Lahore University of Management Sciences

Department of Economics

Homework # 2 E411: Advanced Microeconomics

Mushtaq A. Khan Due: March 26, 2018 (5:00 pm)
1. Consider a two-sector general equilibrium of production system. Sector one’s unit cost function
is c1 = w1/3r2/3 and that of sector two is c2 = w1/2r1/2, where w and r are the wage rate of labor and
the rental rate of capital, respectively. Both the input and output markets are all characterized by
perfect competition and full employment of both the factors of production. For a one-percent
increase in the price of the commodity produced in sector two, what are the percentage changes
in factor prices? (15 marks)

2. Consider the general equilibrium of a pure exchange economy in which two agents may engage
in trade. The utility functions for the two agents are identical: U 1 = A1B1 and U2 = A2B2, where Ai
and Bi are consumption levels of the two goods, A and B, for agent i (i = 1, 2). The initial
endowment vectors are given as follows: Agent 1: (a1, b1) = (100, 0); Agent 2: (a2, b2) = (0, 100).
Suppose that they both maximize utility and that each agent accepts as given the market price as
quoted by a referee. Answer the following questions:

a. Calculate the demand functions of both agents. (10 marks)

b. Determine the equilibrium prices that will clear the markets. (10 marks)
c. Calculate the equilibrium allocation in consumption. (10 marks)
d. Construct the locus of equilibrium points (the offer curve) for each agent. Examine
the shape of the two offer curves, using the geometrical construction of Edgeworth-
Bowley consumption box. (10 marks)
e. Show that the results derived in (b) and (c) satisfy both offer curves. (10 marks)

3. Consider a two-person (A, B), two-goods (X, Y), and pure-exchange economy of general equilibrium with
utility functions:
UA = (XA)(YA)
UB = (XB)(YB)2.
Where XA, YA, XB, and YB are consumption levels of the two commodities (X, Y) by the two individuals
(A, B). Individual A has endowments of 20 and 80 units of X and Y respectively; individual B has
endowments of 120 and 60 units of X and Y respectively.

a. Determine excess demand functions for the two consumers. Calculate the equilibrium
allocation in consumption. (10 marks)
b. Determine the competitive equilibrium price ratio for the economy and show that both
individuals will be better off if they engage in transactions at the competitive equilibrium
prices. (10 marks)
c. Construct the offer curve for each consumer. Show that the equilibrium derived in part (b)
satisfies both offer curves. (15 marks)

4. Consider a simple economy in which there are two sectors (1 and 2) producing two different
commodities (Y1 and Y2) from capital and labor inputs. Labor is homogeneous and perfectly mobile
between sectors with no costs. Capital inputs are heterogeneous in that they can be classified into two
groups in terms of different types. As a result, capital of type 1 can only be used in sector 1
whereas capital of type 2 can only be used in sector 2. The production functions for the two
sectors are Y1 = f (L1, K1) and Y2 = g (L2, K2), where Li the number of workers, Kj is the amount
of capital employed in the ith sector (i = 1, 2). The production functions are twice
differentiable and linearly homogenous. Capital markets, labor market, and output markets
are all perfectly competitive. The equilibrium wage rate of labor is w, the rental rate in sector
1 is r1, the rental rate in sector 2 is r2, and the market price of commodity Yi is Pi (i = 1, 2).
Assume that all factors of production are fully employed.

a. Present the general equilibrium conditions for the small open economy. (10 marks)
b. Conduct a comparative statics analysis to examine the short-run and the long-run
effects of an increase in P1/P2 on factor rewards (r1, r2, w) and discuss their
implications. (15 marks)
c. What would be the short-run and the long-run effects of an exogenous increase in labor
on domestic production? (15 marks)