Beruflich Dokumente
Kultur Dokumente
www.lancaster.ac.uk/postgrad/murphys4 /
s.murphy5@lancaster.ac.uk
office: LUMS C85
Question 1(a)
Explain, in detail, what is meant by a Edgeworth box in the context
of a 2 good (1,2), 2 person (A,B) model of consumption. (5 marks)
When we draw the axes for our box, we want to show the total
amount (A’s endowment + B’s endowment) of Good 1 on the X axis
and the total amount of Good 2 on the Y axis.
We graph A’s initial Endowment as a
point.
Note: Because A & B’s endowments
sum to the total amount in the box,
when we graph B’s endowment, we’ll
find that it will be on the dot that we
used to represent A’s endowment.
How to Draw the Edgeworth Box
Budget Constraint:
Our budget constraint is: , where wealth (w) is given by our initial endowment.
The slope of our budget constraint is equal to the ratio of the prices of the two
goods: .
In our case, we don’t have to be quite so technical, and we’re just going to draw
in a budget constraint that isn’t quite to scale. The key thing is to make sure it is
downward sloping (because both prices are positive) and that it is going through
our initial endowment point.
Note: Earlier we said that because A & B’s
endowments sum to the total amount in the
box, when we graph B’s endowment, we’ll
find that it will be on the dot that we used to
represent A’s endowment.
Similarly, If both are facing the same prices
(this is generally the case in this type of
problem), then the line we use for A’s budget
constraint will also represent B’s budget
constraint.
How to Draw the Edgeworth Box
Next, we can draw in the indifference curves.
Starting with person A, If the indiff. curve is tangent to the budget constraint at
the endowment point, it will look like this:
This means that the endowment maximizes
A’s utility, subject to the budget constraint. A
is in equilibrium.
Ian’s Answer: The dashed line shows a budget constraint that results in
A and B’s demand for good 2 being greater than supply (the height of
the box), and the overall demand for good 1 being less than available
supply (the width of the box). There is excess demand for 2 of ED2 and
excess supply of 1 of ES1.
Question 1(b)
My notes:
This graph shows a situation where the
endowment is in disequilibrium. This is
evident because A’s indifference curve
that is tangent to the budget constraint is
NOT at the point of A’s endowment.
Instead, it is at some other point. (we can only have one indifference
curve that is tangent to the budget constraint for each person, because
indifference curves cannot cross each other (for a given agent).)
My notes, ctd.:
Likewise, B can sell some good 1 and buy good 2 and move down and
to the right, to reach a place where he maximizes utility (where indiff.
curve is tangent to budget constraint).
The problem is they can’t both do that if there are no other agents in
the economy to trade with.
So at these prices the demand for good 2 is greater than the total level
of good 2 in the economy, so there is excess demand for good 2. For a
similar reason there is excess supply of good 1.
To take this a bit further,
If only A and B are in this economy
how can they deal with this
disequlibrium and get to a place
where both can maximize their
utility?
A will increase utility if he can move to an indifference curve further away from the
origin (shown by the arrows).
The same is true for B.
Both can increase their utility by consuming at any point in the gold region.
There is a line which represent points where A and B’s indiff. curves are tangent to
each other. This line is called the contract curve and is represented in grey.
If the prices shift so that the price ratio intersects the contract curve within the gold
region, then they can trade with each other, which increases both utilities compared
to their utilities at E.
To look at this with more detail, Here is an example of two utility isoquants
(indifference curves) which are tangent, so we can see that they define a point on the
contract curve:
How can A and B get here from the original graph in 1(b)? They can negotiate prices
so that their budget constraint (the ratio of prices) that goes through the endowment
also goes through the gold-colored region, specifically, also through the contract
curve.
If we clean this graph up, we will have the same (not exactly to scale) graph as we see
in the next slide for part 1(c).
To look at this with more detail, Here is an example of two utility isoquants
(indifference curves) which are tangent, so we can see that they define a point on the
contract curve:
How can A and B get here from the original graph in 1(b)? They can negotiate prices
so that their budget constraint (the ratio of prices) that goes through the endowment
also goes through the gold-colored region, specifically, also through the contract
curve.
If we clean this graph up, we will have the same (not exactly to scale) graph as we see
in the next slide for part 1(c).
