1) Consider an Edgeworth box with 2 goods, apples and oranges.

There are two consumers Alice and Bob. Alice has an endowment of 10 oranges while Bob has an
endowment of 10 apples. Both Alice and Bob have Cobb-Douglas Utility 𝑈(𝐴, 𝑂) = 𝐴0.5 𝑂0.5.

a) Show that the competitive equilibrium in this exchange economy is where Alice and Bob have 5
oranges and 5 apples each and that the competitive price is where 𝑃𝑂 = 𝑃𝐴 . Illustrate this in an
Edgeworth Box, showing how it is pareto efficient.

From utility maximisation, each of them spends half their budget on oranges and apples.

Hence, we have:

𝑝𝐴 𝐴𝐴 = 0.5 × 10𝑝𝑂

𝑝𝐴 𝐴𝐵 = 0.5 × 10𝑝𝐴

Likewise,

𝑝𝑂 𝑂𝐴 = 0.5 × 10𝑝𝑂

𝑝𝑂 𝑂𝐵 = 0.5 × 10𝑝𝐵

𝑃
If 𝑃𝑂 = 1, we can show that each of them demands 5 oranges and 5 apples each and both markets
𝐴
clear. Thus, we have shown that Alice and Bob having 5 oranges and 5 apples each and 𝑃𝑂 = 𝑃𝐴 form
a competitive equilibrium – I.e., maximising their utility relative to these prices, their demands are
indeed (5,5) and markets clear.

b) Give two examples of a redistribution of the original endowment which will result in the same
pareto efficient outcome in a competitive equilibrium.

Any endowment which lies on the above price line passing through (𝐴𝐴 , 𝑂𝐴 ) = (5,5) will result in
the same competitive equilibrium. For example, (𝐴𝐴 , 𝑂𝐴 ) = (7,3) or (𝐴𝐴 , 𝑂𝐴 ) = (3,7).

[With Bob having an endowment of the rest of the apples and oranges.]

c) Show that the allocation of 9 oranges and 9 apples to Alice and 1 orange and 1 apple to Bob is also
pareto efficient.

𝑴𝑼 𝟎.𝟓𝑶𝟎.𝟓 𝑨−𝟎.𝟓 𝑶
𝑴𝑹𝑺𝑨𝒍𝒊𝒄𝒆 = − 𝑴𝑼𝑨 = − 𝟎.𝟓𝑶−𝟎.𝟓 𝑨𝟎.𝟓 = − 𝑨𝑨 ;
𝑶 𝑨

𝑴𝑼 𝑶
𝑴𝑹𝑺𝑩𝒐𝒃 = − 𝑴𝑼𝑨 = − 𝑨𝑩
𝑶 𝑩
(The flipped answer is also correct)

A pareto efficient outcome is where the MRS is the same: you can check that the allocation gives a
value of -1 for both.
2) Linus Straight’s utility function is 𝑈 (𝑎, 𝑏) = 𝑎 + 2𝑏, where a is his consumption of apples and b
is his consumption of bananas. Lucy Kink’s utility function is 𝑈 (𝑎, 𝑏) = 𝑚𝑖𝑛{𝑎, 2𝑏}. Lucy initially
has 12 apples and no bananas. Linus initially has 12 bananas and no apples.

(a) Draw an Edgeworth box, showing the initial allocation and sketching in a few indifference
curves. Measure Lucy’s consumption from the upper right corner and Linus’s from the lower
left corner. Draw a line through all of the Pareto optimal allocations.

The only set of pareto optimal allocations is where 𝑎 = 2𝑏 for Lucy. At all other points,
where 𝑎 ≠ 2𝑏 for Lucy, the excess good can be given to Linus to improve his utility. This will
consist a pareto improvement.

(b) In this economy, in competitive equilibrium, what will be the ratio of the price of apples to the
price of bananas?
1/2.

This has to hold, otherwise, there will always be excess demand.

𝑃 1 𝑀𝑈
If 𝑃𝑎 > 2, then 𝑀𝑈𝑎 = 0.5 < 𝑃𝑎 /𝑃𝑏 . Linus will demand only bananas=12. Excess demand as
𝑏 𝑏
Lucy also has positive demand of bananas.
𝑃 1 𝑀𝑈 12𝑝𝑏
If 𝑃𝑎 < 2, then 𝑀𝑈𝑎 = 0.5 > 𝑃𝑎 /𝑃𝑏 . Linus will demand only apples. 𝑎 = > 24.
𝑏 𝑏 𝑝𝑎
Excess demand on apples.

