ECON 201, Summer 2016

July 25, 2016

Problem Set 4 Solutions

1. There are two consumers (A and B), and two goods (x and y). The
initial endowment of A (respectively, B) is 2 (respectively, 4) units of x
and 3 (respectively, 2) units of y. Find the core and the contract curve
if the utility functions are as follows:
The endowment of this economoy is as follows:
x¯A = 2, y¯A = 3, x¯B = 4, y¯B = 2
1/2 1/2 1/2 1/2
(a) uA (xA , yA ) = xA yA and uB (xB , yB ) = xB yB

XA XB
M RSA = M RSB =
yA yB

For interior PE allocations:

yA yB 5 − yA
= =
xA xB 6 − xA
6yA − xA yA = 5xA − xA yA

5
Contract curve: yA = xA for xA ∈ [0, 6]
6
xA + xB = 6 , yA + yB = 5

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The allocation in the core must be Pareto efficient, and satisfy
individual rationality constraints:
UA (xA , yA ) ≥ UA (2, 3)
UA (xB , yB ) ≥ UA (4, 2)
5
y A = xA
6
First, find the points for which the above points hold with equality:
1/2 1/2
xA yA = x¯A 1/2 y¯A 1/2
1/2 5
xA ( xA )1/2 = 21/2 31/2 = 61/2
6
5
( )1/2 xA = 61/2
6
6
xA = 1/2 (Point a in the Edgeworth Box)
5
1/2 1/2
xB yB = x¯B 1/2 y¯B 1/2
1/2 5
xB ( xB )1/2 = 41/2 21/2 = 81/2
6
48
xB = ( )1/2 (Point b in the Edgeworth Box)
5
48
Corresponding to this xB is xA = 6 − ( )1/2 , point b in the
5
Edgeworth box

2
 6
The core consists of {(xA , yA ), (xB , yB )} such that 1/2 ≤ xA ≤
5
48 1/2 5
6 − ( ) , yA = xA and xA + xB = 6, yA + yB = 5
5 6
(b) uA (xA , yA ) = 2xA + yA and uB (xB , yB ) = xB + 3yB

1
M RSA = 2 M RSB =
3
Contract curve: xB = 0 or yA = 0; xA + xB = 6, yA + yB = 5 and
xi , yi ≥ 0 for i = A, B

UA (xA , yA ) ≥ UA (2, 3) = 4 + 3 = 7
2xA + yA ≥ 7

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If yA = 0, xA ≥
2
UB (xB , yB ) ≥ UB (4, 2) = 4 + 6 = 10

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xB + 3yB ≥ 10. If xB = 0, yB ≥
3
(c) uA (xA , yA ) = 2xA and uB (xB , yB ) = xB + 3yB
Contract curve: yA = 0, yB = 5, xA + xB = 6 and xi , yi ≥ 0 for
i = A, B.

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2. Consider an exchange economy as follows: There are two individuals A
and B, and two goods x and y. A owns 10 units of x and no y, whereas
B owns 10 units of y and no x. Find the competitive equilibrium when
(a) uA (xA , yA ) = xA + 2yA and uB (xB , yB ) = 3xB + yB
1
We know that M RSA = − and M RSB = −3. Moreover, we
2
know that mA = 10px and mB = 10py . Let set py = 1. Then we
can write the demand functions for consumer A and B as follows:
10px 1


 if px <
 px
 2
xA (p) =
1


0

if px >
2

1


0 if px <

 2
yA (p) =


10px 1
if px >

2
and
 10


p if px < 3
x
xB (p) =


0 if px > 3


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 
0
 if px < 3
yB (p) =

10 if px > 3


1
If px < then there is excess demand for x, and if px > 3, then
2
there is excess demand for y. Then px ∈ [1/2, 3]. In this case,
10
we know that (xA , yA ) = (0, 10px ) and (xB , yB ) = ( , 0). From
px
market clearing condition, we have
xA + xB = 10
0 + 10px = 10 → px = 1
and
yA + yB = 10
10
+ 0 = 10 → px = 1
px
Therefore, we find the equilibrium prices as (px , py ) = (1, 1) and
the allocations as (xA , yA ) = (0, 10) and (xB , yB ) = (10, 0)
(b) uA (xA , yA ) = min{xA , yA } − 8 and uB (xB , yB ) = 15 + xB + yB
10px
Demand functions for consumer A is xA = xB = and for
px + 1
consumer B

 10


p if px < 1
x
xB (p) =


0 if px > 1



0
 if px < 1
yB (p) =

10 if px > 1


If px < 1, then there is excess demand for y, and if px > 1,

then there is excess demand for x. Then px = 1, which implies
(xA , yA ) = (5, 5) and (xB , yB ) = (5, 5).

