Intermediate Microeconomics and Its

Application 11th Edition Nicholson

Solutions Manual
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CHAPTER 10
General Equilibrium and
Welfare
A. Summary
This chapter provides a very elementary introduction to general equilibrium
theory. It begins by showing why taking a general equilibrium approach may
be necessary to address some important economic questions and then pro-
ceeds to build a simply model of two markets. That model (drawn primarily
from the graphical approach to international trade theory) generalizes “sup-
ply” by using the production possibility frontier and “demand” by using a
typical person’s indifference curve. An advantage of this approach is to
stress that the economic “problem” is how to make the best (utility-
maximizing) use of scarce resources.
The middle portion of the chapter is devoted to showing the “first theo-
rem of welfare economics” (that perfectly competitive prices, under certain
circumstances, yield economic efficiency). Again this is done using the pro-
duction possibility frontier and indifference curves to show how the opera-
tions of markets cause the economy to hone in on the efficient point.
Reasons why the first theorem may fail are discussed in the third section
of the chapter. Subjects given very brief treatment include: (1) Imperfect
competition; (2) Externalities; (3) Public goods; and (4) Imperfect infor-
mation. Each of these topics is covered in considerable detail in later chap-
ters. The discussion here also includes a brief discussion of equity and of
how goals of equity and efficiency may sometime (but by no means always)
be in conflict. The Edgeworth Box Diagram is the primary tool used for this
purpose.
The chapter concludes with a brief discussion of how money enters into
general equilibrium models. The main goals here are: (1) to introduce the
“classical dichotomy” between monetary and real sectors; and (2) to illustrate
the notion of fiat money and why this innovation has important economic
implications.

B. Lecture and Discussion Suggestions

Repeating the development of the general equilibrium model in this chapter
in lecture would probably be quite dull. Hence, it may better to assume that
students have understood the development in the text and just use the model
to illustrate some results. One approach that seems to work well is to use
separate supply and demand curves for goods X and Y together with the gen-
eral equilibrium model to show how both approaches to equilibrium are get-
ting at the same sort of thing. Reasons for the superiority of general
equilibrium should become readily apparent in this comparison. Having an
operational, simple GE model can also provide students with a lot of insights
about how these models work in practice.

1
2 Chapter 10: General Equilibrium and Welfare

Discussions of general equilibrium might focus on “what more did you

learn by using these models?” For example, students may find that tax inci-
dence questions are much more complicated than they at first thought. Espe-
cially interesting are discussions of the role of capital taxation and how
theoretical insights might shed light on real world issues about, say, the inci-
dence of the corporate tax. Use of general equilibrium models to look at
trade issues also provides a number of good discussion questions. For exam-
ple, students may have rather simple views about how the NAFTA may have
affected the welfare of low income workers and it may be useful to show
them how complex answering this question actually is.

C. Glossary Entries in the Chapter

• Contract Curve
• Economically Efficient Allocation of Resources
• Equity
• Externality
• First Theorem of Welfare Economics
• General Equilibrium Model
• Imperfect Competition
• Initial Endowments
• Pareto Efficient Allocation
• Partial Equilibrium Model
• Public Goods

SOLUTIONS TO CHAPTER 10 PROBLEMS

10.1 a. The production possibility frontier for M and C is shown as:

b. If people want M = ½ C and technology requires C + 2M = 600, then C +

2(1/2C) = 600.
2C = 600 or C = 300. M = 150.
c. For efficiency RPT=MRS=1/2, so
PC 1
RPT = MRS = =
PM 2
 Chapter 10: General Equilibrium and Welfare 3

10.2 a. See Graph

b. See Graph
c. The production possibility frontier is the set of food and cloth outputs that sat-
isfy both constraints (see graph).
d. The frontier is concave because the two goods use differing factor proportions.
The slope changes as a different input becomes the binding constraint.
e. The constraints intersect at F = 50. For F < 50 the slope of the frontier is -1.
P
Hence, in this range, F = 1 . For 50 < F < 75 the slope of the frontier is -2
PC
P
(because land is the binding constraint). In this range therefore F = 2 .
PC

PF 5
f. With these preferences, = .
PC 4
g. Any price ratio between 1.0 and 2.0 will cause production to occur at the kink
in the frontier.
h. This capital constraint lies always outside the previous production possibility
frontier. It will not therefore affect any of the calculations earlier in this prob-
lem.

