ECON 702 PROBLEM SET 1

GARTH BAUGHMAN
Exercise (1.1). For this economy, an A-D equilibrium consits of and allocation, ((c
i
t
)
3
i=1
)

t=1
,
and prices, (p
t
)
t=1...
, which satisfy

i
(c
i
t
e
i
t
) = 0 for all t (market clearing) and, for each
i, solves
max
(c
i
t
)

t=1

t=0

t
i
ln c
i
t
s.t.

t
p
t
(c
i
t
e
i
t
) = 0 (budget constraint) (1)
c
i
t
> 0 (non-negativity). (2)
Specifying for this economy simply involves substituting (e
1
t
, e
2
t
, e
3
t
) = (e
1
, e
2
, e
3
) = (2, 3, 1)
for all t
Exercise (1.2). For this part, assume that

t
p
t
converges. As in the notes, one obtains
the following from the rst order conditions:
p
t+1
c
i
t+1
=
i
p
t
c
i
t
= c
i
t
= c
i
0
p
0

t
i
p
t
.
But budget balance requires

t
p
t
c
i
t
=

t
p
t
e
i
. Or, that

t
p
t
e
i
=

t

t
i
c
i
0
p
0
= c
i
0
p
0
/(1
i
).
Thus, c
i
0
= ((1
i
)e
i

t
p
t
)/p
0
whereby c
i
t
= (
t
i
(1
i
)e
i

t
p
t
)/p
t
. So, nally,
x
t
i
= e
i
_

t
i
(1
i
)

s
p
s
p
t
1
_
Exercise (1.3). So, given the excess demand above, to obtain markt clearing we must have

i
x
i
t
=0 t
=

i
e
i
_

t
i
(1
i
)

s
p
s
p
t
1
_
=0
=

s
p
s
p
t
_

i
e
i

t
i
(1
i
)
_
=(e
1
+ e
2
+ e
3
)
=
(

s
p
s
) (

i
e
i

t
i
(1
i
))
e
1
+ e
2
+ e
3
=p
t
1
2 GARTH BAUGHMAN
Exercise (1.4). In this economy an allocation, ((c
i
t
)
3
i=1
)

t=1
, is P.E. if it is feasible (i.e.

i
c
i
t
=

e
i
for all t) and it solves the social planners problem
max
((c
i
t
)
3
i=1
)

t=1

t
1
ln c
1
t
s.t.

t
i
ln c
i
t
u
i
for i = 2, 3 and some {u
i
}

i
c
i
t
=

i
e
i
for all t
Note, however, since the UPS is convex (because the feasible set is and utilty is concave) we
can equivalently pose the planners problem as
max
((c
i
t
)
3
i=1
)

t=1

t
1
ln c
1
t
s.t.

i
c
i
t
=

i
e
i
for all t
for some
i
0
Exercise (1.5). The rst welfare theorem requires that every AD equilibrium constitute a
PE allocation. The standard proof applies: By way of contradicion assume that ((c
i
t
)
i
))
t
is AD but not PE and that (( c
i
t
)
i
)
t
is a (feasible) Pareto improvement on ((c
i
t
)
i
)
t
. Wlog,
suppose agent one is strictly better o under this improvement. But then the cost to agent
one of the improvement is strictly greater than his budget because, if not, (c
1
t
)
t
would have
been afordable and agent one would have preferred it this contradicts optimality of ((c
i
t
)
i
)
t
.
Also,

t
c
i
t


t
c
i
t
for i = 2, 3. To see this, note simply that if not (i.e.

t
c
i
t
>

t
c
i
t
)
there is some
i
such that

t
c
i
t


t
c
i
t
+
i
. Dene c
i
1
= c
i
1
+
i
/p
1
, c
i
t
= c
i
t
for t > 1 and
i = 2, 3 and c
1
t
= c
1
t
for all t. Then the allocation (( c
i
t
)
i
)
t
is aordable but gives both agents
two and three higher utility than ((c
i
t
)
i
)
t
. We conclude that

t
c
i
t


t
c
i
t
. But this too
leads to a contradiction because now

t
p
t
_

i
c
i
t
_
>

t
p
t
_

i
c
i
t
_
which implies (because ((c
i
t
)
i
)
t
, (p
i
)
i
>> 0)

t
_

i
c
i
t
_
>

t
_

i
c
i
t
_
=

i
e
i
so that (( c
i
t
)
i
)
t
can not be a (feasible) pareto improvement on ((c
i
t
)
i
)
t
. We conclude that
there are no (feasible) pareto improvements on ((c
i
t
)
i
)
t
so that ((c
i
t
)
i
)
t
is PE.
Exercise (1.6). First, impose
1
= 1
2

