QuestionsforReviewGeneralEquilibrium

1. Bobhasaninitialendowmentconsistingof10unitsoffoodand10unitsof clothing.Erichasaninitialendowmentof10unitsoffoodand20unitsof clothing.DrawanEdgeworthExchangeBoxfortheseconsumers. Wedidthisoneinclass.Thebox(EEB)shouldbe20unitshighby30units wide,presumingthatyouputfoodontheverticalaxisandclothingonthehorizontal. LetsassumethatyoudecidetoputBobsoriginatthebottomleftandEricsorigin atthetopright.MarkamountsoffoodandclothingontheaxessothatBobmeasures increasingamountsoffoodinanupwarddirectionandincreasingamountsof clothinginarightwarddirection.Ericwillthenmeasureincreasingamountsoffood inadownwarddirectionandincreasingamountsofclothinginaleftwarddirection. 2. Bobregardsfoodandclothingasperfectoneforonesubstitutes,while Ericregardsthemasperfectcomplementsbutinaratioof3unitsof clothingfor2unitsoffood.Whatisthesetofallocationsthatarepareto preferredorparetosuperiortotheoriginalendowmentgivenabove? WhereisthecontractcurveintheEEB?Whatsetoftradescouldleadto thecontractcurve?Whatpriceratiowouldberequiredtoensurethata competitiveequilibriumreachesthecontractcurvefromtheinitial endowment? PerfectoneforonesubstitutesmeansthatBobsindifferencecurvesarestraightlines joiningequalamountsoffoodandclothingalongtheaxes(i.e.,oneindifferencecurve isastraightlinejoiningthepointrepresenting10unitsoffoodandnoclothingtothe pointrepresenting10unitsofclothingandnofood).ThismeansthatBobgetsequal amountsofutilityfrom10unitsoffoodor10unitsofclothingoranylinear combinationofthesetwo.Incontrast,EricsindifferencecurvesareLshaped (upsidedownLshapedsincehisoriginisinthenortheastcorneroftheEEB).The vertexoftheLalwayshasanallocationoffoodandclothingtoEricintheratioof3 unitsofclothingto2unitsoffood.Anyotherratioinvolveseitherexcessclothingor excessfood,inthesensethatEricgetsnoadditionalutilityfromtheexcessfood whichisabovearatioof2to3,andnoadditionalutilityfromtheexcessclothing whichisabovearatioof3to2. TheinitialendowmentgiveninQuestion#1givesEric10unitsoffoodand20units ofclothing.ThisimpliesthatErichas5unitsofexcessclothingatthisinitial endowment.Heisthereforewillingtotradeawayclothinginexchangeforfood.On theotherhand,Bobgetsequalutilityfromaunitoffoodoraunitofclothing(they areperfectsubstitutes).So,forinstance,ifEricweretotrade2unitsofclothingand get2unitsoffoodinreturn,hewouldbebetteroffandBobwouldbenoworseoff,so thiswouldbeaparetosuperiormove.

