Microeconomics

Solution/General Equilibrium

Exercise 1
Consider a two-individual, two-good economy. The preferences of individual A and individual B over
good 1 and good 2 are represented by the utility function:
u (x1 ; x2 ) = x1 x2 ; x1 0; x2 0;
where xi denotes the quantity of good i consumed by the individual. There are 3 units of each good in the
economy.

1. Characterize the set of Pareto optimal allocations.

The agents have the same Cobb-Douglas preferences over consumption bundles. Interior Pareto
optimum allocations are characterized by

A x2A x2B
MRS12 x1A ; x2A = MRS12
B
x1B ; x2B , = : (1)
x1A x1B
Using the binding material constraints,
x1B = 3 x1A ;
x2B = 3 x2A ;
(1) is equivalent to
x2A 3 x2A
A
= , x2A 3 x1A = x1A 3 x2A , x1A = x2A ;
x1 3 x1A
which corresponds to the 45 -line inside the Edgeworth box. We have to add (0; 0) and (3; 3) to
this segment to get the whole Pareto set:
n o
x1A ; x2A ; x1B ; x2B 2 [0; 3]4 : x1A = x2A and x1B = x2B = 3 x1A :

The 3 units of each good are initially shared as follows between the two individuals: A has one unit
of good 1 and 2 units of good 2; B has 2 units of good 1 and 1 unit of good 2:
2. Determine the Walrasian equilibria.
A Walrasian equibrium is (x ; p ) such that: (1) each individual maximizes his utility s.t. his budget
constraint; (2) the market clearing condition holds.
Individual i0 s UMP leads to the Marshallian demand functions:
1 p1 + 2p2 1 p1 + 2p2
x1i (p; w) = and x2i (p; w) = ; i = fA; Bg :: (2)
2 p1 2 p2

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By Walras’ law, each markets clears iff:
p1 + 2p2 p1
2x1i (p; w) = 3 , =3, = 1: (3)
p1 p2

The Walrasian equilibrium is therefore x1A ; x2A ; x1B ; x2B = 32 ; 23 ; 32 ; 23 and p1 = p2 :

At the equilibrium, the resources of the economy are shared equally.

3. Represent the economy in the Edgeworth box. Comment.

In this economy, everything is symmetric. So, at the Walrasian equilibrium, the Marshallian de-
mands for goods 1 and 2 of every individual must be the same. Consequently, the Walrasian equi-
librium must be at the center of the Edgeworth box 23 ; 23 ; 32 ; 23 :

Exercise 2
Consider a two-person, two-good pure exchange economy. A’s preferences over consumption bundles
(x1 ; x2 ) are represented by the utility function

U A (x1 ; x2 ) = x1 x2

where x1 0 denotes the quantity of good 1 and x2 0 the quantity of good 2: B’s preferences over
consumption bundles are represented by the utility function

U B (x1 ; x2 ) = x1 + x2 :

The initial endowments in goods 1 and 2 are respectively Ω1 = 1 and Ω2 = 2:

1. Represent this economy in the Edgeworth box.

2. Define a Pareto optimum allocation for this economy.

3. Derive the set of Pareto optimum allocations. Represent it on the graph depicted in Question 1.
4. Would you have enough information to compute the general equilibria of this economy? Explain
the difference between a Pareto optimal allocation and a general equilibrium.

Paeto optimal allocations are solution to

max U A x1A ; x2A (4)

xA 0;xB 0

subject to

U B x1B ; x2B uB ; (5)

0 x1A + x1B 1; (6)
0 x2A + x2B 2: (7)

The optimization programme is concave. The material balance constraint are binding at the optimum. So,
the Lagragian can be written as:

L = x1A x2A + λ x1B + x2B = x1A x2A + λ 1 x1A + 1 x2A : (8)

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The necessary and sufficient first-order conditions are:

x2A λ 0 = 0 if x1A > 0 ; (9)

x1A λ 0 = 0 if x2A >0 : (10)

There are three cases.

