ECON 2020A: SECTION 8

SARAH WOLFOLDS AND CUICUI CHEN

Agenda
(1) Exchange Equilibrium and the Second Welfare Theorem
(2) Two Sector Equilibrium with Production
1. Exchange Equilibrium and the Second Welfare Theorem
Consider an exchange economy with two identical consumers. Their common utility
function is ui (x1i , x2i ) = x1i x1
for 0 < < 1. Society has 10 units of x1 and 10 units
2i
of x2 in all. Find endowments 1 and 2 , where 1 6= 2 , and prices that will support an
equilibrium allocation of (5,5) for both consumers.
First well start as usual by normalizing prices so that our price vector p* = (1, p).
Also note that we can write each consumers endowment as 1 = (11 , 21 ) and 2 =
(10 11 , 10 21 ) since there are a total of 10 units of each good in the economy.
Next find each consumers Walrasian demands. We know consumer 1s wealth is 11 +p21 ,
so consumer 1s Walrasian demands are:
(1)

x1 = (x11 , x21 ) = ((11 + p21 ), (1 )

(11 + p21 )
).
p

Similarly, consumer 2s wealth is 10 11 + p(10 21 ) and her Walrasian demands are

are:
(10 11 + p(10 21 )
).
p
To find the price ratio where markets clear, we can set x11 + x12 = 10:
(2)

x2 = (x12 , x22 ) = ((10 11 + p(10 21 )), (1 )

(3)

(11 + p21 ) + (10 11 + p(10 21 )) = 10,

which simplifies to
(4)

10 + 10p = 10,

Date: November 6 and 7, 2014.

Parts of these notes are shamelessly plagiarized from past TFs, including Daria Pelech, Katherine Donato,
Wonbin Kang, Abby Friedman, and Sam Richardson.
1

SARAH WOLFOLDS AND CUICUI CHEN

which implies that:

1
.

To find all endowments that will support as a Walrasian equilibrium allocation the equaldivision allocation giving both consumers the bundle (5,5) at these prices, we consider
conumer 1s Walrasian demands, and find all allocations such that x11 = 5. In other
words:
1
21 ) = 5.
(6)
x11 = (11 + p21 ) = (11 +

This equality holds true when

5 (1 )21
(7)
11 =

which means that the set of all endowments supporting the Walrasian equilibrium allocation
(5,5) is:
(5)

p=

(8)
5 (1 )21
, 11 + 12 = 10, 21 + 22 = 10, and 11 6= 5}

Notice that we only had to look at one consumers Walrasian demand (in this case we
chose x11 ) to find the conditions defining the set of endowments that support (5,5) as a
Walrasian equilibrium. If its not clear why that was sufficient, check that setting each of
x21 , x12 , and x22 equal to 5 all yield the same condition as we saw in (7).
(1 , 2 ) = {(11 , 21 ) : 11 =

Now, assuming that the consumers endowments are 1 = (2, 4) and 2 = (8, 6). What
transfers would need to be made in order to reach an endowment that supports the Walrasian equilibrium (5,5)?
From before, we know that consumer 1s wealth is 11 + p21 and consumer 2s wealth is
10 11 + p(10 21 ), and that p = 1
. Moreover, we know that after the transfer, each
consumer must be able to afford the bundle x = (5, 5), which means each will have wealth
equal to 5 + 5p = 5 + 5 1
. The transfers then are the difference between the wealth
needed to consume x and each consumers initial wealth:
(9)

T1 = p x p 1 = 1 5 +

1
1
1
5 (1 2 +
4) = 3 +

1
1
1
5 (1 8 +
6) = 3

As expected, consumer 1 needs a positive transfer from consumer 2 to be able to afford

the bundle (5,5). Note also that the transfers will always exactly balance out. With two
consumers, we really only needed to solve for T1 or T2 , and then we could find the other
one by multiplying by negative 1.
(10)

T2 = p x p 2 = 1 5 +

ECON 2020A: SECTION 8

2. Two Sector Equilibrium with Production

A self-sufficient farmer divides her time between labor and leisure. She consumes
three goods: leisure (xL ), rice (xR ), and bread (xB ). Her utility function is given by
1/2 1/2
u(xL , xR , xB ) = xL + xR xB . She has H hours to divide between labor and leisure, thus
her division of time must satisfy H = L + xL , where L is the total amount of time put into
labor.
Question 2a) Suppose that this farmer produces rice; if she devotes LR hours to home
1/2
production, she produces LR units of rice. Normalize the price of rice to 1 and denote
the price of bread by p. The farmers only source of wealth is from selling the rice that she
produces.
Question 2a1) What is the budget constraint for this farmer?
1/2

