ECO310, Midterm Solutions 2013

Question 1
Grading
Number of mistakes 0 1 2 3 4 5 6 7 8
Grade for question 20 18 16 12 10 8 6 4 0
Part a
Answer: False. u(x
1
, x
2
) = x
1
+x
2
does not represent the same preference relation as u(x
1
, x
2
) =
(x
1
)
2
+ (x
2
)
2
. To see this, consider the preference between (1, 1) and (2, 0). According to u:
u(1, 1) = 2 = u(2, 0)
and therefore (1, 1) (2, 0). However:
u(1, 1) = 2 < 4 = u(2, 0)
Part b
Answer: True. If u represents then for every two alternatives, x, y X, either u(x) u(y) or
u(y) u(x). If the rst is true then x y, while if the second holds then y x.
Part c
Answer: True. If a consumers demand for a good increases when income increases and prices
stay xed, then the good is normal. It was shown in lecture that every normal good must be
ordinary, i.e. the demand for the good must decrease when price decreases and income stays xed,
as asserted by the statement.
Part d
Answer: True. Remember that the marginal cost is:
C (w, y)
y
=
w
f

(y)
hence:

2
C (w, y)
y
2
=
wf

(y)
(f

(y))
2
1
increasing marginal costs imply that

2
C (w, y)
y
2
< 0
which is true only if f

(y) < 0, i.e. f is strictly concave, meaning that it has decreasing returns to
scale.
Part e
Answer: False. Remember that the marginal decrease in the sellers price if a small tax is
instituted is:
p

S
(0) =

D
(p)

S
(p)
D
(p)
while the increase in the buyers price is:
p

D
(0) =

S
(p)

S
(p)
D
(p)
hence, if the demand elasticity is bigger than the supply elasticity, i.e.
S
(p) <
D
(p)then we must
have p

S
(0) > p

D
(0), i.e. the change in the price for the buyers is smaller than the change for the
sellers. [Statement e claims the otherway around].
Part f
Answer: True. To see this, assume the statement is false. Hence, neither consumer will object to
switching from

x
1
1
, x
1
2

x
2
1
, x
2
2

to

x
1
1
, x
1
2

x
2
1
, x
2
2

. Note that it cannot be that one of the con-

sumers is strictly better o in

x
1
1
, x
1
2

x
2
1
, x
2
2

than in

x
1
1
, x
1
2

x
2
1
, x
2
2

since

x
1
1
, x
1
2

x
2
1
, x
2
2

is ef-
cient. Therefore, both consumers must be indierent between

x
1
1
, x
1
2

x
2
1
, x
2
2

and

x
1
1
, x
1
2

x
2
1
, x
2
2

.
However, since

x
1
1
, x
1
2

x
2
1
, x
2
2

is no ecient, there exists another feasible allocation

x
1
1
, x
1
2

x
2
1
, x
2
2

that strictly improves the state of at least one consumer without hurting the other. But since
both consumers are indierent between

x
1
1
, x
1
2

x
2
1
, x
2
2

and

x
1
1
, x
1
2

x
2
1
, x
2
2

, we have by tran-
sitivity of the consumers preferences that switching from

x
1
1
, x
1
2

x
2
1
, x
2
2

to

x
1
1
, x
1
2

x
2
1
, x
2
2

strictly improves the state of at least one consumer without hurting the other, a contradiction to

x
1
1
, x
1
2

x
2
1
, x
2
2

being ecient.
Part g
Answer: False. To see this, let players A, B be such that A is strictly taller than B, but B has a
strictly greater vertical jump than A. Then neither player is ranked against the other.
Part h
Answer: False. For a counter example, take an exchange economy with two consumers, both
having the preferences U
i

x
i
1
, x
i
2

= x
i
1
+ x
i
2
and endowment

i
1
,
i
2

= (1, 1). The price ratio

in any competitive equilibrium in this economy will be 1, but there are innitely many possible
allocations, all of which will be ecient.
2
Question 2
This question is about an exchange economy with two consumers
Consumer 1: The endowment is

!
1
2
; !
1
2

= (1; 0) and the utility function is

u
1
(x
1
1
; x
1
2
) =

x
1
1
1
2

x
1
2
1
2
Consumer 2: The endowment is

!
2
1
; !
2
2

= (0; 10) and the utility function is

u
2
(x
2
1
; x
2
2
) = 2 ln

x
2
1

+x
2
2
(a) Dene a competitive equilibrium for this economy.
A competitive equilibrium consist of prices (p
1
; p
2
) and a consumption plan

x
i
1
; x
i
2

for each consumer

i = 1; 2 such that:

x
i
1
; x
i
2

solves the problem of consumer i given prices (p

1
; p
2
);
Markets for good 1 and 2 clear.
(b) Dene what it means for a consumption plan to be Pareto ecient.
A feasible consumption plan is Pareto ecient if there is no other feasible consumption plan such that:
all consumers are at least as well o;
some consumer is strictly better o.
(c) Normalize p
2
= 1 and nd a competitive equilibrium for this economy.
Let us rst obtain the individual demands for a given price p
1
. Given that the utility of Consumer 1 is
Cobb-Douglas we can use the condition MRS = p
1
and the budget constraint to obtain the demands. This
yields
x
1
1
=
1
2
x
1
2
=
1
2
p
1
Consumer 2 has quasi-linear preferences and this means that in principle we could have corner solutions.
However, this is not the case here, and so we can use the same conditions as before to determine Consumer
2s demands, that is, MRS = p
1
and the budget constraint. The demands are
x
2
1
=
2
p
1
x
2
2
= 8
Now we can use the previous demands to obtain the equilibrium price p

