Welfare Economics

Mid-Term Assignment

Problem 1. Suppose that an agent has a preference, denoted by a binary relation R (and thus, a strict
preference and an indifference relation are written by using P and I), for consumption bundles (x1 , x2 ),
where xi is the consumption level of good i = 1, 2. The agent’s preference is assumed to satisfy Strict
Monotonicity, Order, Continuity, and Strict Monotonicity, so that it is represented by a utility function
U(x1 , x2 ). Choose below all correct explanations regarding this agent; write your answer choice(s). (2
marks)

(a) U(x1 , x2 ) = U(y1 , y2 ) holds if x1 = y1 and x2 > y2 .

(b) If (x1 , x2 )P(y1 , y2 ), then U(x1 , x2 ) > U(y1 , y2 ) holds.

(c) If (x1 , x2 )I(y1 , y2 ), then U(x1 , x2 ) > U(y1 , y2 ) holds.

(d) If U(x1 , x2 ) = U(y1 , y2 ), then U(z1 , z2 ) > U(y1 , y2 ) where zi = 12 xi + 12 yi for each i = 1, 2.

(e) Indifference curves of this agent are upward-sloping.

( f ) If (x1 , x2 )P(y1 , y2 ) and (y1 , y2 )I(z1 , z2 ), then U(x1 , x2 ) > U(z1 , z2 ).

Problem 2. Consider the 2-person and 2-good exchange economy where agent i’s (i = 1, 2) preference
for consumption bundles (x1i , x2i ) is represented by
1 2
U 1 (x11 , x21 ) = (x11 ) 3 (x21 ) 3

and
2 1
U 2 (x12 , x22 ) = (x12 ) 3 (x22 ) 3 .

The initial endowment of agent i is denoted by (ωi1 , ωi2 ) for each i = 1, 2. The market price of good j is
denoted by p j for each j = 1, 2. Answer questions (1) – (4).

(1) Choose below all correct explanations regarding agent 1. (2 marks)

x21
(a) The marginal rate of substitution of agent 1 is x11
.
x21
(b) The marginal rate of substitution of agent 1 is 2x11
.
(c) If (ω11 , ω12 ) = (4, 4) and (p1 , p2 ) = (4, 5), the optimal consumption is (x11 , x21 ) = (3, 4.8).
(d) If (ω11 , ω12 ) = (4, 8) and (p1 , p2 ) = (3, 3), the optimal consumption is (x11 , x21 ) = (4, 8).
(e) If (ω11 , ω12 ) = (2, 4) and (p1 , p2 ) = (6, 3), the optimal consumption is (x11 , x21 ) = (4, 4).

(2) Choose below all correct explanations regarding agent 2. (2 marks)

2x22
(a) The marginal rate of substitution of agent 2 is x12
.
x22
(b) The marginal rate of substitution of agent 2 is 2x12
.
(c) If (ω21 , ω22 ) = (3, 4) and (p1 , p2 ) = (4, 6), the agent’s demand for good 1 is 6.
(d) If (ω21 , ω22 ) = (3, 4) and (p1 , p2 ) = (4, 6), the agent’s demand for good 2 is 3.
(e) If (ω21 , ω22 ) = (7, 2) and (p1 , p2 ) = (6, 6), the optimal consumption is (x12 , x22 ) = (6, 3).

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(3) Assume that the agents’ initial endowments are given by ((ω11 , ω12 ), (ω21 , ω22 )) = ((9, 3), (3, 2)). Choose
below all correct explanations of this exchange economy. (2 marks)
p1
(a) The price ratio p2 = 1
2 is a Walrasian equilibrium.
p1
(b) The price ratio p2 = 1
3 is a Walrasian equilibrium.
(c) The price vector (p1 , p2 ) = (5, 10) is a Walrasian equilibrium.
(d) The price vector (p1 , p2 ) = (5, 15) is a Walrasian equilibrium.
(e) The price vector (p1 , p2 ) = (1, 2) is a Walrasian equilibrium.

