UNIVERSITY OF OXFORD Department of Economics Undergraduate - Microeconomics

Last updated: 05-Oct-11

Tutorial/Class 2. More GE and Optimisation This set of questions contains: further problems on General Equilibrium (introductory GE problems are in Question Set 1) questions on trade as an application of GE applications of the optimisation techniques covered in the mathematics lectures. For questions on the second topic in the maths lectures, integration, see Chapter 10 of the Maths Workbook.

Problems and Multipart Questions

1. An Economy with Production I Consider an economy with a single turnip farmer endowed with one unit of time (available for work and leisure) and a eld. The farmer has preferences represented by the utility function: u(t, l) = ln t + ln(1 l) , where t is the number of turnips consumed and l is labour supplied. There is only one industry in this economy turnip production which requires two inputs, labour and elds. Turnips are competitively produced with a production function: 1 1 f (L, F ) = L 2 F 2 , where L is the total labour used and F is the total number of elds used. Assume that all three markets in this economy (for turnips, labour, and elds) are competitive. Normalise the turnip price to 1. Let w be the wage, and r the elds rental price. (a) Argue that the farmers budget constraint may be written t wl + r. (b) Hence (using a Lagrangean) nd the farmers optimal demand for turnips and supply of labour in terms of r and w. When is labour supply positive? (c) If the industry employs inputs L and F , what are costs? (d) Using a Lagrangean with multiplier , solve the cost-minimisation problem and deduce the factor demand curves for labour and elds. Interpret . (e) Remember that the supply of elds is 1. Calculate turnip supply in terms of Using three market clearing conditions, nd the Walrasian equilibrium.
r . w

2. An Economy with Production II Consider a small closed economy with two consumption goods, good 1 (meat) and good 2 (berries). There are two types of agent, h and g, and they have the same preferences over consumption, represented by the utility function: u(x1 , x2 ) = ln x1 + ln x2 , but there are twice as many type-h agents as type-g agents. The only factors of production are their labour: when a type-h agent chooses to spend a fraction of his day producing meat and the rest producing berries then his output h h is y1 , y2 = 2, 2(1 ) ; a type-g agent is more productive when she chooses to spend a fraction of her day producing meat and the rest producing berries then her g g output is y1 , y2 = 3, 12(1 ) . Normalise the price of one unit of berries (good 2) to 1, and let p be the price of one unit of meat (good 1). (a) What would the agents choose for and if p < 1? What would the agents choose for and if p > 4? Argue that those values of p cannot be part of an equilibrium. Now, assume that 1 < p < 4. (Check later that these inequalities are strict.) (b) Taking p as given, calculate what each agent will produce daily. Imagine that the agents sell their output to the market at prices p and 1, producing income, and then decide on how much of each good they actually want to consume, resulting in expenditure. Calculate what each agent will demand. (c) Remembering that there are twice as many type-h agents as type-g agents, nd the value of p that equates demand and supply in the meat market, and conrm that 1 < p < 4. Check that with this value of p, demand and supply are equated in the market for berries. (d) Show that in this equilibrium, type-h agents each consume 1 unit of meat and 3 units of berries, whereas type-g agents each consume 2 units of meat and 6 units of berries. The hunter-gatherers now have the possibility of opening up their economy to free trade. In world markets, 1 unit of meat can be exchanged for 2 units of berries, and the country would be a price-taker. (e) Using world prices, calculate what each agent would produce daily. By considering whether each type of agent would become better or worse o, what do you think would be the likely outcome of a referendum on whether or not to open up the economy? 2

3. Pure exchange economy [Specimen exam paper 2010, Part B] Consider a pure exchange economy with two goods, x and y, and two consumers, a and b, that trade the goods. The preferences of consumer a are represented by the utility function: ua (xa , ya ) = xa + ln ya and the preferences of consumer b are represented by the utility function: ub (xb , yb ) = xb + ln yb . (a) With the price of good x normalised to 1, calculate the Walrasian equilibrium when consumer a has an endowment (4, 0) of (x, y) and consumer b has an endowment (0, 4). (b) Now assume that consumer a has an endowment (0, 4) and consumer b has an endowment (4, 0). What is the Walrasian equilibrium in this case? (c) Illustrate your ndings in an Edgeworth box, and clearly indicate all the Pareto ecient allocations. (d) Comment briey.