Question 2a2) Fix the consumers total wealth, so that LR = (H xL )1/2 = w,

and assume the choice of leisure is fixed as well. What does the consumer choose to spend,
and on what?
Question 2a3) What is the optimal choice of LR for this farmer?
Question 2a4) What bundle (xL , xR , xB ) is associated with this choice of LR ?
Question 2b) Suppose that another farmer produces bread; if she devotes LB hours to
1/2
home production, she produces LB units of bread. The utility function for this second
1/2 1/2
farmer is v(yL , yR , yB ) = 2yL + yR yB . The farmers only source of wealth is from selling
the bread that she produces. She also has H hours to divide between labor and leisure.
Question 2b1) What is the budget constraint for this farmer?
Question 2b2) Fix the consumers total wealth, so that L1B /2 = (H yL )1 /2 = w,
and assume the choice of leisure is fixed as well. What does the consumer choose to spend,
and on what?
Question 2b3) What is the optimal choice of LB for this farmer?
, y ) is associated with this choice of L ?
Question 2b4) What bundle (yL , yR
B
B

Question 2c) Suppose that the economy consists of just these two consumers. What
price p is necessary to clear the market for bread (and simultaneously for rice)?
Question 2d) What bundles do these consumers choose at that equilibrium price p?
Describe this equilibrium outcome in practical terms - who produces what and what do

SARAH WOLFOLDS AND CUICUI CHEN

they trade?
Question 2e) How does farmer 2s greater relative preference for leisure affect the
nature of the equilibrium results? Depending on the equilibrium price that you identified
in part (c), why is this price greater than / equal to / less than 1?
Solutions. Question a1) As is standard, we want our budget constraint to reflect the
fact that the consumer cannot spend more than her wealth. Here, the wealth is given by
her production of rice:
(11)

1/2

1 xR + p xB 1 LR

Question a2) If w is fixed, and we dont need to consider the consumers choice of
xL , then the remaining preferences are simply Cobb-Douglas over the other two goods.
1/2 1/2
And since we have Cobb-Douglas with xR xB , we know that the consumer will split her
wealth evenly between the two goods (each will have a budget share = 1/2). This means
xR = 21 w and xB = 21 wp .
Note here that preferences are quasilinear, with leisure as the numeraire. This means
that, for sufficient levels of rice and bread, the marginal utility of additional leisure will
be larger than the marginal utility of bread or rice. If we use the Lagrangian, we see that
u
1
the marginal utility of leisure is the inverse of our wage ( x
= wage
). We can think of
L
the wages as the price of leisure or what we pay in foregone income when we choose
to work less.
Note that we usually normalize the price of the numeraire to 1, and therefore the value
of the Lagrange multiplier is usually equal to 1. In the standard quasilinear model, we
usually think about the numeraire as money, which means that the Lagrange multiplier
or the shadow price of wealth is denominated in dollars. However, in this model, weve
chosen to normalize the price of emphrice to 1, and so the shadow price of wealth is instead
directly related to our wage.
Question a3)
To evaluate the farmers optimal behavior, we can solve her constrained optimization
problem:
(12)

1/2 1/2

max xL + xR xB s.t. 1 xR + p xB 1 (H xL )1/2

We can form the Lagrangian in order optimize:

(13)

1/2 1/2

L = xL + xR xB (1 xR + p xB 1 (H xL )1/2 )

Taking the first-order conditions with respect to the choice variable and Lagrangian we
get:

ECON 2020A: SECTION 8

(14)

L
1/2 1/2
= 1/2xR xB = 0
xR

(15)

L
1/2 1/2
= 1/2xR xB p = 0
xB

(16)

L
= 1 + [.5(H xL )1/2 ] = 0
xL

L
= (H xL )1/2 xR p xB = 0

If we use the first two equations to solve for , we can set them equal:

(17)

1/2 1/2

(18)

1/2 1/2
1/2xR xB

(19)

1/2xR xB
=
p

xB =

xR
p

If we plug this into our expression for from the first first-order condition, we get:
(20)

1/2

= 1/2xR

xR 1/2
) = 1/2p1/2
p

Next, we can use the third first-order condition to get another expression for :
(21)

1 = .5(H xL )1/2

(22)

= 2(H xL )1/2

We use this expression and set it equal to the expression for that we wrote above:
(23)

1/2p1/2 = 2(H xL )1/2

Simplifying this equation, we get:

(24)

(25)

1/p = 16(H xL )
xL = H

1
16p

SARAH WOLFOLDS AND CUICUI CHEN

1/2

As defined above, Lr

= (H xL )1/2 , so
LR =

(26)