(4) Assume that the agents’ initial endowments are given by ((ω11 , ω12 ), (ω21 , ω22 )) = ((9, 3), (3, 2)). Choose
below all correct explanations of this exchange economy. (2 marks)

(a) The Walrasian equilibrium allocation is ((x11 , x21 ), (x12 , x22 )) = ((6, 4), (6, 1)).
(b) The Walrasian equilibrium allocation is ((x11 , x21 ), (x12 , x22 )) = ((7, 3), (5, 2)).
(c) The Walrasian equilibrium allocation is ((x11 , x21 ), (x12 , x22 )) = ((8, 2), (4, 3)).
3x11
(d) The contract curve is given by x21 = .
14 − x11
20x11
(e) The contract curve is given by x21 = .
12 + 3x11

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Problem 3. The 1st fundamental theorem of welfare economics is stated as follows.

In a m-person and n-good exchange economy (m, n ≥ 2), if agents’ preferences satisfy Strict
Monotonicity, Order, Continuity, and Strict Convexity, then the Walrasian equilibrium allo-
cation x = (x1 , . . . , xm ) associated with a Walrasian equilibrium price vector (p1 , . . . , pn ) is
Pareto efficient, where xi is the consumption bundle of agent i for all i = 1, . . . , m.

Choose an answer choice, from (a) to (l), that need to be filled in [ 1 ] to [ 4 ] in the following proof of
the theorem. (4 × 2 marks)

Proof. We prove the theorem by contradiction. Let ωi = (ωi1 , . . . , ωin ) be the initial endowment of
agent i = 1, . . . , m, and let x = (x1 , . . . , xm ) be the Walrasian equilibrium allocation associated with a
Walrasian equilibrium price vector (p1 , . . . , pn ). By way of contradiction, suppose that the Walrasian
equilibrium allocation x = (x1 , . . . , xm ) is not Pareto efficient. By the definition of Pareto efficiency,
there exists a feasible allocation z = (z1 , . . . , zm ) such that

[ 1 ] holds for all agents i = 1, . . . , m,

and

[ 2 ] holds for at least one agent i∗ = 1, . . . , m.

∗
Since x is the Walrasian equilibrium allocation associated with (p1 , . . . , pn ), xi maximizes i∗ ’s utility
under the budget constraint
∑n ∑n
i∗ ∗
pjxj ≤ p j ωij .
j=1 j=1

Therefore,
∑
n
∗
∑
n
∗
p j zij > p j ωij
j=1 j=1

must hold. This is because, if this does not hold, that is, if

∑
n
∗
∑
n
∗
p j zij ≤ p j ωij
j=1 j=1

∗
holds, then zi satisfies the budget constraint of agent i∗ as well as [ 2 ], which is a contradiction to that
∗
xi maximizes the utility of agent i∗ under the budget constraint. Likewise, for each agent i = 1, . . . , m
to whom [ 1 ] holds, zi must satisfy
∑n ∑
n
p j zij ≥ p j ωij .
j=1 j=1

This can be verified as follows. If

∑
n ∑
n
p j zij < p j ωij
j=1 j=1

holds, then we can find a consumption bundle z̄i that satisfies

∑
n ∑
n
p j z̄ij = p j ωij
j=1 j=1

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and
z̄i1 > zi1 and z̄ij > zij for all j = 2, . . . , n.

Since the preference of agent i satisfies Strict Monotonicity, [ 3 ] must hold. Thus, by [ 1 ] and [ 3 ], we
obtain [ 4 ], which is a contradiction to that xi maximizes the utility of agent i under the budget constraint.
Consequently, summing up the left-hand sides and the right-hand sides of the derived inequalities for all
agents, we obtain
∑ m ∑ n ∑
m ∑
n
p j zij > p j ωij .
i=1 j=1 i=1 j=1

Meanwhile, since z is feasible, it follows from the definition of feasibility that, for each j = 1, . . . , n,

∑
m ∑
m
zij = ωij .
i=1 i=1

Multiplying both sides of this equation by p j , we eventually obtain

n ∑
∑ m ∑
n ∑
m
p j zij = p j ωij ,
j=1 i=1 j=1 i=1

which contradicts to the inequality we derived above. Thus, x must be Pareto efficient.

