Schweighofer-Kodritsch, Li WS 18/19

Advanced Microeconomics
Exercise Sheet 3

Exercise 1 (Pure Exchange Economy) Consider an economy in which two consumers

β 1−β
have Cobb-Douglas utility functions u1 (x11 , x21 ) = xα11 x1−α
21 and u2 (x12 , x22 ) = x12 x22 for
some α, β ∈ (0, 1).
a) Derive the demand functions for both consumers if the wealth level of consumer i
(for i = 1, 2) is wi .
Now consider this economy as an Edgeworth Box economy in which the consumers have
initial endowments (ω11 , ω21 ) and (ω12 , ω22 ). Assume α = β = 12 .
b) Draw the Edgeworth box with the initial endowments (1, 2) for consumer 1 and (2, 1)
for consumer 2. Identify graphically the area where both consumers are better off by
exchanging some of their endowments by drawing appropriate indifference curves.

c) Determine all the Pareto optimal allocations for such an economy.

d) Determine the equilibrium price ratio and allocation for the initial endowments
described under b).
Exercise 2 (First Fundamental Welfare Theorem) Recall the proof from the First
Fundamental Theorem of Welfare Economics from the lecture. Please explain briefly the
following steps:
a) Step 3: What is the argument for the conclusion
ul (xl ) > ul (x∗l ) ⇒ p∗ xl > vl ?

b) Step 4: What is the argument for the conclusion

ui (xi ) ≥ ui (x∗i ) ⇒ p∗ xi ≥ vi ?
(Hint: You need a local non-satiation argument for this implication.)

c) Step 5 and 6: Explain each step of the inequality and the resulting contradiction.
Exercise 3 (General Equilibrium) Consider an economy with two firms and two
consumers. Firm 1 is entirely owned by consumer 1. It produces guns from oil via the
production function yg = −2yo . Firm 2 is entirely owned by consumer 2; it produces
butter from oil via the production function yb = −3yo . Each consumer owns 10 units of
2 3
oil. Consumer 1’s utility function is u(xg , xb ) = xg5 xb5 and consumer 2’s utility function is
u(xg , xb ) = 10 + 12 ln xg + 12 ln xb . Answer the following questions:
a) What are the market clearing prices for guns, butter and oil?

b) How many guns and how much butter does each consumer consume?

c) How much oil does each firm use?