EC2A1: Microeconomics II

Class 2: Exercise and Solution

Winter Term 2024

Consider an economy comprising two individuals Meghan (labelled as

consumer A) and Harry (labelled as consumer B) who produce and consume
two goods: Net‡ix series (good 1) and books (good 2). The price of Net‡ix
series is p1 and books is p2 . Let xA A
1 ; x2 and xB B
1 ; x2 denote Meghan and
Harry’s consumption bundles:
Meghan and Harry are keen to use their talents to become …nancially
independent and, to do so, they supply labour to produce one of the goods
which they can sell in a competitive market. Meghan can produce 2 units of
Net‡ix series for each hour worked and Harry can produce 4 units of books
for each hour worked.1 Let LA ; LB be Meghan and Harry’s labour supply
levels measured in hours.
Preferences for goods and labour supply for Meghan are
q
A 1 A 2
x1 + 2 xA 2 L
2
and Harry’s preferences are
q
1 B 2
xB
1 +2 xB
2 L
2
(There is no need to worry about convexity and non-satiation and you can
work with interior solutions.)

1. How much labour will Meghan and Harry supply for …xed prices (p1 ; p2 ) ?
[Hint: for this part and what follows, use the budget constraint to solve
1
You may think of units of tv series as the minutes of screenplay and book units as a
number of pages written.

1
for consumption of one of the goods and the substitute it into the util-
ity function before solving for labour supply and the demand for the
other good.]

First set up the budget constraint. This time the agents don’t have an
endowment, but thanks to their labour are able to get money to spend
on the two goods they like. Assuming p1 = 1 their budget constraints
are: For Meghan:

2LA = xA A
1 + p 2 x2

and for Harry:

4p2 LB = xB B
1 + p 2 x2

So we can rewrite the budget constraints as:

xA
1 = 2L
A
p 2 xA
2

and
xB B
1 = 4L p2 p 2 xB
2

To optimize, substitute this into the budget constraint and take the …rst
order conditions. This is the same method we used for problem set 1.
Using this we can get the answers for both part 1 (labour supply) and
part 2 (demands for good 2).
q
^ A ; xA 1 A 2
L 2 = arg max xA
1 +2 xA
2 L =
2
q
1 A 2
2LA p 2 xA
2 +2 xA
2 L
2
@F ( )
=2 LA = 0
@L^A
implying
LA = 2
Similarly
@F ( ) 1
=0= p2 + (xA
2)
2
@xA
2

2
 implying
2
1
xA
2 =
p2
so optimally
^ A ; xA = 2; (1=p2 )2
L 2

Similarly for person B we maximize

q
^ A ; x2B = arg max xB 1 B 2
L 1 +2 xB
2 L =
2
q
B 1 B 2
4L p2 p 2 xB
2 + 2 xB
2 L
2
Taking FOC we get:
@G( )
= 4p2 LB = 0 implyingLB = 4p2
^B
@L
and
2
@G( ) 1 1
=0= p2 + (xB
2)
2 implyingxB
2 =
@xB
2 p2
Optimally
^ A ; x2 = 4p2 ; (1=p2 )2
L B

This means that overall the labour supplied is LA = 2 and LB = 4p2 .

2. What are Meghan and Harry’s demands for books? How does their
consumption of books di¤er? What is the elasticity of demand for
books?

The demand for good 2 is the same for both consumers and it’s the one
derived above.
2
xA B
2 = x2 = (1=p2 )

The elasticity of demand is:

2
@xB
2 p2 @xA
2 p2 3 1 3
B
= = 2 (p2 ) (p2 ) = 2 (p2 ) (p2 )3 = 2
@p2 x2 @p2 xA
2 p2
so demand is elastic.

3
3. How does Meghan and Harry’s consumption of Net‡ix series vary as p2
varies? Are the goods complements or substitutes?

We look at what happens to Net‡ix series consumption if the price of

books increases. For Meghan:
2
1 1
xA
1 = 2L
A
p 2 xA
2 = 4 p2 =4
p2 p2

and for Harry:

2
1 1
xB B
1 = 4L p2 p 2 xB
2 = = 4p2 4p2 p2 = 16 (p2 )2
p2 p2

When p2 increases both demands will increase (you can also take partial
derivatives to check for this, and/or …nd the cross-price elasticity for
good 1). Intuitively the two goods have some substitutability, so when
the price of good 2 increases the consumers will consume less of it and
shift consumption to good 1.

4. What is the general equilibrium price ratio? (Hint: set supply equal to
demand. Supply of Net‡ix series (books) is determined by the labour
supply of Meghan (Harry). You can also set p1 = 1.)