1
16p

Question a4) Now we simply want to plug in this optimal value into the fourth first
order condition, which we can rewrite as:
(27)

(H xL )1/2 = xR p xB = xR + p

xR
= 2xR
p

We can then solve for xR and plug in for the value of xL we found in the previous section:

(28)

xR

(H (H
(H xL )1/2
=
=
2
2

1
1/2
16p ))

1
8p1/2

Now, we use the relationship we found between xR and xB to find our last variable:
(29)

xB =

xR
1
1
1
= 1/2 = 3/2
p
p
8p
8p

Question b1) Again, we just want to find an expression to ensure the farmer does not
spend more than he makes by producing bread:
(30)

1/2

1 yR + p yB p LB

Question b2) If w is fixed, the consumer will split her wealth evenly between the two
= 1 w and
goods bread and rice (each will have a budget share = 12 ). This means yR
2
= 1w
yB
2 p
Question b3)
We will use the same steps as we did in part a.
(31)

1/2 1/2

max 2yL + yR yB s.t. 1 yR + p yB p (H yL )1/2

We can form the Lagrangian in order optimize:

(32)

1/2 1/2

L = 2yL + yR yB (1 yR + p yB p (H yL )1/2 )

Taking the first-order conditions with respect to the choice variable and Lagrangian we
get:
(33)

L
1/2 1/2
= 1/2yR yB = 0
yR

ECON 2020A: SECTION 8

(34)

L
1/2 1/2
= 1/2yR yB p = 0
yB

(35)

L
= 2 + [.5p(H yL )1/2 ] = 0
yL

L
= p(H yL )1/2 yR p yB = 0

If we use the first two equations to solve for , we can set them equal:

(36)

1/2 1/2

1/2 1/2
yB

(37)

1/2yR

(38)

yB =

1/2yR yB
p
yR
p

If we plug this into our expression for from the first first-order condition, we get:
1/2

(39)

= 1/2yR

yR 1/2
) = 1/2p1/2
p

Next, we can use the third first-order condition to get another expression for :
2 = .5p(H yL )1/2

(40)

(41)

4(H yL )1/2
p

We use this expression and set it equal to the expression for that we wrote above:
1/2p1/2 =

(42)

4(H yL )1/2
p

Simplifying this equation, we get:

p1/2 = 8(H yL )1/2

(43)

yL = H

(44)
1/2

As defined above, LB = (H yL )1/2 , so

1
p
64

SARAH WOLFOLDS AND CUICUI CHEN

1
p
64
Question b4) Now we want to plug in this optimal value into the fourth first order
condition, which we can rewrite as:
LB =

(45)

yR
= 2yR
p
We can then solve for yR and plug in for the value of yL we found in the previous section:

(46)

p(H yL )1/2 = yR + p yB = yR + p

1
p))1/2
p(H (H 64
p(H yL )1/2
p3/2
=
=
2
2
16
Now, we use the relationship we found between yR and yB to find our last variable:

(47)

yR
=

(48)

yB
=

yR
p3/2 1
p1/2
=
=
p
16
p
16

Question c) Using the market clearing condition for bread, we get:

(49)

1/2

yB + xB = LB

Plugging in for the optimal values of these variables we found in previous sections, we
get:
(50)

p1/2
1
p1/2
+ 3/2 =
16
8
8p

Simplifying, we get:
(51)

p1/2
p2 + 2
=
8
16p3/2

(52)

8p2 + 16 = 16p2

(53)

8p2 = 16

(54)

p = 21/2

Note that we could also check the market-clearing price for rice, but it will give us the
same price by construction (although its always good to check ones algebra!)

ECON 2020A: SECTION 8

Question d) To find the equilibirium bundles, it is just a matter of plugging in the

price we found to the demand functions we had found in previous sections.
The first consumer chooses:
1
, xR = .105, xB = .074
(55)
xL = H
16 21/2
And the second consumer chooses:
21/2
(56)
yL = H
, yR = .105, yB = .074
64
Thus, we see that the first farmer works .044 hours and produces .21 units of rice whereas
the second farmer works .022 hours and produces .149 units of bread. They trade .105 units
of rice for .074 units of bread to get an allocation where they both actually consume equal
amounts of rice and bread, despite the fact that the second farmer only works half as much!
Question e) Farmer 2 has a stronger preference for leisure (built into his utility function) and thus he works less and less bread gets produced than rice if the prices of bread
and rice were equal. As a result, the relative scarcity of bread makes the price go up (e.g.,
p > 1 where the price of rice was normalized to 1) since each consumer has equal marginal
utilities of bread and rice. This is what allows consumer 2 to consume the same bundles
as consumer 1, despite his lower work ethic.