Case 1: Interior solution. Obtained when x1A > 0 and x2A > 0: The first-order conditions are:

x2A
= 1 , x2A = x1A : (11)
x1A
Therefore,

x1B = 1 x1A ; (12)

x2B = 1 x2A : (13)

Case 2: Corner solution with x1A = 0: Since A has Cobb-Douglas preferences which do not intersect
the x1A = 0 axe for x2A > 0, it must be x2A = 0: A’s origin belongs to the Pareto set. (Have a look at the
figure drawn in Question 1)
Case 3: Corner solution with x1A = 1. For x2A < 1; there is no maximum with x1A = 0: For x2A 1;
and U B = uB given, U A is maximum along the right-hand side of the Edgeworth rectangle. (Have a look
at the figure drawn in Question 1)
In summary, the Pareto set is given by 0 x1A 1; 0 x2A 2 such that:

x1A = x2A ; (14)

or x1A = 1 and 1 x2A 2: (15)

Exercise 3
Consider a two-person two-good pure exchange economy. Person A’s and person B’s preferences over
consumption bundles (x1 ; x2 ) 2 R2+ are represented by the following utility functions:

U A (x1 ; x2 ) = x1 + ln x2 ;
U B (x1 ; x2 ) = x1 + 2 ln x2 :

There are initially 5 units of good 1 and 3 units of good 2 in the economy.

1. Determine the set of Pareto optimum allocations. Represent it in the Edgeworth box.
Interior Pareto optimum allocations are characterized by

A x2B
MRS12 x1A ; x2A = MRS12
B
x1B ; x2B , x2A = : (16)
2
Using the material constraint x2A + x2B 3; which must be binding at any Pareto optimum since U A
and U B are strictly increasing in x1 and x2 ; (16) is equivalent to

3 x2A
x2A = , x2A = 1:
2
Hence, interior Pareto optimum allocations are such that

x2A = 1 and x2B = 2:

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 The Pareto set is therefore
n o
x1A ; x1B ; x2A ; x2B 2 (0; 5)2 (0; 3)2 : x2A = 1 and x2B = 2 [ ff0g [0; 1]g [ ff5g [1; 2]g :

2. Consider any Pareto optimum allocation x1A ; x2A ; x1B ; x2B >> 0; where xij stands for the quantity of
good i available to person j:

(a) Establish that it is a general equilibrium associated with a price vector and a distribu-
tion of person A’s and person B’s exogenous incomes, denoted ω A and ω B respectively.
Without loss of generality, the price of good 1 will be normalized to 1:
It must be established that there is a price vector and a distribution of wealth for which any
given interior Pareto optimum is obtained as a general equilibrium. To this aim, let us first
derive each consumer’s Marshallian demand functions.
(i) Since we are focusing on interior Pareto optimum allocations, we are only interested in the
demand functions for interior solutions. A necessary condition for A’s utility maximization
programme is:
A 1
MRS12 x1A ; x2A = x2A = ;
q
where p = 1 is the normalized price of good 1 and q the price of good 2: Using A’s budget
constraint, which must be binding, one gets:

x1A = ω A qx2A = ω A 1;

where ω A is A’s initial wealth.

Proceeding similarly, it is found that

B x2B 1 2
MRS12 x1A ; x2A = = , x2B = ;
2 q q
from which
x1B = ω B qx2B = ω B 2:
(ii) Any interior Pareto optimum allocation must satisfy

x2A = 1 and x2B = 2:

Therefore, using (i), the utility maximization programmes of the consumers lead to an interior
Pareto optimum allocation provided 1=q = 1 and 2=q = 2; i.e.

q = 1;

in which case

ωA = x1A + 1;
ωB = x1B + 2:

(b) Determine the Pareto optimum allocation for which the distribution of incomes is egali-
tarian in the sense that ω A = ω B :
Using Question 2b, it must be

ω A + ω B = x1A + x1B + 3 , 2ω A = 8 , ω A = 4:

