 9 15 15 T
OC B (p∗ ) = ( + ∗ ; ∗
+ ) = ( + ; 3 + )T = ( ; ) = (3.75 ; 7.5)T
2 2px 2py 2 2 4 2 4 2

3c) According to the First Theorem of Welfare Economics (FTWE) any

Walsarian equilibrium is a Pareto efficient allocation1 . Thus, in principle,
there is nothing to be checked here, other than verifying that individual
preferences are locally non satiated. Yet, you may want to check that the
equilibrium allocation you computed is an element of the set of Pareto effi-
cient allocations defined above.

4) Start from the given efficient allocation. Since it is interior, and Pareto
efficient, you know that the corresponding M RSs of the two agents are
equal to 2. Because at an interior equilibrium M RSs equal relative prices,
the only candidate, relative, price is px /py = 2. Without loss of generality
(using the fact that individual demands are homogeneous of degree zero in
prices), normalize the price of y to 1, i.e. let (px , py ) = (2, 1). To find the
necessary transfers, just impose budget balance with transfers; for agent A:

2 × 2, 5 + 5 = 2 × (ωxA + tA ) + ωyA
1
An allocation x in the Edgeworth box is Pareto efficient (or Pareto optimal ) if there is
0 0
no other allocation x0 in the Edgeworth box such that x i  xi for i = A, B, and x i  xi
for some i. In other words an allocation is Pareto efficient if:
+ there is no other way to allocate society’s resources and make somebody better off
without harming someone else.

4
Compute tA by solving the latest equation at the initial endowment point
(ωxA , ωyA ) = (2, 1), assuming that this is the initial situation faced by the
planner:
10 = 4 + 2 × tA + 1 =⇒ tA = 2.5, tB = −2.5
If you instead did the exercise starting from the equilibrium allocation, then
just modify the last step by setting endowments equal to that allocation:
(ωxA , ωyA ) = (1.25, 2.5)

Solution to Problem 2

1) Walrasian equilibria can be both characterize algebrically and geometri-

cally.
Algebrically, we can use local non satiation (LNS) to establish the fact that
every individually optimal allocation (i.e. every allocation in the demand
correspondence) at given prices and endowments is such that total expen-
diture equals individual wealth; i.e. the LNS agent consumes on the budget
line. Therefore, if the allocation is interior (meaning strictly positive) it
must be that the chosen allocation is at the tangent point between the
budget line and an indifference curve going through that point. By con-
tradiction, suppose this is not the case: at the chosen point the individual
M RS between two commodities does not equal relative prices. Thus, say,
either M RS1,2 > p1 /p2 or M RS1,2 < p1 /p2 . Then, the allocation would not
be individually optimal, a contradiction. Indeed, in the first case it would be
budget feasible for the consumer to buy an extra unit of good 1 at price p1
and selling a unit of good 2 at price p2 , therefore exchanging a unit of good
1 against p1 /p2 units of good 2. This makes her better off, since to be as
well off she should have exchanged a unit of good 1 against M RS1,2 > p1 /p2
units of good 2; what she saves - M RS1,2 − p1 /p2 - in terms of good 2 is
what make her better off. Geometrically, consider the (Figure 3).

2) The Walrasian equilibrium does not always require that the MRSs equal
relative prices. In fact, there are equilibria in which one or more consumers
choose not to consume some commodity, thereby demanding an allocation
that is at the boundary of the Edgeworth box (Figure 4). Panel I depicts
a Walrasian equilibrium allocation x∗ at which MRSs need not be equalize.
Panel II shows that for an economy with endowments not in the interior of
the box, and same preferences, no equilibrium exists. The MRSs are not
equalized as Panel I, but there are no prices (p∗1 ; p∗2 ) at which x∗ is the Wal-
rasian equilibrium allocation.