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 (c) uA (xA , yA ) = xA yA and uB (xB , yB ) = 3xB + yB − xA
10px 10
Demand functions for consumer A xA = = 5 and xB = =
2px 2
5 and for B,

 10


p if px < 3
x
xB (p) =


0 if px > 3



0
 if px < 3
yB (p) =

10 if px > 3


px can not be larger than 3, since then there is excess demand for y.
Then px < 3, and from the market clearing condition:

xA + xB = 10
10
+ 5 = 10 → px = 2
px

Therefore, the allocations are (xA , xB ) = (5, 5) and (xA , xB ) = (5, 5).

3. In a 2-commodity (x, y), 2-consumer (consumer A, consumer B) world,

suppose the utility functions are given by uA (xA , yA ) = xA + 2yA and
uB (xB , yB ) = 2xB + yB and the endowments are given by ωA (x, y) =
(2, 3) and ωB (x, y) = (6, 1)

(a) Sketch the edgeworth box, show the endowment point in the box.
Notice that both individuals’ preferences are linear. Therefore,
indifference curves will be lines.
1
M RSA = − M RSB = −2
2
B’s indifferences curves are steeper.

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 (b) Derive the Pareto set (contract curve).
Since there will not be an interior Pareto-efficient allocation (You
need to verify this by taking any point inside the box and showing
that there is a better point for at least one person without de-
creasing the utility of the other one), pareto efficient allocations
will lie on the edges of the box. You will see that the Pareto
Efficient allocations are as shown above on the Edgeworth box.
Edges where consumer A consumes 0 units of x2 and consumer B
consumes 0 units of x1 can not be optimal, because consumer A
values x2 more and consumer B values x1 more.
4. Suppose that a monopolist’s market demand is given by p(y) = 100−2y
and the marginal cost is given by M C = y/2.
(a) Calculate the profit maximizing monopoly price and quantity. We
know that at the profit maxizing output level M R = M C, i.e.
y
100 − 4y =
2
200
9y = 200 → yM =
9

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 and the quantity is
200
pM = 100 − 2 ∗
9
500
=
9
(b) Calculate the profit maximizing price and quantity under perfect
competition with a supply curve of P = y/2. If p = y/2, then we
have
y
= 100 − 2y
2
yP C = 40 → pP C = 20

5. Find the deadweight loss due monopoly (You need to compare the
producer and consumer surplus in monopoly and perfect competition
case).

500 200 200 100 1 200 450

Monopoly: Producer surplus is ∗ − ∗ ∗ = ∗
9 9 9 9 2 9 9
500 200 1 400 100
Consumer surplus is (100 − )∗ ∗ = ∗ . A total surplus
9 9 2 9 9
200 650
of ∗ Perfect Competition:
9 9
1
Producer surplus is 20 ∗ 40 − ∗ 20 ∗ 40 = 400
2
8
 1
Consumer surplus is (100 − 20) ∗ 40 ∗ = 1600 A total surplus of 2000
2
200 650
Deadweight loss is 2000 −
9 9
6. (From Introduction to Economic Analysis, by Preston McAfee). For
both parts of this question assume that the cost of production is zero
for the monopolist.

(a) Suppose there are two equal sized groups of customers, group 1
with aggregate demand q(p) = 12 − p, and group 2 with demand
q(p) = 8 − p. Find the prices charged by a monopolist who can
discriminate between these customers. What is the total surplus?
Find the price charged by a nondiscriminating monopolist. What
is the total surplus, and how does it compare to the surplus in the
previous case (in other words what is the effect of price discrimi-
nation)?
If a monopoly can discriminate between consumer groups then it
will maximize its profits in each group, i.e.,

max q1 (12 − q1 )
max q2 (8 − q2 )

Taking derivative with respect to qi where i ∈ {1, 2}, we find q1∗ =

6 and q2∗ = 4. Respectively, equilibrium prices are 6 and 4. Then
the total surplus for a discriminating monopolist is 6∗6+4∗4 = 52.
For a nondiscrimanating monopolist, we need to look at the total
demand:
(
12 − p if p > 8
Q(p) =
20 − 2p if p ≤ 8

If p > 8 then q(12−q) is maximized at a quantity of 6 which implies

p = 6. Therefore, we have p ≤ 8. Then the profit maximizing
output level is q ∗ = 10 and equilibrium price is 5. Then the total
surplus for a nondiscriminating monopolist is 10 ∗ 5 = 50. If a
monopoly price discriminates it would obtain an additional of 2
units.