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 So, ω A = ω B = 4 with q = 1; from which

x1A = ωA 1 = 3;
x2A = 1;
x1B = ωB 2 = 2;
x2B = 2:

(c) Person A has 4 units of good 1 and 2 units of good 2: Person B has 1 unit of each good.
What are the income transfers from A to B which lead to the egalitarian equilibrium?
Given prices p = q = 1; A’s initial wealth amounts to

ω A = 6:

Let T denote a transfer from A to B: Then, A’s post-transfer wealth is

ωA T =6 T:

B’s post-transfer wealth is thus

ω B + T = 2 + T:
We want to equalize post-transfer wealth, i.e. determine T such that

6 T = 2 + T , T = 2:

Exercise 4
Consider a two-good (1 and 2), two-individual (A and B) economy. Let x = (x1 ; x2 ) 2 R+ R++ be a
consumption bundle. A’s preferences are represented by the utility function defined over consumption
bundles, uA : R+ R++ ! R with
uA (x) = x1 + ln x2 ;
B0 s preferences are represented by uB : R+ R+ ! R with

uB (x) = min fx1 ; x2 g :

A and B’s endowments in goods 1 and 2 are ω A = (3; 0) and ω B = (0; 3) :

1. Compute the Walrasian equilibrium.

(i) Draw a graph to see that all Pareto optimal allocations are interior (except 0A and 0B ). Since each
Walrasian equilibrium is Pareto optimal, the equilibrium will be in the interior of the Edgeworth
box and x1i = x2i ; i = A; B at this equilibrium.
(ii) B’s utility maximization programme yields
wB
x1B = x2B = : (17)
p1 + p2

A’s utility maximization programme is

max x1 + ln x2 s.t. p1 x1 + p2 x2 = wA ; (18)

from which p1
if wA p1 ;
x2A = p2 (19)
wA =p2 otherwise.

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 Here, wA = 3p1 > p1 ; so the solution is always interior.
(iii) Market clearing requires:
p1 3p2 p1
+ = 3 , 0 = p (2 p) , p = 2; with p = : (20)
p2 p1 + p2 p2
The unique equilibrium is thus:

E 1 = p; x1A ; x2A ; x1B ; x2B = (2; 2; 2; 1; 1) : (21)

2. A productive sector is now added to the pure exchange economy considered above. The productive
sector consists of one firm which transforms a quantity y1 of good 1 in a quantity y2 of good 2
according to the technology
y2 = f (y1 ) = ay1 ; where a > 0:

(a) Define a Walrasian equilibrium for this economy.

Given a private economy preferences and endowments a (Walrasian) equilibrium is (x; y; p)
s.t.
(i) the firm chooses its production levels so as to maximize its profits;
(ii) A and B maximize their respective utility subject to their budget constraint;
(iii) market clear, i.e. x2A + x2B = 3 + y2 :
(b) Compute a Walrasian equilibrium E 2 for this economy. Comments?
The firm has a constant-returns-to-scales technology. The firm’s profit is

π = p2 y2 p1 y1 = (p2 a p1 ) y1 :

(i) Let us suppose there is a strictly positive quantity solution to the firm’s maximisation
programme. Then, it must be
p1
ap2 p1 = 0 , = a: (22)
p2
Without loss of generality, let p1 = 1: Then
3
x2A = a and x2B = : (23)
a+1
By Walras’ law, the production plan ( y1 ; ay1 ) is chosen so as to clear the market for good 2:

3 a 2
a+ = 3 + ay1 , y1 = : (24)
a+1 1+a
In conclusion,
a 2 a (a 2)
a > 2 : y1 = and y2 = , etc. (25)
1+a 1+a
0 < a 2 : y1 = y2 = 0 and E 2 = E 1 : (26)

If the technology used to transform good 1 into good 2 is not effective enough, the firm won’t
produce at the general equilibrium.

