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1.1
Setup
x1A
x2A
uA x1B ; x2B
x1B
x2B
1.2
Demand functions
Let us rst look at consumer A. For some budget MA and prices p = (p1 ; p2 ),
he solves
max
uA x1A ; x2A s:t: p1 x1A + p2 x2A MA
1
2
xA ;xA
p1 =
0 =
(MA
x1A
p2 =
p1 x1A
x1A
x2A
x2A
n
x1A
p2 x2A ), with
x2A
p1
1
Divide the rst two conditions to get the "MRS = price ratio" condition
=x1A
=
) =x2A
1
u1
=
u2
(1
and solve for x2A :
p1
x2A
=
1
xA
p2
x2A =
p1 1
x , x1A (p; MA ) =
p2 A
p1 1
x
p2 A
Substitute into budget constraint to obtain
MA = p1 x1A + p2
MA
p1
p2
By symmetry we have
x2A (p; MA ) =
1.3
(1
) MA
p2
x1B (p; MB ) =
MB 2
(1
; xB (p; MB ) =
p1
) MB
p2
Gross Demands
MA = p1 ! 1A + p2 ! 2A ;
Thus gross demands are given by
p1 ! 1A + p2 ! 2A
=
p1
p1 ! 1A + p2 ! 2A
x2A (p; p ! A ) = (1
)
p2
2
1
p1 ! B + p 2 ! B
=
x1B (p; p ! B ) =
p1
p1 ! 1B + p2 ! 2B
2
xB (p; p ! B ) = (1
)
p2
x1A (p; p ! A ) =
1.4
! 1A +
p2 2
!
p1 A
= (1
p1 1
! + ! 2A
p2 A
! 1B +
p2 2
!
p1 B
= (1
p1 1
! B + ! 2B
p2
!1 =
! 2 = (1
p2 2
!
+
p1 A
p1 1
)
! + ! 2A
p2 A
! 1A +
! 1B +
p2 2
!
p1 B
!1
+ (1
p1 1
! + ! 2B
p2 B
!2
Verify Walraslaw:
p1 ! 1A + p2 ! 2A + p1 ! 1B + p2 ! 2B
p1 ! 1
) p1 ! 1B + p2 ! 2B
+ (1
) p1 ! 1A + p2 ! 2A + (1
p1 ! 1A p1 ! 1B
= p1 ! 1A + p2 ! 2A + p1 ! 1B + p2 ! 2B
= 0
p1 z1 (p) + p2 z2 (p) =
p2 ! 2
p2 ! 2A p2 ! 2B
1.5
We know that we need to x one price, say p1 = 1, or solve directly for the
price ratio. We also know that then we can use the condition that one of
the excess demands is zero to nd the equilibrium. But which one? The one
that looks nicer to you! (The result must be equal!). Take the condition
z1 (p) = 0, or
! 1A +
or
p2 2
!
p1 B
!1 = 0
) ! 1A + (1
) ! 1B
! 1B +
p2 2
p2 2
!A +
! = (1
p1
p1 B
or
1.6
p2 2
!
p1 A
) ! 1B
) ! 1A + (1
! 2A + ! 2B
(1
p2
=
p1
1.7
=
=
) ! 1A + (1
) ! 1B 2
!A
! 2A + ! 2B
! 1A ! 2A + ! 1A ! 2B + (1
) ! 2A ! 1B
! 2A + ! 2B
! 1A +
(1
The other gross demands look similar and can be found from intelligent (and
lucky) cut-and-paste, for example for good 2:
x2A = (1
! 1A ! 2A + (1
) ! 2A ! 1B + ! 1A ! 2B
(1
) ! 1A + (1
) ! 1B
3
Net demands:
x1A
! 1A =
x2A
! 2A =
(1
(1
) ! 2A ! 1B (1
) ! 1A ! 2B
! 2A + ! 2B
) ! 1A ! 2B
(1
) ! 2A ! 1B
(1
) ! 1A + (1
) ! 1B
! 1A +
p2 2
x
p1 A
! 2A
or
0 =
+
=
) ! 1A ! 2B
) ! 2A ! 1B (1
! 2A + ! 2B
) ! 1A ! 2B
(1
) ! 1A + (1
) ! 1B (1
2
2
1
!A + !B
(1
) ! A + (1
(1
(1
! 2A
) ! 2A ! 1B
) ! 1B
0
=0
+ ! 2B
(u!)
1.8
While the preceding was easy, this part is a bit more complicated mathematically (but not conceptually). We want to nd the point where the oer
curves cross in the Edgeworth box. That is, contrary to the above we rst
nd the equilibrium quantities, and then derive the equilibrium prices.
