Problem set 3

Due Monday 9th March 12 noon

Adeola Oyenubi [70 marks]
Question 1 [70 marks]
Consider an exchange economy with two consumers A and B. Consumers A and B have
utility functions (1 , 2 ) = (1 )(2 ) and (1 , 2 ) = (1 )(2 ), respectively. They
face prices 1 and 2 for good 1 and good 2, respectively. For simplicity denote the rand
value of their initial endowment with and , respectively. While their initial
endowment is given by = 1 2 where = [4 marks].
1.1 Calculate Marginal Utilities for both goods and both consumer [8]

= , = ,
= , = [ ]

1.2 Write the budget constraint for both consumers as a function of their initial
endowment. [4]
+ = + = ,

+ = + = [ ]

1.3 Now write down the MRT given the budget constraint above [2]
Simply writing

suffice for this question or express as a function of and

use differentiation which will give similar result. [2 marks]

1.4 Calculate the optimal choice of both consumers by equating their MRT to their MRS
(Be careful to write the budget constraint in terms of and not the initial endowment.
This is where denoting the rand value of their initial endowment by and comes in
handy)? [16]

= =

[]

Combined with the budget constraint
=

= +

[]

=
[]

Because B have similar utility function

= [3marks]

=
[]

1.5 Show that the optimal bundle calculated in 1.6 meet the optimal condition =
(Simply show that you can obtain the optimal bundle using = ).
[6]

= []

=
[]

Instead of substituting answers from the previous questions a student can use the
MRS=MRT condition together with the budget constraint to derive the answer.
1.6 Explain why [4]
= 1 1 + 2 2 = 1 1 + 2 2 .
The consumer cannot spend more that the value of his or her initial endowment
[4marks].
1.7 If = (10,2) and = (10,18)draw the edgeworth both showing the initial
allocation. [9]

Good2

Good 1

1 mark for each correct label totalling 9marks

1.8 Show that the point of initial endowment indicated above is not pareto efficient [4]

= = , = = [ ]

At the initial endowment point and cannot be equal because they are
constants. Therefore this cannot be a pareto efficient point.
1.9 If 1 = 1 and 2 = 1 show that walras law holds [17]

=
=
= []

=
=
= []

=
= []

=
=
= []

Walras law
+ = []

( +
) + ( + ) = []

( + ) + ( + ) = []
Therefore at this prices walras law holds.