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Exercise 5
Let us consider a two-good, one-consumer (A) economy. x is the sole consumption good and leisure is
denoted L: A’s preference relation is represented by the utility function U (x; L) = xα L1 α ; with 0 < α < 1:
His initial endowment is 0; L : So, labour is defined as ` := L L: A firm uses labour ` to produce the
consumption good x:

1. Examine the Walrasian equilibria of this economy when the technology is x = `1=2 :
Without loss of generality, p
the price of the consumption good is normalized to 1:
(i) The firm’s profit is π = ` ω`: The FOC is:
1 1=2 1
` ω = 0 , `d (ω) = : (27)
2 (2ω)2
So, the firm’s supply is
1
xs = : (28)
2ω
The firm’s profit amounts to:
1 1 1
π (ω) = ω 2
= : (29)
2ω (2ω) 4ω

(ii) The consumer chooses ` to maximize

1 α
U (x; `) = xα L ` s.t. x + ω L ` = Lω + π (ω) :

Hence,
Lω + π (ω) 1 1 α
L ` = (1 α) = (1 α) L + , `s (ω) = Lα : (30)
ω 4ω 2 4ω 2

By Walras’ law, the wage equilibrium is obtained for `s (ω) = `d (ω) ; i.e.
r
12 α
ω = > 0: (31)
L 4α

2. Examine the Walrasian equilibria of this economy when the technology is x = a`; a > 0:
We know that each factor is paid at its marginal productivity. Hence,

ω = a:

In addition,
π = 0:
So, A’s budget constraint reads:
x+ω L ` = Lω: (32)
Since the considered individual has Cobb-Douglas preferences, his Marshallian demand functions
are
Lω
L ` = (1 α) ;
ω
x = αLω.

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 (Recall that the consumption price has been normalized to 1): Consequently, at the equilibrium,

L ` (ω ) = (1 α) L , ` (ω ) = Lα; (33)
x (ω ) = ω ` = Laα: (34)

With constant returns to scale, there is a dichotomy when solving for the equilibrium: the production
side of the economy yields the price equilibrium, while the consumption side of the economy
provides the quantities which are produced and traded at the equilibrium.
3. The technology is x = `2 :

(a) Represent the production possibility set and draw some indifference curves in the (`; x)-
space.
For α = 1=2; for instance, the equation of the indifference curve of level k is:

e2k
x= ; (35)
L `
e2k e2k
with x0 = 2 > and x00 = 2 3 > 0:
(L `) (L `)
(b) Determine the Pareto optimal allocation of this economy. Represent it in the same graph.
The Pareto optimal allocation is solution to:

max U x; L ` s.t. x = `2 ; 0 ` L: (36)

x;`

This programme is equivalent to maximizing 2α ln ` + (1 α) ln L ` s.t. 0 ` L: As-

suming an interior solution, the FOC is:
2α
` =L : (37)
1+α
Since ` > 0 and
2α
< 1 , α < 1; (38)
1+α
the solution is interior (provided α < 1): The production x is thus:
2
2α
x = L : (39)
1+α

(` ; x ) is Pareto optimal.
(c) Show that the Pareto optimal allocation cannot be decentralized as a Walrasian equilib-
rium. Comment.
Let us try to decentralize this allocation. The consumer owns all initial endowments (i.e. a
quantity of labour). His budget constraint reads:

x+ω L ` = Lω + π; (40)

where π is the firm’s profit. Hence, the consumer’s labour supply amounts to

(1 α) π
` = Lα : (41)
ω

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If ` is equalized to ` ; the Pareto optimum labour supply found in (b),

Lα
π= ω < 0: (42)
1+α
The equilibrium can be decentralized only if π < 0:
As a consequence, this Pareto optimal allocation cannot be decentralized with a wage earner,
on the one hand, and an entrepreneur, on the other hand (provided the entrepreneur’s prefer-
ence relation is monotonic and thus his utility function increasing in π; which is the case for a
rational agent). The second fundamental theorem of welfare economics cannot apply because
of the non-convexities of the production side of the economy.