3a) To draw the Walrasian equilibrium allocations, let’s study the shape
of consumers’ indifference curves. The consumer A has a quasilinear utility
function, instead, the consumer B has a linear utility function only in the

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Figure 3: Interior solution context. The geometric interpretation of the
equality between MRSs and the price ratio. The Walrasian equilibrium
allocation x∗ (·).

Figure 4: Boundary solution context. Walrasian equilibrium allocation x∗ (·)

does not require the MRSs are equalized.

6
good two. The indifference curves generated by these utility functions are
plotted in (Figure 5, Panel I).

Figure 5: Endowment point and the existence of the Walrasian equilibrium.

First, observe that indifference curves are quasi-linear in commodity 1 for

agent A.2 While agent B cares only to consume commodity 2. It is therefore
natural to conjecture that if an equilibrium exists it will be on the boundary
of the box for most economies (i.e. initial endowment distributions).
To characterize equilibria you should concentrate on consumer A; B will
always spend all his wealth on commodity 2. So, let us define the demand
of A.
Since A0 s preferences are convex, first order conditions characterize the A0 s
consumer demand:

∂l uA ≤ λpl with equality if xl > 0, l = 1, 2

p · (x − ω) = 0

for some λ ≥ 0.
Consider a solution with x = (x1 , x2 ), with x1 > 0, x2 = 0, satisfying,
p1
M RS(x) = 1 + x2 |x2 =0 >
p2
p1
⇔ <1 (5)
p2

Therefore, if pp12 < 1, at endowments ω A , A chooses (xA A A A

1 , x2 )(p, ω ) = (ω1 +
p2 A A A B B
p1 ω2 , 0). At equilibrium, market for good 1 clears: x1 (p, ω )+x1 (p, ω ) =
2
Drawing indifference curves of A on (x1 , x2 ). Take the exponential transformation of
ū
A s utility: eū = ex1 (x2 + 1), the level set ū is x2 = eex1 − 1. A0 s M RS is: ex1 dx2 +
0

x1 dx2
e (x2 + 1) dx1 = 0 ⇒ dx2 + (x2 + 1) dx1 = 0 ⇒ M RS := − dx 1
|u = x2 + 1

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ω 1 ; using the fact that xB B
1 (p, ω ) = 0, substituting,

p2 A
ω1A + ω = ω1
p1 2

and rearranging (with the assumption that ω1B > 0),

p1 ωA
= 2B (6)
p2 ω1

Since condition (5) must hold, not all the economies can lead to the type of
equilibria just described; instead, only those economies with initial endow-
ments ω2A < ω1B . Graphically, these are economies are identified by the set
of points in the box lying below the main diagonal, cutting it from the left
highest corner to the right lowest one (Figure 5, Panel II).
Therefore, we can conclude that for ω2A < ω1B equilibria exist.
You can also test that if ω2A ≥ ω1B (i.e. if the economy is one on or above
ω A +1
the diagonal cutting the box) an equilibrium exists with pp12 = ω2B +1 ≥ 1.
1
When the latter inequality is strict, equilibrium allocations are such that
A B

xB∗ = (0, ω̄2 − xA∗ A∗ = ω̄ , p1 − 1 , where p1 − 1 = ω2 −ω1 . Thus,
2 ), x 1 p2 p2 ω1B +1
equilibria do always exist in this box-economy.

3b) You basically have just to rap up the observations made in the last
solution set. For all the economies with 0 ≤ ω2A < ω1B the equilibrium price
p1 ω2A p2 A
is p2 = ω1B
, with allocations xA∗ = (ω1A + p1 ω2 , 0), x
B∗ = (0, ω̄2 ).
ω A +1
For all the economies with ω2A ≥ ω1B ≥ 0 the equilibrium price is pp21 = ω2B +1 ,
  1

with allocations xA∗ = ω̄1 , pp12 − 1 , xB∗ = (0, ω̄2 − xA∗

2 ).
Graphically, equilibria are either along the lower hedge or along the right
vertical hedge of the box, depending whether we are considering economies
described by initial endowments lying below or above the main diagonal.