ECO 317 Economics of Uncertainty Fall Term 2009

Week 7 Precepts November 11

General Equilibrium and Efficiency - Questions

Question 1 Pareto-Efficient Allocations

Consider a two-good, two-person exchange situation. There is one (perfectly divisible) unit
of each of two goods, food (F ) and clothing (C). There are two consumers, Ann and Betty.
Denoting their consumption quantities by FA for Anns consumption of food etc., their utility
functions are
UA (FA , CA ) = FA CA ,
UB (FB , CB ) = (FB )2 CB .
Find expressions for their marginal rates of substitution. For Pareto efficiency, the two MRSs
should be equal. This gives you one equation linking the four quantities FA , CA , FB , CB .
There are two other equations, namely the material balance requirements that for each
good, the amount allocated to the two consumers should add up to the total available:
FA + FB = 1,

CA + CB = 1 .

Use these to solve for CA , FB , and CB , each of them as a function of FA .

Show CA as a function of FA in the Edgeworth box diagram (as in Lecture Handout
11) with FA on the horizontal axis and CA on the vertical axis. Remember that the total
amounts of each are 1, so only the portion of the graph in the unit square (0 FA 1,
0 CA 1) has economic significance. With Anns quantities measured from the usual
origin, Bettys quantities are automatically the residuals, as if they were measured from an
origin at the diagonally opposite point (1, 1) and axes going to the left and downward. In
this box, note that the graph you drew lies above the 45-degree line? What is the intuition
for this?

Question 2 Competitive Equilibrium

Suppose that in the above example, Ann initially owns the unit of food and Betty owns the
unit of clothing. They can exchange these goods, acting as price-takers. Denote the price of
food by PF and the price of clothing by PC .
(1) Write down their demand functions.
(2) Using the demand functions, find their price-consumption curves, also called offer
curves, and show them in a diagram.
(3) You will have found that the offer curves are horizontal and vertical. Explain the
intuition for this.

ECO 317 Economics of Uncertainty Fall Term 2009

Week 7 Precepts November 11
General Equilibrium and Efficiency - Solutions

Question 1 Pareto-Efficient Allocations

Anns MRS is

dCA 
UA /FA
CA


=
=
.

dFA UA =constant UA /CA
FA
Bettys MRS is


dCB 
UB /FB
2 F B CB
2 CB


=
=
.
=
2

dFB UB =constant UB /CB
(FB )
FB
Equating the two, the efficiency condition is
CA / FA = 2 CB / FB .
To solve for the other three variables in terms of FA , begin with FB = 1 FA . Then the
efficiency condition gives
2 FA
CB .
CA =
1 FA
Therefore


1 + FA
2 FA
1 = CA + CB =
+ 1 CB =
CB .
1 FA
1 FA
Then
1 FA
CB =
,
1 + FA
and substituting into the above equation for CA in terms of CB , finally
CA =

2 FA
.
1 + FA

Figure 1 shows the graph of this, as the thick curve extending from OA to OB . It lies above
the 45-degree line. The reason is that Betty has a relatively stronger preference for food over
clothing than does Ann. Therefore it is efficient to give Betty an appropriately lower ratio
of clothing to food than is given to Ann (CB /FB < CA /FA ). In fact the mathematics gives
a more precise relationship: CA /FA is exactly two times CB /FB .

F
B
OC
A
OC

O
B

C
B

C
A

O
A

F
A

Figure 1: Pareto-Efficient Locus

Question 2 Competitive Equilibrium

Anns budget constraint is
PF F A + PC C A = 1 PF .
She has a Cobb-Douglas utility function with powers 1 and 1. Therefore her demand functions are
1 PF
1
1 PF
PF
FA =
=
CA =
=
.
1 + 1 PF
2
1 + 1 PC
2 PC
Her price-consumption curve is found by eliminating PF /PC between these to leave a relationship between FA and CA ; here it becomes simply FA = 12 , a vertical line in the figure.
Bettys budget constraint is
PF F B + PC C B = 1 PC .
She has a Cobb-Douglas utility function with powers 2 for food and 1 for clothing. Therefore
her demand functions are
FB =

2 PC
2 PC
2 PC
=
=
2 + 1 PF
3 PF
3 PF

CB =

1 PC
1
= .
2 + 1 PC
3

Her price-consumption curve is found by eliminating PC /PF between these to leave a relationship between FB and CB ; here it becomes simply CB = 13 , a horizontal line in the
figure.
The reason is that in Anns demand for food, the income effect of a price change exactly
offsets the substitution effect, leaving a perfectly inelastic Marshallian demand. Similarly
for Bettys demand for clothing. (Note that a similar thing happens with the labor supply
of a consumer for whom wages are the only source of income, and whose utility function is
Cobb-Douglas in consumption and leisure.)