Answers to Ch.

2 problems
Question 2.1
a) max U x1 x 22 with constraint x1 15 3 x 2
b) insert constraint into U and find maximum x1 5 and x 2 10 / 3
c) net demand: gross demand minus endowment x1net 2 and x 2 net 2 / 3
d) household is net buyer of good 1 and net seller of good 2.
e) as a) but with new price: x1 1.4 and x 2 9.33 , x1net 1.6 and x 2 net 5.33
Question 2.2
a) Maximise utility with respect to budget constraint p1 x1 p 2 x 2 9 . From FOC receive
x1 3 p11 and x 2 6 p 21 .
b) Profit of firm 1 = p1 x1 L1 and profit of firm 2 = p 2 x 2 L2 . As CRS technology, in
equilibrium profit of both firms = 0. p1 1 and p 2 1 .
c) Insert the prices from b) into the demand functions found in a) to get: x 3 and x 6 .
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1 2

d) According to the resource constraint L1 L2 9 , substitute in production functions to

receive x1 x 2 9 production possibility frontier is x 2 9 x1 and MRT = 1.
U x1 1 x2
e) MRS = .
U x 2 2 x1
f) Pareto efficient allocations if MRS = MRT efficiency if x 2 2x1 .
g) Yes, the combination x 3 and x 6 satisfies x 2 2x1 . The first theorem of welfare
* *
1 2

economics.
Question 2.3
40 p 2
x1* 20 / 3; x1* ;
3 p1
a) Person A: 10 p1 Person B:
x 2* 20
3 p2 x 2*
3
b) x
1
A

x1B 10 x A
2
x 2B 20 insert results from a)
p1
c) 4 in coth cases; d) No, only the ratio is determinate. Prices are homogenous of
p2
degree 0 ; e) take one good as numeraire, eg. p1 1 , then p 2 1 / 4

Question 2.4
a) From the two firms first order conditions (CRS): p1 1 and p 2 12 . Profits are 0.
b) Max utility s.t. budget constraint with income=10. FOC with Cobb-Douglas x1 5 / p1
and x 2 5 / p 2 .
c) Insert prices from a) into demand functions in b): x1* 5 and x 2* 10 .
d) Use production functions and the labour resource constraint LA LB 10 and get
y 2 20 2 y1 .
U / x1
e) MRS = U / x2 x2
x1 .
f) Slope of production possibility frontier = MRT = -2. Efficiency where tangency, i.e. MRS
= MRT efficiency when x 2 2x1 .
g) Yes, the combination x1* 5 , x 2* 10 satisfies x 2 2x1 .
Question 2.5

a) y1

b) Decreasing returns to scale

max p 2 y 2 p1 ( y1 )
c)
s.t. y 2 A( y1 ) b

1 b
p1 b 1 p1 b 1
d) y1* ; y 2* A
Abp 2 Abp 2

b 1
p1 b 1 p1 b 1
e) Ap 2 p1
Abp 2 Abp 2

Question 2.6
a)
y1

y2

The requirement of strictly convex production set is not satisfied

b) Constant returns to scale (CRS)
c) If p1 / p 2 A , y 2 =0, no production takes place.
d) If p1 / p 2 A , the higher the output y 2 is, the larger the profit is. Thus, if it were
possible, the firm would use an amount of input and produce an amount of output.
No profit maximising amount of input exists.
e) If p1 / p 2 A , any profit maximising amount of input can exist, because profit is zero in
any case.