(c) Find the quantities of apples and bananas consumed in competitive equilibrium by Linus and
Lucy and sketch the competitive equilibrium in the Edgeworth box.
Let 𝑎𝐿 be Lucy’s consumption of apples and let 𝑏𝐿 be her consumption of bananas. To
maximize her utility, she must consume 𝑎𝐿 = 2𝑏𝐿 . This gives us one equation in two
unknowns. To find a second equation, consider Lucy’s budget constraint, which gives 𝑃𝑎 𝑎𝐿 +
𝑃𝑏 𝑏𝐿 = 12𝑃𝑎 .

Substitute 𝑃𝑎 /𝑃𝑏 = 1/2 into the second equation. Finally, we can solve 𝑎𝐿 = 6, 𝑏𝐿 = 3.
For Linus, he consumes 12 − 𝑎𝐿 = 6 units of apples and 12 − 𝑏𝐿 = 9 unites of bananas.
3) Paul and David consume apples and oranges. Paul’s utility function is 𝑈𝑃 (𝐴𝑃 , 𝑂𝑃 ) = 2𝐴𝑃 + 𝑂𝑃
and David’s utility function is 𝑈𝐷 (𝐴𝐷 , 𝑂𝐷 ) = 𝐴𝐷 + 2𝑂𝐷 , where 𝐴𝑃 and 𝐴𝐷 are apple consumptions
for Paul and David, and 𝑂𝑃 and 𝑂𝐷 are orange consumptions for Paul and David.

There are a total of 12 apples and 12 oranges to divide between Paul and David.

(a) Draw an Edgeworth box showing some of their indifference curves. Mark the Pareto optimal
allocations on your graph.

Oranges C David

D David’s indifference
curves

Pareto optimal
allocations in
Paul’s indifference curves B orange.

Apples
Paul
Any point in the interior of the edgeworth box or to the left and top is pareto dominated by some
other allocation (to their bottom right). For example, point A in the interior is dominated by point B.
Points C and D on the top and left are dominated by B as well.

Any point on the bottom or right border cannot be pareto dominated by anything in the edgeworth
box (i.e. a feasible allocation).

Notice that the set of pareto optimal allocations can be found by drawing the indifference curves of
Paul for utility 0 (0 apples, 0 oranges) to utility 36 (12 apples, 12 oranges), and finding for each of
Paul’s indifference curve, the highest curve at which David’s curve touches Paul’s such that there is
no pareto improving area. (I.e maximise David’s utility subject to fixing Paul’s utility at some value.)_

You can also do the opposite, draw the indifference curves of David and find for each indifference
curve, the highest curve at which Paul’s curve touches David.

For this case of perfect substitutes, the pareto optimal allocations always lie on the border.
(b I & II) Write one inequality that says that Paul likes his own bundle as well as much as he likes
David’s and write another inequality that says that David likes his own bundle as much as he likes
Paul’s.

𝑈𝑃 (𝐴𝑃 , 𝑂𝑃 ) ≥ 𝑈𝑃 (𝐴𝐷 , 𝑂𝐷 )

2𝐴𝑃 + 𝑂𝑃 ≥ 2𝐴𝐷 + 𝑂𝐷
𝑈𝐷 (𝐴𝐷 , 𝑂𝐷 ) ≥ 𝑈𝐷 (𝐴𝑃 , 𝑂𝑃 )

𝐴𝐷 + 2𝑂𝐷 ≥ 𝐴𝑃 + 2𝑂𝑃

(b III) Use the fact that at feasible allocations, 𝐴𝑃 + 𝐴𝐷 = 12 and 𝑂𝑃 + 𝑂𝐷 = 12 to rewrite the
above inequalities in terms of 𝐴𝑃 and 𝑂𝑃 for Paul and 𝐴𝐷 and 𝑂𝐷 for David.

Just substitute these equalities in the question into the respective inequalities in b) to obtain:

2𝐴𝑃 + 𝑂𝑃 ≥ 2(12 − 𝐴𝑃 ) + (12 − 𝑂𝑃 )

2𝐴𝑃 + 𝑂𝑃 ≥ 18

𝐴𝐷 + 2𝑂𝐷 ≥ (12 − 𝐴𝐷 ) + 2(12 − 𝑂𝐷 )

𝐴𝐷 + 2𝑂𝐷 ≥ 18

(b IV and C)

(1) The allocations where Paul prefers his own bundle in the allocation to David’s bundle in the
allocation: Blue area
(2) The allocations where David prefers his own bundle in the allocation to Paul’s bundle in the
allocation: Red Area
(3) Envy free allocations: Purple Area
(4) Fair allocations: Orange lines.
4) Dean Foster Z. Interface and Professor J. Fetid Nightsoil exchange platitudes and bromides. When
Dean Interface consumes 𝑇𝐼 platitudes and 𝐵𝐼 bromides, his utility is given by

𝑈𝐼 (𝐵𝐼 , 𝑇𝐼 ) = 𝐵𝐼 + 2√𝑇𝐼

When Professor Nightsoil consumes 𝑇𝑁 platitudes and 𝐵𝑁 bromide, his utility is given by

𝑈𝑁 (𝐵𝑁 , 𝑇𝑁 ) = 𝐵𝑁 + 4√𝑇𝑁

Dean Interface’s initial endowment is 12 platitudes and 8 bromides. Professor Nightsoil’s initial
endowment is 4 platitudes and 8 bromides.

