EC2066 Microeconomics

EC2066 Microeconomics
Chapter 7: General equilibrium and welfare – Sample examination
questions

Question 1

Consider a given allocation of resources that is not Pareto efficient. Not all Pareto
efficient allocations in the economy Pareto dominate this allocation. Is this true or
false? Explain.

This is false. Not all parts of a contract curve can Pareto dominate any given allocation in an
Edgeworth box.

Question 2

Consider a pure exchange economy with two agents, Ann and Bob, who consume
only two goods, x and y. In the economy there are 4 units of x and 2 units of y.
Ann is endowed with 1 unit of x and 2 units of y, and Bob is endowed with 3 units
of x and 0 units of y. Their utility functions are:
√
uA (xA , yA ) = xA yA and uB (xB , yB ) = xB + 2yB .
(a) Draw the Edgeworth box, showing the endowment point, and the indifference
curves.
(b) Derive the contract curve.
(c) Derive the demand functions of the two agents.
(d) Calculate the exchange equilibrium price ratio.
(e) Calculate the exchange equilibrium allocation.

The Edgeworth box and the contract curve are shown below. M is the endowment point. The
price line coincides with the indifference curve of B. E is the equilibrium.

1
Chapter 7: General equilibrium and welfare – Sample examination questions

The MRS of A is yA /xA , and the MRS of B is 1/2. Therefore, the contract curve is given by:
yA 1
= .
xA 2
This is shown in the previous figure.

Let p be the relative price of x (so the price of y is 1). The demand function of agent A can be
found as follows.

The budget constraint is:

pxA + yA = p + 2.
From MRS = p, we get yA /xA = p, or yA = pxA . Using this in the budget constraint, we get the
demand functions:
p+2
xA =
2p
and:
p+2
yA = .
2
For B, the MRS = 1/2. Therefore, in equilibrium, we must have p = 1/2 (the price line must
coincide with the indifference curve of B through the endowment point as shown in the figure.

The equilibrium allocation is as follows. Since p = 1/2, we get xA = 2.5 and yA = 1.25. Market
clearing implies xB = 1.5 and yB = 0.75.

Question 3

The following questions are about the first welfare theorem.

(a) State the first welfare theorem.

(b) Provide an outline of the proof in the context of an exchange economy with two
agents and two goods.
(c) Discuss an outline of the proof in an economy with production.
(d) Discuss the implications of this theorem.
(e) In what situations might the theorem fail? Discuss.

See Sections 7.4.1 and 7.4.2 of the subject guide for the answer.

Question 4

The following questions are about the second welfare theorem.

(a) State the second welfare theorem.

(b) Discuss an outline of the proof in the context of an exchange economy with two
agents and two goods.
(c) Explain why the theorem requires preferences to be convex.
(d) Discuss the policy implications of this theorem.
(e) Discuss the practical problems with the implications of the theorem.

See Sections 7.4.3 and 7.4.4 of the subject guide for the answer.