Infact,anypointonthelensformedbytheirtwoindifferencecurvesthatpass throughtheinitialendowmentwillbeparetosuperior(exceptfortheoneexceptionof theallocationattheextremeoppositeendofthelens).Further,sincethistradewould giveEric18unitsofclothingand12unitsoffood,itwouldgivehimanallocation thatwasparetooptimal(Ericsallocationcouldnotbefurtherimprovedwithout makingBobworseoff).Acompetitivepriceratioof11(i.e.,PF/PC=1)wouldallow thisparetooptimaltradetotakeplace. 3. Considerasimpleeconomywithonlyfoodandclothingandtwo consumers,AnnandBill.Bothhaveregularlyshapedconvexindifference mappings.Foragiveninitialendowment,whentheratiooffoodto clothingpricesintheeconomyis3/1,Annwantstobuy6unitsof clothing,whileBillwantstosell2unitsoffood.Isthecurrentpriceratio anequilibriumpriceratio?Ifnot,inwhatdirectionwillthispriceratio change? Thispriceratiocannotbeanequilibriumone,becausebothAnnandBillwanttobuy clothingandsellfoodatthispriceratio.Therewillbeexcessdemandforclothing andexcesssupplyoffoodatthispriceratioandtheirdesireddemandsandsupplies willthereforenotclearthemarket.Inordertobringtheirdemandsandsuppliesinto balance(consistencywithoneanother),thepriceofclothingwouldhavetorise (reducingquantitydemanded)andthepriceoffoodwouldhavetofall(reducing quantitysupplied).Inotherwords,theratioofthepriceoffoodtothepriceof clothingwouldhavetofall. 4. Howwilltheanswerto#3changeifAnnwantstosell3unitsofclothing andBillwantstosell2unitsoffood? ThiswouldmeanthatAnnwouldsell3unitsofclothingandbuy2unitsoffood.At thecurrentpriceratio(PF/PC=3/1),Annwouldget$3forsellingher3unitsof clothing,butthenwouldbuyonly1unitoffoodwiththis$3.Themarketdoesnot clearatthispriceratio.BillwantstosellmorefoodthanAnnwantstobuy.The priceoffoodwillthereforehavetofall(or,whatisthesamething,theratioofthe priceoffoodtothepriceofclothingwillhavetofall). 5. Giventhecurrentallocationofproductiveinputs,themarginalrateof transformationoffoodforclothinginasimpletwogoodeconomyis equalto2.Atthecurrentallocationofgoodsforconsumption,each consumersmarginalrateofsubstitutionoffoodforclothingis1.5.Isthis economyefficientinitsproductmix?Ifso,explainwhy.Ifnot,describea reallocationthatwouldleadtoaparetoimprovement.

Forproductmixefficiency,thecommonMRSofeachoftheconsumers(alongtheir indifferencecurves)mustbeequaltotheMRT(measuredalongthePPF).Inthis case,theMRSsareequalacrossconsumers,butare1.5,whereastheMRTis2.0. Thismeansthat,atthecurrentproductmix,theeconomycanproduce2unitsmore offoodbygivingup1unitofclothing.However,atthecurrentproductmix, consumersarewillingtogiveup1.5unitsofclothingtoget1moreunitofX.In otherwords,consumersdontvaluetheextraXashighlyasthecostoftheextraXin termsofunitsofYgivenup(alongthePPF).Inotherwords,thiseconomyis producingtoomuchX,andnotenoughY.ThatmeansthatadditionalYshouldbe produced.WhenmoreYisproduced,theMRT(theopportunitycostofX)willfall from2.0toalowernumber(becausethePPFisanincreasingcostfunction).This productmixwithmoreYandlessXwillmeanthattheMRSofconsumerschanges (itwillbecomegreaterthan1.5,becauseasmoreYisconsumed,Xbecomesrelatively morevaluabletoconsumers).Somewhereinthemiddle,theMRSandtheMRT wouldbeequal,withmoreYandlessXintheproductmix. 6. Acastawayonadesertisland(Robin)canmake5unitsoffoodperdayor 10unitsofclothing,usingallhislabourresourcesinproducingeitherone ortheother.Thereisnocapitalequipment.Ifhedivideshistime betweenthetwo,hisoutputofeachisproportionaltotheamountoftime spentoneach.Thiscastawayisfortunatetohavebeenleftontheisland withhisgirlfriend,whosenameisTuesday.Tuesdaycanmakeeither10 unitsofclothingor15unitsoffoodoranyproportionalcombination. Giventhisinformation,describetheproductionpossibilitiesfrontierfor theireconomy. Assumingthatclothingismeasuredontheverticalaxisandfoodonthehorizontal, whenRobinandTuesdaycombinetheireffortstheycould,atmost,produce20units ofclothingontheverticalaxis,or20unitsoffoodonthehorizontalaxis. ThePPFisnotastraightlinejoiningthesetwopointsbecauseRobinandTuesday aredifferentiallyproductiveinproducingfoodandclothing.Asyoucanseefromthe numbersgiven,Robindoesnotgiveupmuchfoodwhenheproducesclothing,but Tuesdaygivesupalotoffoodwhensheproducesclothing.Youcan,ifyoulike, calculatethevalueofopportunitycostoffoodandofclothingproducedbyeachoneof theseproducers.TheresultisthatRobinsopportunitycostofclothingislow,while Tuesdaysishigh.Correspondingly,Robinsopportunitycostoffoodishigh(alotof clothinggivenupforeachunitoffoodproduced),whereasTuesdaysopportunity costoffoodisnotsohigh.TheimplicationisthatTuesdayshouldbethefirstoneto switchfromproducingclothingtoproducingfoodaswemovedowntotheright alongthePPF.