(a) If Dean Interface consumes 𝑇𝐼 platitudes and 𝐵𝐼 bromides, what will be his marginal rate of
substitution? If Professor Nightsoil consumes 𝑇𝑁 platitudes and 𝐵𝑁 bromide, what will be his
marginal rate of substitution?
𝜕𝑈 𝜕𝑈
For Dean Interface, 𝑀𝑅𝑆 = − 𝜕𝑇 𝐼 / 𝜕𝐵𝐼 = −𝑇𝐼 −1/2
𝐼 𝐼
𝜕𝑈 𝜕𝑈
For Professor Nightsoil, 𝑀𝑅𝑆 = − 𝜕𝑇 𝑁 / 𝜕𝐵𝑁 = −2𝑇𝑁 −1/2
𝑁 𝑁
The flipped answer is also correct as the question doesn’t mention the y axis or x axis.

(b) On the contract curve, Dean Interface’s marginal rate of substitution equals Professor
Nightsoil’s. Write an equation that states this condition.
−𝑇𝐼 −1/2 = −2𝑇𝑁 −1/2
𝑇𝐼
= 1/4
𝑇𝑁
This equation is especially simple because each person’s marginal rate of substitution
depends only on his consumption of platitudes and not on his consumption of bromides.

(c) Draw an Edgeworth box, showing the initial allocation and sketching in a few indifference
curves. Measure Dean Interface’s consumption from the lower left and Professor Nightsoil’s
from the upper right. Illustrate on the same diagram, the locus of Pareto optimal allocations.
𝑇
From previous question, we know the Pareto optimal allocations satisfy 𝑇 𝐼 = 1/4. And the
𝑁
allocations should also satisfy the total consumption of platitudes must equal the total
endowment of platitudes, 𝑇𝐼 + 𝑇𝑁 = 16. It gives 𝑇𝐼 = 3.2 and 𝑇𝑁 = 12.8, which is the
horizontal blue line on the Edgeworth box.
There are other pareto efficient allocations on the border of the edgeworth box, for which the MRS
is not equal for them. This is not mentioned in the question.

Note that for the axes in the diagram, the MRS of Interface and Nightsoil are actually
𝝏𝑼𝑰 𝝏𝑼𝑵 𝟏
𝝏𝑩𝑰 𝟏/𝟐 𝝏𝑩𝑵 𝑻𝟐𝑵
− 𝝏𝑼𝑰 = −𝑻𝑰 and − 𝝏𝑼𝑵 =− 𝟐
𝝏𝑻𝑰 𝝏𝑻𝑵

On the left border, if the MRS of Nightsoil is steeper than the MRS of Interface, then there is no
pareto improving allocations within the box. (See the left hand side indifference curves)
𝟏
𝑻𝟐𝑵 𝑻𝑵
occurs if > 𝑻𝑰 𝟏/𝟐 or when > 𝑻𝑰 .
𝟐 𝟒

𝟔𝟒
Simplifying, one can get 𝑻𝑵 > 𝟒(𝟏𝟔 − 𝑻𝑵 ) or 𝑻𝑵 > = 𝟏𝟐. 𝟖
𝟓

On the right border, if the MRS of Nightsoil is less steep than the MRS of Interface, then there is no
pareto improving allocations within the box. (See the right hand side indifference curves)
𝟏
𝑻𝟐𝑵
This occurs if < 𝑻𝑰 𝟏/𝟐 or simplifying like before, 𝑻𝑵 < 𝟏𝟐. 𝟖.
𝟐

The full pareto set is thus as shown below, highlighted in green.

Platitudes (Y axis)
Nightsoil

B Pareto
improvements on B
lie outside the box

Pareto
improvements on A
lie outside the box 3.2
A

Interface Bromides (X axis)

d) Find the competitive equilibrium price ratio and quantities.