Here we set supply equal to demand for good 2 (you could also work
with good 1).
Supply of good 2 is the amount of hours Harry works times the amount
of Net‡ix series he can produce so 4 LB = 16 p2 hence when supply
equals demand:
2
1
16p2 = 2
p2
Solving for p2 yields:
1=3
1
p2 = = 0:5.
8

4
5. What are the income and utility levels of Meghan and Harry? Explain.

Plug demands and labour supplies back into the utility function to
yield:
q
A 1 A 2
U = xA
1 + 2 xA
2 L =
2
p 1 A 2
= 2LA p 2 xA
2 + 2 xa2 L
2
s
2 2
1 1 1
=4 p2 +2 (2)2
p2 p2 2
1 1
=2+ =2+ =4
p2 0:5
Similarly for Meghan we plug in the demands and labour supply:

q q
1 B 2 1 B 2
U B = xB
1 +2 xB
2 L = = 4p2 LB p 2 xB
2 +2 xB
2 L
2 2
s
2 2
2 1 1 1
= 16 (p2 ) p2 +2 (4p2 )2
p2 p2 2
2
1 1 1 1 2
= 16 1 +2+ 1 (2) = 4 2+2+2 2=4
2 2 2
2

And incomes are

mA = 2 LA = 4
2
1
mB = 4 p2 LB = 4 p2 4 p2 = 16 = 4:
2
Interestingly, even though the two workers have di¤erent productivities
they end up with the same utility.

5
6. Is the ratio of the income levels of Meghan and Harry greater than or
less than the ratio of their productivities? Explain.

The income ratio is 1:1 whereas productivity is 1:2. This is because of

general equilibrium. Harry is more productive than Meghan but because
of that the good he produces sells at a lower price.

7. Does it make sense to compare Meghan and Harry’s utility levels? Ex-
plain.

Not with standard assumptions about ordinal and non-comparable util-

ity. A good opportunity to remember that utility is ordinal and not
comparable in the standard model. This will be mentioned again in the
lectures on welfare economics where we relax this assumption.

8. Suppose now that due to their move to the United States, Harry be-
comes less productive and can now only produce 2 units of books for
every hour rather than 4 units of books for every hour worked. How
does this negative shock to Harry’s productivity a¤ect the prices and
income levels of Meghan and Harry?

Here we change Harry’s productivity to 2 and set up the consumer

optimization again. The budget constraints are now:

2LA = xA A
1 + p 2 x2

2p2 LB = xB B
1 + p 2 x2

Then for Meghan nothing changes:

p 1 A 2
^ A ; xA = arg max 2LA
L p 2 xA xa2
2 2 +2 L
2
And optimally
^ A ; xA
L 2 = 2; (1=p2 )2

But for Harry xB

1 = 2L
B
p 2 xB
2 now so the maximization becomes:

q
^ B ; xB = arg max xB + 2 1 B 2
L 2 1 xB
2 L =
2

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 q
1 B 2
= arg max 2LB p 2 xB
2 +2 xB
2 L
2
so optimally
^ B ; xB
L 2 = 2p2 ; (1=p2 )2
just like for Meghan, so with lower labour supply than before.

The overall supply of good 2 is now:

^B = 2
2L 2p2 = 4p2

Set supply equal to demand to get:

2
1
4p2 = xA
2 + xB
2 =2
p2
2
1
4p2 = 2
p2
2
1
2p2 =
p2
1
(p2 )3 =
2
1=3
p2 = 2 = 0:8 > 0:5

so the relative price of good 2 goes up. This is because supply has
fallen. Comparing incomes:

mA = 4
mB = 4 (p2 )2 = 4(2 2=3
)<4

So the Harry’s income is now lower than Meghan’s even though they
are equally productive. This is because p2 < p1 = 1 (in turn because of
the preferences A and B have).

7
 9. How is Meghan’s utility level a¤ected by the fall in Harry’s productiv-
ity? Explain
Now note that Meghan’s utility is
q
A A 1 A 2
U = x1 + 2 xA 2 L =
q 2
1 A 2
= 2LA p2 xA 2 +2 xA
2 L =
s 2
2 2
1 1 1 2
= 4 p2 +2 (2) =
p2 p2 2
1 1
=4 1 + 2 1 2=
23 23
1 1
=2+ 1 =2+ <4
23 0:8
so she is worse o¤ - that is because the price of good 2 has increased.

10. More open ended questions:

(a) Is this a good model for thinking through how environmental

degradation a¤ects the economy?
(b) Think of some other examples of environmental shocks and what
data you might use to examine their impact.
(c) Can a modelling framework like this help us think about policy
responses?
(d) Is there a case for making a transfer to Harry for his loss of pro-
ductivity?

It is important to think about productivity changes (including those due to

climate change) because they don’t a¤ect only the producers’whose utility has
changed. They are likely to shock the entire system and have repercussions
on the incomes and utility of people. It is a good point to start them thinking
about distributional implications as that is what we will take up in the next
lecture.