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 (b) Same as part a), only change the demand of group 2 as q(p) = 4−p.
For the discriminating monopolist, we have

max q1 (12 − q1 )
max q2 (4 − q2 )

Taking derivative with respect to qi where i ∈ {1, 2}, we find q1∗ =

6 and q2∗ = 2. Respectively, equilibrium prices are 6 and 2. Then
the total surplus for a discriminating monopolist is 6∗6+2∗2 = 40.
For a nondiscrimanating monopolist, we need to look at the total
demand:
(
12 − p if p > 4
Q(p) =
16 − 2p if p ≤ 4

If p > 4 then q(12 − q) is maximized at a quantity of 6 which

implies p = 6. The surplus fo the monopolist in this case would
be 6.6 = 36. If we have p ≤ 4. Then the profit maximizing output
level is q ∗ = 8 and equilibrium price is 4. Then the total surplus
for a nondiscriminating monopolist is 4 ∗ 8 = 31. Since 36 > 32,
the monopolist will choose p∗ = 6 and q ∗ = 6

7. Solve 25.3, 31.3 and 31.4 in Workouts in Intermediate Microeconomics.

• (25.3)
(a) Banana’s long-run average cost function is AC(Q) = $10.000
and the long-run marginal cost function is M C(Q) = $10.000.
(b) The graph for part a) and this part is as follows:

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(c) If Banana is maximizing its profits, it will sell 250 computers
in the domestic market at 15.000 dollars each and 150 com-
puters in the foreign market at 17.500 dollars each demand
(Hint: Just equate the marginal cost to marginal revenue in
each market). The total profits are 2.375.000 dollars.
(d) At the profit maximizing price and quantity, the price elas-
ticity of demand in the domestic market is −3, and the price
elasticiy of demand in the foreign market is −2.33. Demand
is less elastic in the market where higer price is charged.
(e) The graph is as follows:

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 (f) Given that costs have not changed, Banan computers would
sell 400 units and it would charge a price of 15.714. Banana’s
profits would decrease by 89.284 dollars, if it can no longer
practice price discrimination.
8. (31.3)
(a) If Dean Interface consumes TI platitudes and BI bromides, his
1
marginal rate of substitution will be − √ . IF professor Nightsoil
TI
consumes TN platitudes and BN bromides, his marginal rate of
2
substitution will be − √
TN
(b) On the contract curve, Dean Interface’s marginal rate of substi-
tution equals Professor Nightsoil’s. The equation that states this
1 2 √ √
condition is − √ = − √ , i.e. TN = 2 TI
TI TN
(c) From this equation we see that TI /TN = 1/4 at all points on the
contract curve.
(d) But we also know that along the contract curve, it must be that
TI +TN = 16 since the total consumption of platitudes must equal
to the total endowment of platitudes.
(e) Solving these two equations in two unknowns, we find that every-
where on the contract curve, TI and TN are constant and equal

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 to
16 − TI
TI = → TI = 3.2
4
TN = 16 − 3.2 = 12.8

(f) The initial endowment level and indifference curves are as follows:

As can be seen in the edgeworth box, the contract curve is a

horizontal line.
(g) The equilibrium quantities
√ and prices are TI = 3.2 and TN = 12.8
and PT = 1 and PB = 3.2

9. (31.4)

(a) The edgeworth box is as follows:

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(b) See edgeworth box in part a.
WB WK
(c) =
QB QK
(d) See edgeworth box in part a.
(e) In this example, at any Pareto efficient allocation, where both
consumers consume both goods, the slope of Ken’s indifference
curve will be −2. Therefore, since we know that competitive equi-
librium must be Pareto efficient, we know that at a competitive
equilibrium, pQ /pW = 2
(f) In the competitive equilibrium Ken’s optimal bundle is (QK , WK ) =
(2, 4) and Barbie’s optimal bundle is (QB , WB ) = (2, 4)
(g) See the edgewort box in part a.

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