1
1/2 𝑇𝑁2 𝑝
At competitive equilibrium, MRS=price ratio. For Interface, 𝑇𝐼 = 𝑝𝐵 /𝑝𝑇 , For Nightsoil = 𝑝𝐵 .
2 𝑇
𝑝 2 𝑝 2
For market equilibrium, we need 𝑇𝐼 + 𝑇𝑁 = 16, or ( 𝑝𝐵 ) + 4 ( 𝑝𝐵 ) = 16
𝑇 𝑇
𝑝
Hence 𝑝𝐵 = √3.2
𝑇
At this price, 𝑇𝐼 = 3.2 and 𝑇𝐵 = 12.8.
Leftover income is consumer on bromides, so
12𝑝𝑇 +8𝑝𝐵 −3.2𝑝𝑇 8.8 4𝑝𝑇 +8𝑝𝐵 −12.8𝑝𝑇 8.8
𝐵𝐼 = = + 8. 𝐵𝑁 = =8−
𝑝𝐵 √3.2 𝑝𝐵 √3.2

Notice that the market clears in both markets.

5) Consider a small exchange economy with two consumers, Astrid and Birger, and two
commodities, herring and cheese. Astrid’s initial endowment is 4 units of herring and 1 unit of
cheese. Birger’s initial endowment has no herring and 7 units of cheese. Astrid’s utility function is
𝑈(𝐻𝐴 , 𝐶𝐴 ) = 𝐻𝐴 𝐶𝐴 . Birger is a more inflexible person. His utility function is 𝑈(𝐻𝐵 , 𝐶𝐵 ) =
𝑚𝑖𝑛{𝐻𝐵 , 𝐶𝐵 }.

(Here 𝐻𝐴 and 𝐶𝐴 are the amounts of herring and cheese for Astrid, and 𝐻𝐵 and 𝐶𝐵 are amounts of
herring and cheese for Birger.)

(a) Draw an Edgeworth box, showing the initial allocation and sketching in a few indifference curves.
Measure Astrid’s consumption from the lower left and Birger’s from the upper right. In your
Edgeworth box, draw two different indifference curves for each person.

(b) Illustrate on the same diagram, the locus of Pareto optimal allocations.

Notice that if in an allocation, 𝐻𝐵 ≠ 𝐶𝐵 , then it is not a pareto optimal allocation, as some of the
excess can be given to Astrid without hurting Birger. That new allocation would pareto dominate the
initial allocation.

All allocations where 𝐻𝐵 = 𝐶𝐵 are pareto optimal as the indifference curves are tangent to each
other at all these points. Hence there are no allocations which pareto dominate them.

Solid Black line:

Pareto Optimal
Allocations

The pareto set also includes the horizontal line from 0 to 4 cheese. There is no are of pareto
improvement for these allocations.
This is because the indifference curve for 0 utility for Astrid is different in shape from the blue
indifference curves. More accurately it is the green L shaped line as shown below. Why? This is
because if Astrid has either 0 cheese or 0 herring, utility will always be equals to 0. This means that
we cannot actually find a pareto improvement on the horizontal black line.

This is just a peculiarity of the utility function: if Astrid is consuming 0 herring, then even if we give
him more cheese (for which Birger may have excess), he still doesn’t get more utility.

(c) Let cheese be the numeraire (with price 1) and let 𝑝 denote the price of herring. Derive the set of
allocations and prices in the competitive equilibrium.
You can use the following procedure.

I. Write an expression for the amount of herring that Birger will demand at price 𝑝.
(Hint: when maximising utility, Birger will demand a fixed proportion of herring to
cheese.)
II. Likewise, write an expression for the amount of herring will Astrid demand at price
𝑝.
III. Use the market clearing conditions together with c) and d) to compute the
competitive equilibrium and sketch it on the diagram.

(I) Birger will demand an equal amount of herring and cheese as this is the most efficient use of his
income. This will cost p + 1. Since his income is 7 given that he owns 7 units of cheese, he will hence
7
demand p+1 units of herring (and cheese)

(II)For cobb douglas utility with the above parameters, Astrid will spend half of his budget on herring
and half on cheese (since the exponents are the same). He will hence demand (1 + 4p)/2p units of
herring.

Alternatively, you can equate MRS=price ratio to get the final answer.

See https://en.wikipedia.org/wiki/Cobb–Douglas_production_function for more on cobb douglas

utility.

(III)

𝑥∗
There is equilibrium when the demand for herring equals to the supply of herring in the economy.

This is when
1 7
2+ + = 4.
2p p + 1
(p + 1 + 14p)
=2
2p(p + 1)

15p + 1 = 4p2 + 4p

4p2 − 11p − 1 = 0

11 √137
p= +
8 8

Substitute this into the demand functions to get their quantities demanded at this price.

Notice that the competitive equilibrium is pareto efficient.

(Note that you can follow the same procedure but for cheese instead and you will get the same
answer. The reason that we only need to solve 1 market is because when there is market clearing in
one market, there will automatically be market clearing in the other market if consumers exhaust
their budgets.)