10.3 a. The frontier is a quarter ellipse:

4 Chapter 10: General Equilibrium and Welfare

2 2
b. If Y = 2X, X + 2(2X) = 900.
2
9X = 900; X = 10, Y = 20. This point is shown on the frontier in part a.
c. If X = 9 on the production possibility frontier,
Y = 819 / 2 = 20.24

If X = 11, Y = 779 / 2 = 19.75

Hence, RPT = 0.49/2 = 0.245 . This is the ratio of prices that will cause produc-
tion to occur at X = 10, Y = 20.
d. See graph in part a.
2 2
10.4 Since LF + LC = 8 . the production possibility frontier is F + C = 8

Given H = 16, U = 4F¼ C¼ and we know that optimality will require C = F since the
goods enter both the utility function and the production possibility frontier symmetri-
2
cally. Since C = F, have 2C = 8 or C = F = 2. Utility = 4 2.

10.5 a. Given the production conditions, the production possibility frontier will be a
straight line with slope - 3/2. Hence the price ratio in this economy must be
PX 3 X Y
= . The equation for the frontier is + = 20 .
PY 2 2 3

3 5 8
b. Using the hint, X S = XJ = XT =
PX PX PX

12
Similarly YT = . Substituting these into the equation for the frontier and us-
PY
2P 4 4 10 1 1
ing the fact that PY = X yields + = = 20 PX = ; PY = . Notice
3 Px PY PX 2 3
how setting the wage here also sets the absolute price level.
 Chapter 10: General Equilibrium and Welfare 5

c. With these prices, total demand for X is 16, total demand for Y is 36. Hence 12
hours of labor must be devoted to Y production, 8 hours to X.

10.6 a. For region A the production possibility frontier is X A2 + YA2 = 100 . For region
B it is X B2 + YB2 = 25 . Hence the frontiers are concentric circles with radius 10
for A and 5 for B.
b. Production in both regions must have the same slope of the production possi-
bility frontier. In this case that means that the ratio X/Y must be the same in
both regions – production must take place along a ray through the origin.
c. The geometry of this situation suggests that for efficiency
X A = 2 X B YA = 2YB . Hence X T = 3 X B YT = 3YB and the frontier is given
by X T2 + YT2 = 9( X B2 + YB2 ) = 225 . If X T = 12 YT = 9 .

10.7 a. U1 = 10 U 2 = 5 .
F2
b. F1 = which implies F1 = 40 F2 = 160 .
4
c. The allocation in part a achieves this result --
F1 = F2 = 100  U1 = 10 U 2 = 5 .
d. A natural suggestion would be to maximize the sum of utilities. This would
1 1
require that marginal utilities be equal. Because MU1 = MU 2 =
2 F1 4 F2
equality of marginal utilities requires F1 = 4F2 F1 = 160; F2 = 40 -- a rather
unequal distribution. Still the sum of utilities is 15.8 – the largest possible.
With an equal allocation the sum of utilities, for example, is 15.0.

10.8 a. The total value of transactions is 20w. So, money supply = 60 = money de-
1 12 1 12
mand = 5w. So w = 12. PX =  = 0.6 PY =  = 0.4 .
2 10 3 10
b. If the money supply increases to 90, all wages and prices increase by 50 per-
cent: w = 18, PX = 0.9, PY = 0.6 . Relative prices and the overall allocation of
resources remain the same. Yes, this economy exhibits the classical dichoto-
my.
6 Chapter 10: General Equilibrium and Welfare

10.9 a-c. See Graph

d. As before, efficient points are the tangencies of the isoquants.

e. The production possibility frontier shows the maximum amount of Y that can
be produced for any fixed amount of X. Any point off the contract curve has
the property that Y can be increased even if X is held constant.
f.
(i) The production possibility frontier is a single point where X gets all labor
input, Y gets all capital input.
(ii) The frontier would be a straight line
(iii) Again, the frontier would be a straight line. Only with differing factor
intensities would the frontier have a concave shape.
(iv) The frontier would be convex.
 Chapter 10: General Equilibrium and Welfare 7

10.10 a. The preferences of Smith and Jones are shown in the figure. The only ex-
change ratio that can prevail is set by Jones’ preferences – 1C must trade for
0.75H. On the other hand, all efficient allocations must lie along the main di-
agonal of the box where, because of Smith’s preferences, C = 2H.

b. This is an equilibrium – the allocation lies on the contract curve and any trade
would make at least one person worse off.
c. Now the initial position is off the contract curve. Smith has 20“extra” H. If
Jones gets all the gains from trade because Smith gives these to him/her, utility
will increase from U J = 4(40) + 3(120) = 520 to U J = 4(60) + 3(120) = 600 . If
Smith gets all the gains from trade, the new equilibrium requires
4 H + 3C = 520 and C = 2 H . Hence, the equilibrium requires Jones to get H =
52, C = 104. Smith gets H = 48, C = 96 and is much better off than at the ini-
tial allocation. Smith may be able to enforce this equilibrium or, if he/she is
especially strong may in fact take everything.