(a) U i (zi ) ≥ U i (xi )

(b) U i (zi ) ≤ U i (xi )

(c) U i (zi ) = U i (xi )

∗ ∗ ∗ ∗
(d) U i (zi ) > U i (xi )
∗ ∗ ∗ ∗
(e) U i (zi ) < U i (xi )
∗ ∗ ∗ ∗
( f ) U i (zi ) = U i (xi )

(g) U i (zi ) > U i (z̄i )

(h) U i (zi ) < U i (z̄i )

(i) U i (zi ) = U i (z̄i )

( j) U i (xi ) > U i (z̄i )

(k) U i (xi ) < U i (z̄i )

(l) U i (xi ) = U i (z̄i )

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Problem 4. Consider the 2-person and 2-good exchange economy that is illustrated as the Edgeworth
box diagram below.
O2
12 10 8 6 4 2 0

12 0
I2 I1

10 2

8 A
4

6
ω
6

4 B 8

2 10

I3 I4
0 12
O1 0 2 4 6 8 10 12

In the box diagram, (i) point Oi is the origin for agent i = 1, 2, (ii) the two dotted curves are connecting
the origins passing through the points A and B, respectively, (iii) the downward-sloping straight line
is passing through the points A, B and ω, and (iv) the curves labeled as I1 , I2 , I3 , and I4 are agents’
indifference curves. The preferences of two agents are assumed to satisfy Strict Monotonicity, Order,
Continuity, and Strict Convexity. Point A is a tangent point of indifference curves I1 and I3 the straight
line and its coordinates are
A = (4, 8)

measured from the bottom-left origin O1 . Likewise, measured from the bottom-left origin O1 , the coor-
dinates of the point B is
B = (8, 4),

and thus, the coordinates of the point B is (4, 8) if measured from the top-right origin O2 . At point B,
the indifference curves I2 and I4 intersect with each other. Finally, measured from the bottom-left origin
O1 the coordinates of ω is
ω = (6, 6).

Answer questions (1) – (6).

(1) Among the four indifference curves, which of them are the indifference curves of agent 2? Explain
why you think this to be correct. (2 marks)

(2) Between the two dotted curves connecting the two origins O1 and O2 (one is the curve passing
through A, and the other is the curve passing through B), which is the contract curve of this econ-
omy? Explain why you think this to be correct. (2 marks)

(3) What is the Walrasian equilibrium price ratio p1 /p2 ? (2 marks)

(4) What is the consumption bundle x1 of agent 1 in the equilibrium? (2 marks)

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(5) What is the consumption bundle x2 of agent 2 in the equilibrium? (2 marks)

(6) It can be argued that the Walrasian equilibrium allocation (x1 , x2 ), where xi is agent i’s consumption
bundle, is socially desirable from both efficiency and equity perspectives. Explain why? (5 marks)

Problem 5. Consider the 2-person and 2-good exchange economy that is illustrated as the Edgeworth
box diagram below.
10 8 6 4 2 0
O2
10 0

8 2

6 4
B

4 C A 6

2 8

0 10
O1 0 2 4 6 8 10

In the box diagram, (i) point Oi is the origin for agent i = 1, 2, (ii) the dotted curve is the contract
curve in this economy, (iii) the dashed line is a straight line connecting the origins, and (iv) the other
two curves passing through A are indifference curves of agents 1 and 2 whose preferences satisfy Strict
Monotonicity, Order, Continuity, and Strict Convexity. Point A is a tangent point of agents’ indifference
curves, and each of the points B and C is an intersection of an indifference curve and the dashed straight
line. The coordinates (x1 , x2 ) of the points A, B, C measured from the bottom-left origin O1 for agent
1 are given by, respectively,

A = (6, 4.2), B = (5.1, 5.1), C = (4.9, 4.9).

Thus, measured from the top-right origin O2 for agent 2, their coordinates are given by

A = (4, 5.8), B = (4.9, 4.9), C = (5.1, 5.1).

Answer questions (1) and (2).

(1) Between the two indifference curves (one is the curve passing through B, and the other is the curve
passing through C), which is agent 1’s indifference curve? Explain why you think this to be correct.
(2 marks)

(2) Suppose that the consumption bundle (1, 1) represents basic needs in this economy. It can be argued
that the allocation ((6, 4.2), (4, 5.8)), where agent 1 consumes (6, 4.2) and agent 2 consumes (4, 5.8),
is socially desirable from both efficiency and equity perspectives. Explain why? (5 marks)