ANSWERS FOR PROBLEM SET IN CHAPTER 1

Problem 1: Xuan vs. Thu

1. Denote F for Food, S for Shirts then we have:
1
Xuan: MRSFSXuan = 3 or for Xuan: 1F = 1/3 S or 3F = 1S
2
Thu: MRSFSThu = 3 or for Thu” 1F = 2/3 S or 3F = 2S
⟹ MRS (Xuan) ≠ MRS (Thu)
⟹ This is not Pareto efficiency.
Guide: Here, you know that Xuan values S at a relatively cheaper price than Thu does. That
means S should be transferred from lower valuing person (Xuan) to higher valuing person
(Thu). That is basis to move to section 2 below.
2. For Xuan: 3F = 1S implying that if she has to forgo 3F, she will ask to be
compensated by 1 S so that her utility is unchanged.
For Thu: 3F = 2S implying that if she receives additional 3F, she is willing
to release 2S without changing her utility.
Then, the proposed new distribution pattern will be:
+ Take 3F away from Xuan and give them to Thu
+ Take 2S from Thu and give 1S to Xuan. Thus, one extra S remains.
At this point, utility of both Xuan and Thu is unchanged while there is an
extra S.
3. Suggest different distribution patterns for the extra S:
+ If the extra S is given to Xuan, so it makes Xuan better-off without
harming Thu’s well-being.
+ If the extra S is given to Thu, this makes Thu better-off without harming
Thu’s well-being.
+ If the extra S is divided into 2 parts (not necessary to be equal), each of
whom is given to each person, then this makes both better-off.

Problem 2:

a) MRTScar = 10, implying that for car production: 1L = 10K

MRTScotton = 4, imlying that for cotton production: 1L = 4K

  MRTScar ≠ MRTScotton

 The production sector has not yet been Pareto efficient.

Guide: Here, you know that L is more costly in producing car than in producing cotton. That
means L should be transferred from cheaper sector (cotton) to more expensive one (car) to
equalize labor cost in both sector. That is basis to move to section b below.

b) To achieve Pareto efficiency, we need:

- For cotton production, if the sector has to release 1L, it will require to get
additional 4K to remain its output unchanged.
- For car production, if the sector receive additional 1L, it will be willing to
release 10K without changing its output level.

Therefore, the proposed new distribution pattern will be:

- Take 1L away from cotton production to add into car production, then get
back 10K from car production
- Send back 4K to cotton production and keep extra 6K.

At this point, output levels of both sectors are unchanged while there is extra 6K.

c) To “increase” the output of car without affecting the output of cotton:

Put all 6 redundant capital units in the automobile industry.

Problem 3:
a) Name: Denote product of Beer as X, Cigarette as Y
MRTXY = 3 implying that for efficient production sector, 1X = 3Y (input mix to
produce one can of Beer is enough for producing 3 boxes of Cigarette)
MRSXY = 1 or for efficient consumption: 1X = 1Y. That means utility that one can
of Beer brings to consumers is equal to that brought by 1 box of Cigarette.
Guide: Here, you know that producing Beer is more costly of input mix than producing
Cigarette. That means the economy should produce less costly product (X) and cheaper product
(Y). That is basis to move to section b below.
 MRTXY > MRSXY
 The economy does not achieve overall Pareto efficiency
b) To get overall Pareto improvement, the economy should reduce production
of 1X, so that the available input mix allows the economy to produce
additional 3Y.
Whereas, if consumers have to consume less one unit of X, they require to be
compensated by only one unit of Y. The extra 2Y produced by the economy will
give consumers additional utilities, without a need to utilize more inputs. That is
Pareto improvement relative to the initial production structure.