ThePPFisthereforecomposedofastraightlinefrom20unitsofclothingandnofood toapointwhere15unitsoffoodand10unitsofclothingareproduced(i.e.,Tuesday isproducingonlyfoodandRobinonlyclothingatthispoint).Fromthere,thePPF followsastraightlinedirectlytothepointonthehorizontalinterceptrepresenting20 unitsoffoodandnoclothing.Inotherwords,thePPFisnotregular,butispiecewise linear,withtwopieces. 7. IfRobinandTuesdaybothregardfoodandclothingasperfectoneforone substitutes,howmuchshouldeachproduce? Iffoodandclothingareoneforonesubstitutes,thentheindifferencecurveshaveaslope of1.TherearetwolinearpartsthatmakeupthePPF.Thetoppart(representing Tuesdaysproduction)hasaslopeof2/3(10clothingto15food).Thebottompart (representingRobinsproduction)hasaslopeof2(10clothingto5food).Therefore,the indifferencecurvestouchthePPFrightatthepointwhereTuesdaysproductionends andRobinsproductionbegins(at10unitsofclothingand15unitsoffood).Thisisthe highestindifferencecurvethatcanbereached,soTuesdayshouldproduce15unitsof foodandRobinshouldproduce10unitsoffood. 8. Now,supposeatradingshipvisitstheislandeachdayandofferstobuy andsellfoodandclothingatapriceratioof4/1(priceoffooddividedby priceofclothing).Unfortunately,theshipwillnottakethemoffthe island,butitiswillingtotrade.Willthisshipswillingnesstotrade changetheproductionandconsumptiondecisionsofRobinandTuesday? How? Goodscanbeexportedorimportedatthepriceratioof$4forfoodand$1for clothing.Theslopeofthepricelineis4,whichisquitesteep.Therefore,thehighest pointatwhichthispricelinetouchesthePPFisontheXaxis,whereRobinand Tuesdayaretogetherproducing20unitsoffood.These20unitsoffoodcouldbesold for$80.ThenRobinandTuesdaycanconsumeanyamounttheywantbetween20 unitsoffoodandnoclothingand80unitsofclothing(at$1each)andnofood. Since,RobinandTuesdayregardfoodandclothingasoneforonesubstitutes,they willprefertotradeall20unitsoffoodinexchangefor80unitsofclothing. 9. AnnandBillarepricetakingconsumersinatwoperson,twogood, exchangeeconomywithafixedendowmentof40unitsofgoodXand80 unitsofgoodY.Annhas12unitsofXand30unitsofYasinitial endowment.AnnsutilityfunctionisgivenbyU=X2YandBillsisgiven byU=XY.Findtheequationthatexpressesthecontractcurve. ThecontractcurvewilljointogetherallpointswhereBillandAnnsMRSareequal. ForAnn,theMRS=2XY/X2=2YA/XA.ForBill,theMRS=YB/XB.However,thisis

equivalentto(80YA)/(40XA).ThetwoMRSswillbeequalwhen2YA/XA=(80 YA)/(40XA)orwhen80YA2YAXA=(80XAYAXA)orwhenYA=XA+(1/80)YAXA. 10. UsingtheinformationinQuestion#9,calculateAnnandBillsMRSsat theinitialendowmentpointandexplainbothwhythisinitialendowment isnotparetoefficientandwhowillwanttosellXandwhowillwantto sellY. Attheinitialendowmentpoint,AnnsMRS=60/12=5.Attheinitialendowment point,BillsMRS=50/28=25/14(oralittlebitlessthan2).Therefore,Annis willingtogiveup5Ytoget1XattheinitialendowmentandBilliswillingtogive upabout2Ytoget1X.RelativetoBill,AnnregardsXasvaluable,soshewill wanttobuyXandsellYandBillwillwanttodotheopposite.