4. The 2 2 Production Model and the 2 2 2 Trade Model Country A has two industries, each employing capital and labour to produce output, with constant-returns-to-scale production functions:

y 1 = K1 L 1

1/3

2/3

y2 = K2 L2

2/3

1/3

Factor and product markets are competitive; the prices of the two products are p1 and p2 , and the prices of labour and capital are w and r. (a) By solving the cost minimisation problem for a rm in industry 1 producing an amount of output y1 , show that: the optimal capital-labour ratio in industry 1 is: and the marginal cost of y1 is: and hence similarly:
K2 L2 K1 L1 r 1/3 r 2/3

M C1 = M C2 =

w 2/3 w 1/3

2/3 1/3

w 2r 1/3

2w , r

2/3

Which good is more labour intensive? (b) The country has an endowment of 160 units of capital, and 200 units of labour. Use the optimal capital-labour ratios above to determine how much capital and labour will be used in each industry, as functions of the factor price ratio. Illustrate the factor market equilibrium in an Edgeworth box for the case when w/r = 1. How would the output of the two industries change if the endowment of labour decreased? (c) Use the conditions that price equals marginal cost in both industries to show that there is a one-to-one relationship between relative factor prices and relative product prices: 3 w p1 = (1) r p2 How does the wage change if demand for product 1 increases? Explain this result intuitively. (d) Explain how your results relate to the Stolper-Samuelson and Rybczynski Theorems. There is a second country, B, identical to A except that it has a smaller endowment of labour. Consumers in the two countries have identical preferences: the relative y1 demand for the two goods, y2 , is a function only of the relative prices, p1 . p2 (e) Initially both countries are both in autarkic (no trade) equilibrium. Suppose that product prices in country A (determined by consumer demand) are equal: p1 /p2 = 1. What can you say about relative product prices and relative factor prices in country B? 4

(f) Now suppose that the countries can trade freely with each other. Describe what happens to relative product and factor prices in the two countries. Which goods will be imported and exported by country A? What happens in country A to employment and output in the two industries? 5. Optimisation with inequality constraints The consumers of a poor country each have utility function u(q, x) = 4q 1/2 + x, where q is the quantity of food and x is other consumption goods. The prices of food and other goods are pf and po respectively. All consumers face the same prices but their incomes dier. Using the Kuhn-Tucker method, show that: (a) All consumers will spend the whole of their income. (b) All consumers, irrespective of income, will consume a positive amount of food. (c) Poor consumers, with incomes less than 4p2 /pf , will consume food only. o (d) Rich consumers will all consume the same amount of food and spend the rest of their income on other goods. Draw the Engel curves for the consumption of both goods. 6. Optimisation, Comparative Statics, and the Envelope Theorem A worker has utility function U (C, L) = C + ln(T L) where C is consumption and L is hours of work per week. The price of a unit of consumption is 1, the total number of hours available in the week is T , and the hourly wage rate is W . The worker receives a welfare benet B from the government, and labour income is taxed at rate t. (a) Express the workers decision problem as a constrained optimisation problem. Assuming that there is an interior optimum, solve it by the Lagrangian method to nd the workers consumption and labour supply. What condition must be satised to ensure that 0 < L < T ? (b) Show that the labour supply function is upward-sloping. How is labour supply aected by (i) an increase in the tax rate t? (ii) an increase in the benet level B? (c) What is the marginal utility of welfare benets? Explain this result. (d) An improvement in leisure facilities leads to an increase in the parameter . How does this aect the workers utility, assuming that he alters his consumption and leisure accordingly? (e) If the government wants to maximise income tax revenue, what value of t should it choose? What happens to the optimal tax rate, and to government revenue, when leisure facilities improve?

Essay-style Questions
1. Consider the 2 2 production model with constant returns to scale, where the two factors are immobile internationally and the two consumer goods are mobile internationally. Using this model, explain the statement free trade does not benet everyone. (2010) 2. Do workers gain or lose from liberalization of international trade? (Specimen exam paper, Part B)