3
. Then form the lagrangian, take FOC and
arrive at the following three equations for each t:

t
1
c
1
t
=

i

t
i
c
i
t
for i = 2, 3

i
c
i
t
=

i
e
i
ECON 702 PROBLEM SET 1 3
These are then solved for {c
i
t
} and one gets
c
1
t
() =
(6
3
+ 6
2
6)
t
1
(
3
+
2
)
t
2
+ (
3

2
+ 1)
t
1
c
2
t
() =
6
2

2
t
(
3
+
2
)
2
t
+ (
3

2
+ 1)
1
t
c
3
t
() =
6
3

2
t
(
3
+
2
)
2
t
+ (
3

2
+ 1)
1
t
Exercise (1.7). From the FOC we have
t
= (
2

t
2
)/c
2
t
() and so the transfer payments can
be written
t
1
() =

t=0
_

t
2
c
2
t
__
(6
3
+ 6
2
6)
t
1
(
3
+
2
)
t
2
+ (
3

2
+ 1)
t
1
e
1
_
=
1
3

t
(
3
+
2
)
t
2
+ 2(
3
+
2
1)
t
1
=
1
3
_

3
+
2
1
2
+
2(
3
+
2
1)
1
1
_
t
2
() =

t=0
_

t
2
c
2
t
_
(c
2
t
e
2
)
=
1
2

t=0
(
3

2
)
t
2
+ (
1
)
t
1
=
1
2
_

3

2
1
2
+

1
1
1
_
t
3
() =

t=0
_

t
2
c
2
t
_
(c
3
t
e
3
)
=
1
6

t=0
((5
3

2
)
t
2

1

t
1
)
=
1
6
_
5
3

2
1
2

1
1
1
_
Exercise (1.8). Homogeneity is pretty obvious, these are linear equations of alpha. That
the t
i
sum to zero is somewhat less obvious, but...

i
t
i
=
1
6
_
5
3

2
1
2

1
1
1
_
+
1
2
_

3

2
1
2
+

1
1
1
_
+
1
3
_

3
+
2
1
2

2
1
1
1
_
=
_
(5
3

2
)/6 (
3

2
)/2 (
3
+
2
)/3
1
2
_
+
_

1
/6
1
/2 + 2
1
/3
1
1
_
= 0
4 GARTH BAUGHMAN
Exercise (1.9). So, to get our AD equilibrium we set p
t
=
t
and then we have an equilibrium
if t
i
() = 0, i = 1...3. We then have a linear system which is overdetermined but, fortunately,
consistent; the solution being

2
=
3
2
3
4
2
+ 2
1
6

3
=

2
1
4
2
+ 2
1
6
This then gives us consumption and prices:
c
1
t
=

1
t
(6
1
6)

2
t
(2
2
2) + (
1
1)
1
t
c
2
t
=

2
t
(9
2
9)

2
t
(2
2
2) + (
1
1)
1
t
c
3
t
=

2
t
(3
2
3)

2
t
(2
2
2) + (
1
1)
1
t
p
t
=

2
t
(2
2
2) + (
1
1)
1
t
12
2
+ 6
1
18
Ofcourse, to obtain these, I plugged in values for e
i
and the fact that
2
=
3
. So, from
these, it is dicult to interpret the import of these parameters. But relative e
i
seem to
dictate level of consumption whereas relative
i
impact the path.
Exercise (1.10). A sequential equilibrium is an allocation ((c
i
t
, a
i
t+1
)
i=1..3
)

t=0
along with
interest rates ((r
t+1
)

t=0
such that, for i = 1..3, the allocation solves
max
(c
i
t
,a
i
t
)

t=0

t
i
ln c
i
t
s.t. c
i
t
+
a
i
t+1
1+r
t+1
e
i
t
+ a
i
t
c
i
t
0
a
i
t
+ 1 A
i
for some A
i
and, for all t,

i
c
i
t
=

i
e
i
t
and

i
a
i
t+1
= 0.
Exercise (1.11). From the notes we have the following relations:
a
i
t+1
=

=1
p
t+
_
c
i
t+
e
i
_
p
t+1
r
t+1
=
p
t
p
t+1
1.
So that
r
t+1
=
2
t
2
(
2
1) +
t
1
(
1
1)
2
t+1
2
(
2
1) +
t+1
1
(
1
1)
1
and (continues in handwritten pages that follow...)