1
. Using

to denote equilibrium
variables, then the market clearing condition for good 1 implies
x
1
1
+x
2
1
= 1
1
2
+
2
p

1
= 1
and solving for p

1
we get
p

1
= 4
Once we have the equilibrium price, we can use the demands to obtain the equilibrium consumption of
each consumer. Summarizing, the equilibrium is given by prices (p

1
; p

2
) = (4; 1) and consumptions plans

x
1
1
; x
1
2

= (1=2; 2)

x
2
1
; x
2
2

= (1=2; 8)
1
ECO310 Spring 2013 Midterm Answer key

Question 3 (20 points)

a) (5 points) A competitive equilibrium is a triple ((

) (

) (

)) such that:
- The consumption plan (

) maximizes consumers utility given prices and profits:

(

) *(

)|

+
- The production plan (

) maximizes firms profits given prices:

| ()+
- Markets clear:

The following common mistakes were penalized as indicated (with a maximum penalty of 5 points):
- Failure to state the nature of a competitive equilibrium (1 point)
- Failure to state the utility maximization requirement appropriately (up to 2 points)
- Failure to state the profit maximization requirement appropriately (up to 2 points)
- Failure to state the market clearing requirement appropriately (up to 2 points)


b) (5 points) An allocation ((

) (

)) is Pareto efficient if it is feasible and (

)
(

) for every alternative feasible allocation ((

) (

)).

The following common mistakes were penalized as indicated (with a maximum penalty of 5 points):
- Failure to state the utility maximality requirement appropriately (up to 2 points)
- Introducing profit maximization in the definition (2 points)
- Failure to state the feasibility requirement appropriately (1 point)
- Somehow introducing prices in the definition (up to 2 points)

c) (10 points) Any triple ((

) (

) (

)) satisfying
(

) (() ) (

) (() )

is a competitive equilibrium. We can check this by verifying the definition given in part (a):
1) Utility maximization. The utility function is linear with ||

. This implies that

spending all the budget in

and consuming zero of

is optimal. Formally,

2) Profit maximization. In the equilibrium,

((

) (

) )
Since the production function is strictly concave, this first order condition ensures that profit
is actually maximized at

.
3) Market clearing.

() and

.


The following common mistakes were penalized as indicated (with a maximum penalty of 10 points):
- Omitting in the consumers budget constraint (3 points)
- Proposing a non-equilibrium or failing to propose a candidate (up to 8 points)
- Solving for an efficient allocation without justification (up to 6 points)
- Algebraic mistakes (up to 5 points)
- Omitting to specify some component of the equilibrium (up to 3 points)
ECO310, Midterm Solutions 2013
Question 4
Part a
Answer
The expression is strictly negative. To see that, notice rst that we can use the budget constraints
to nd the equilibrium prices. Normalize p
2
= 1. Then consumer 2s budget constraint is:
2p
1
+ 10 = 6p
1
+ 8
subtracting 2p
1
+ 8 from both sides and dividing by 4 gives p
1
=
1
2
. As such, consumer 2s income
is 11, meaning that it could have aorded the plan (10, 6). Since consumer 2s utility function is
strictly increasing, we know that:
u
2
(10, 6) > u
2
(10, 5)
however, since consumer 2 choose to consume (2, 10)in equilibrium we have by revealed preference:
u
2
(2, 10) u
2
(10, 6)
combining these two together gives:
u
2
(10, 5) u
2
(2, 10) < 0
Grading
Full points were given to people who made an argument similar to the above.
Simply saying that the expression is negative and providing a completely incorrect explanation
awarded no points.
Adding irrelevant, incorrect or incomprehensable statements to a correct argument could have
resulted in a penalty of one point.
Mistakes that arised due to calculation errors resulted in a loss of a single point.
Other types of mistakes were graded according to discretion.
1
Part b
Answer
is equal to
4
7
. To show this, rst note that is strictly between 0 and 1, or else the consumer would
not buy any of good 1 (if 0) or good 2 ( 1). Therefore, we have a standard Cobb-Douglas
utility function which gives a demand of:
x
1D
1
(p) =
12p + 8
p
for good 1 and:
x
1D
2
(p) = (1 ) (12p + 8)
for good 2. Using the fact that p =
1
2
(found in part a) and that consumer 1s equilibrium demand
for x
1
is 16 gives:

12
1
2
+ 8
1
2
= 16
or:
28 = 16 = =
4
7
Grading
6 points were given to people who showed that is between
1
2
and 1.
4 points were granted to people who showed that is between 0 and 1.
No points were taken o for failing to show that (0, 1) before proceeding on to nding
according to the standard Cobb-Douglas demand function.
Adding irrelevant, incorrect or incomprehensable statements to a correct argument could have
resulted in a penalty of one point.
Mistakes that arised due to calculation errors resulted in a loss of a single point.
Other types of mistakes were graded according to discretion.
2