Question 1(c)
Argue what would then happen to these prices in a competitive model and show
(and explain) what the resulting competitive equilibrium looks like in this box. (5 marks)
Ian’s Answer: In the face of ED2 and ES1 we would, in a competitive market system,
expect the price of 2 to rise and the price of 1 to fall until the markets were in
equilibrium and the Edgewoth box looked like:
Question 1(d)
Explain, with reference to the diagram from part (c), why the competitive equilibrium
is Pareto efficient. (5 marks)
Ian’s Answer:
Ian’s Answer: At the equilibrium (the black dot) the MRS for A = MRS for B because
both consumers face the same relative prices (as in this diagram).
The equilibrium satisfies Pareto efficiency because the economy cannot move from
this point without making one or both individuals worse off.
That is, no Pareto improvements over this equilibrium are possible – therefore, this
equilibrium is Pareto efficient.
Note also: The set of all such Pareto efficient points is called the contract curve.
Question 2(a)
Explain the Pareto criterion and why this may not, in practice, be very useful
in evaluating the social welfare consequences of a policy change. (2 marks)
My examples:
In practice most policy changes will involve some loss in utility for some
group: For example it may be impossible to give to the poor without taking
something from the rich. It may be impossible to improve the NHS without
putting some people out of jobs, raising taxes, increasing wait time or making
it harder to get certain prescriptions, etc. Even though these policies are not
Pareto improvements, they can still provide more utility to society as a whole.
Early childhood education is the surest way to lower crime, lower poverty,
and raise the GDP for at risk groups and for the country as a whole… 20 years
from now. So if someone dies before the children affected by the policy are
Question 2(b)
Suppose a policy change involves a large number of winners and a small number of losers such
that the financial gains outweighed the financial losses. Could you argue that the winners
could then compensate the losers and still be better off themselves? If not, why not? (3
marks)
Ian’s Answer: Just because the financial gains outweigh the financial losses
does NOT mean that the gainers can compensate the losers.
For example, suppose the winners were all rich and the losers were all poor
then diminishing marginal utility of income might imply that the UTILITY gains
to the financial winners might be small relative to the large UTILITY losses of
the poor. In which case, the winners could NOT compensate the losers.
Only if winners and losers were randomly selected (so, they were equally rich,
on average) could you argue that compensation would work. Alternatively, if
utility were a linear junction of income this could be assured.”
My answer/example:
In the example of early childhood education, we cannot compensate the losers
Suppose there are three individuals in a society Question 2(c)
(1, 2, 3). And there are three possible outcomes 1 2 3
that could be attained (A,B,C). Each individual’s First A B C
rankings of these three alternatives is given here: Second B C A
Third C A B
Explain why majority voting would give
rise to a Condorcet Paradox. (5 marks)
Ian’s Answer:
Two out of three prefer A to B.
Two out of three prefer B to C, and two out of three prefer C to A.
What if, on the other hand, votes were taken on A vs C and then on B vs C?
What is selected as the first choice in this case?
Do you see how the outcome depends on which vote is taken first? This is
the Condorcet Paradox.
Question 2(d)
Suppose the rankings in part (c ) where replaced by the following:
1 2 3
First A C B
Second B B C
Third C A A
Explain what the social choice would be under majority voting. (5 marks)
My note:
In this scenario, each individual’s preferences are transitive and the
preferences determined by social choice/the majority vote are also
transitive. So, no Condorcet Paradox here.
Question 2(e)
Explain what is meant by “single peaked preferences”. Are the
preferences in parts (c ) and (d) single peaked? (5 marks)
We can do social ordering for (d) but not for (c). The social ordering for
(d) is single peaked.
Question 3(a)
Suppose an economy was characterised by a monopoly in one industry.
Suppose that industry exhibited constant returns so that MC was constant,
and suppose the demand curve was linear. Show, using an appropriate
diagram, what the equilibrium price and output would be. Show the profits of
the firm and the deadweight loss (relative to the competitive price) (7 marks)
Question 3(b)
Explain why a policy of regulating this firm to
force it to set p=MC would pass a cost-benefit
criterion. Indeed, show that the benefits of
such a policy would be exactly 50% greater
than the costs of doing so. (7 marks)
Ian’s Answer:
What you may not remember is
that the MR curve has the same
intercept as the Demand curve,
but double the slope.
The consumers would be better off by 3 DWL, and the firm would be worse
off by 2 DWL.
BUT, there may be costs associated with coordinating all of the consumers to
pay this bribe.
There might be a “free rider” problem – each consumer would be better off
if she didn't contribute to the bribe, so the dominant strategy is to not
cooperate. And the bribe doesn't get paid and everyone ends up worse off!
Notes about the Exam
• Friday the 24th – Check your Timetable for time/location
• Bring a pencil, eraser, calculator and your library card #
Good luck!