Remember that the oer curves were curves in the (quantity) Edgeworth
box, that is, we need to express them as "good 2 as a function of good 1",
without having any prices as arguments. So we go back to the rst-order
conditions of the consumers decision problem, that is MRS equal to price
ratio and the budget constraint,
1
x2A
p1
= ; p1 x1A + p2 x2A = p1 ! 1A + p2 ! 2A :
1
xA
p2
Divide the budget constraint by p2 and substitute out p1 =p2 using the rst
condition; then solve for x2A :
x2A =
(1
) ! 2A x1A
:
x1A
! 1A
4
(1
) ! 2B x1B
:
x1B
! 1B
Crossing these two curves in the Edgeworth box means taking into account
that demands must sum up to endowments, i.e. solving
(1
) ! 2A x1A
x1A
! 1A
(1
) ! 2B (! 1 x1A )
=
(! 1 x1A )
! 1B
x2A =
!2
x2A
! 1A ! 2A + (1
) ! 2A ! 1B + ! 1A ! 2B
= x1A
! 2A + ! 2B
etc. as before. Indeed, the oer curves cross at these points! The corresponding quantities for good 2 (just to check that everything is ne) are, from the
oer curve,
x2A ! 1A
x2A x1A
(1
) ! 2A ! 1A
= ! 2A
! 1A
! 1A
(1
) ! 2A x1A
= x2A
=
x1A
! 1A
The equilibrium price ratio is then found equating it to the marginal rate of
substitution:
p1
= M RSA =
p2
1
x2A
=
x1A
(1
Correct!
Short Break
! 2A + ! 2B
p
= 1
1
1
) ! A + (1
) !B
p2
3
3.1
The long way to nd the contract curve is to solve a full maximization problem:
max
uA x1A ; x2A
uB x1B ; x2B
uB
1
1
1
xA + xB = !
x2A + x2B = ! 2
s:t:
uB x1B ; x2B
x1B + 2 ! 2
uB
x2A
x2B
(beautiful, no?) Now the rst-order conditions with respect to the quantities
are
@L
@uA
=
1
@xA
@x1A
@L
@uB
=
1
@xB
@x1B
@L
@uA
=
2
@xA
@x2A
@L
@uB
= 0;
=
2
@xB
@x2B
= 0;
1
=0
2
=0
@uB =@x1B
= M RSB ;
@uB =@x2B
i.e. the indierence curves are tangent. The short way is to start from this
very point.
In the present case, we have
M RSA =
x2A
=
x1A
1
x2B
= M RSB
x1B
Together with the feasibility constraints, the contract curve is then given by
x2A
=
x1A
1
(! 2
(! 1
6
x2A )
x1A )
(1
(1
) ! 2 x1A
) !1 + (
) x1A
3.2
! 1A ! 2A + ! 1A ! 2B +(1
! 2A + ! 2B
) !2
(1
=
) !1 + (
(1
= (1
)! 2A ! 1B
! 1A ! 2A + ! 1A ! 2B +(1
! 2A + ! 2B
)! 2A ! 1B
) ! 2A ! 1B + ! 1A ! 2B
! 1A ! 2A + (1
(1
) ! 1A + (1
) ! 1B
= x2A
Yeah! We were right, our market equilibrium lies on the contract curve and
is therefore Pareto e cient!
3.3
Theorem (the di cult one): "Each Pareto-e cient allocation can be market
equilibrium (with itself as initial endowment)"
(true here because preferences are indeed convex!)
Show that price ratio equal to slope of indierence curves at allocation
gives rise to demands which are equal to this allocation!
Fix some Pareto-e cient allocation x1A , x2A = C (x1A ), x1B = ! 1 x1A ,
x2B = ! 2 x2A , where ! 1 and ! 2 are total quantities of goods 1 and 2, and
let endowments be given by the same allocation: ! 1A = x1A , ! 2A = x2A .
Propose a price ratio equal to the (identical) slopes of the indierence
curves at this point:
p1
= M RSA =
p2
1
x2A
=
x1A
7
(1
!2
) !1 + (
) x1A
Now check whether gross demands for goods 1 and 2 at this price ratio
coincide with the original Pareto-e cient allocations:
x1A
p2 2
C (x1A )
1
+ !A =
xA +
p1
p1 =p2
2 1
(1
) ! xA
x1A +
!2
! 1A
(p; p ! A ) =
=
= x1A
x2A (p; p ! A ) = (1
p1 1
x + C x1A
p2 A