Advanced Microeconomics: Homework 3

Jan Hagemejer
Note: this is the only homework for the second part of the course. It also counts as more points.

1. There are two consumers A and B with the following utility functions and endowment

uA (x1A , x2A ) = x1A x2A and ωA = (3, 2)

uB (x1B , x2B ) = min(x1B , x2B ) and ωB = (2, 3).

(a) Depict the situation in the diagram.

(b) Calculate the market clearing prices and the equilibrium allocation.

2. Person A has a utility function of

uA (x1A , x2A ) = x1A + 2x2A and ωA = (2, 0)
Person B has a utility function of

uB (x1B , x2B ) = min(2x1B , x2B ) and ωB = (0, 4).

(a) Illustrate this situation in an Edgeworth box diagram.

(b) What is the equilibrium relationship between p1 and p2 .
(c) What is the competitive equilibrium allocation?

3. Consider the Varian’s revealed preference version of the second welfare theorem in the pure exchange economy. What
assumption on preferences do you need to have x0i = x∗i for all i. (In other words what assumptions do you need for the
Walrasian equilibrium to guarantee that the competitive equilibrium will be exactly in the allocated Pareto efficient point).

4. Consider a production economy with one consumer with a Cobb-Douglas utility function for leisure x1 and consumption x2
: u(x1 , x2 ) = 0.5 ln x1 + 0.5 ln x2 . Endowment of leisure is one. Consumer can supply its leisure to the firm with technology
q = L − a, where L is the supply of labour to the firm and a ≥ 0 is a constant and q is the output of good 2. Consumer
owns the firm.

(a) Does the competitive equilibrium exist? Why? What is the condition for a for the competitive equilibrium to exist?
(b) Find the Pareto optimal allocation.
(c) Draw your findings on a diagram depicting the production set and the indifference curves.

5. Consider a production economy with one consumer with a Cobb-Douglas utility function for leisure x1 and consumption x2
: u(x1 , x2 ) = x0.5 0.5
1 x2 . Endowment of leisure is one. Consumer can supply its leisure to the firm with a techology q = L,
where L is the supply of labour to the firm. Consumer owns the firm.

(a) Draw the production set and the indifference curves in a single diagram.
(b) Does the competitive equilibrium exist? Find the competitive allocation prices and mark your answer on the diagram.
(c) Is the equilibrium (if it exists) Pareto optimal? Why?

6. Consider a production economy with one consumer with a utility function for leisure x1 and consumption x2 : u(x
√ 1 , x2 ) =
min{x1 , x2 }. Endowment of leisure is one. Consumer can supply its leisure to the firm with a technology q = L, where
L is the supply of labour to the firm. Consumer owns the firm.

(a) Draw the production set and the indifference curves in a single diagram.
(b) Does the competitive equilibrium exist? Find the competitive allocation prices and mark your answer on the diagram.
(c) Is the equilibrium (if it exists) Pareto optimal? Why?

7. (Small open economy with a Leontief function) Assume that we have two countries, each producing two goods: crackers
and beer. Technology of production is the same in the two countries:
1 1 1
Qc = min{ K, 1L} andQb = min{ K, L}.
2 3 4
∗ ∗
Endowments are: at home: ωL = ωK = 100, abroad: ωL = 120, ωK = 80.

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 (a) Which of the goods is more labour intensive? What would be your expectations towards the production pattern i.e.
who will produce more of what?
(b) Compute equilibrium production level assuming that there is full employment, i.e. all factors of production are used.

8. (Small open economy with a Cobb-Douglas function) Assume we have an economy consisting of two firms producing guns
and oranges from capital and labour. Assume that we have a production function for oranges:

o = K 1/3 L2/3

and for guns:

g = K 2/3 L1/3 ,
where K and L are capital and labour.
w 1/3 r 2/3 w 2/3 r 1/3
The associated cost functions are C(g, w, r) = ( 1/3 ) ( 2/3 ) g and C(o, w, r) = ( 2/3 ) ( 1/3 ) o. Assume that this
economy is a small open economy with endowments K̄ = 1 and L̄ = 1. The world prices are po = 1, pg = 1. The producers
trade directly with the rest of the world. Find the equilibrium in the goods and factor markets:

(a) Find the equilibrium factor wages. (Hint: use the equation 15.D.7 from the book).
(b) Derive the unit labour and capital demands agL ,aoL ,agK ,aoK .
(c) Find the factor allocation.
(d) Find the the output levels of final goods.

9. (2 firms x 2 consumers x 1 input economy) 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 g = 2x, where x is the input of oil. Firm 2
is entirely owned by consumer 2. It produces butter from oil via the production function b = 3x. Each consumer owns 10
units of oil. Consumer 1’s utility function is u1 (g1 , b1 ) = g10.4 b0.6 0.5 0.5
1 and consumer 2’s utility function is u2 (g2 , b2 ) = g2 b2 .

(a) Find the market clearing prices for guns, butter and oil (note that consumers do not derive utility from consumption
of oil alone). Use the price of oil as numeraire (set it equal to 1).
(b) How many guns and how much butter does each consumer consume?
(c) How much oil does each firm use?

10. (2 goods/firms x 2 inputs x 2 countries, dr Leszek Wincenciak) A closed economy (Home) produces two goods: Q1 and Q2
using capital K and labour L. The production function in the i = 1, 2-th sector is given by:

Qi = (Ki )αi (Li )1−αi

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where α1 = 3 and α2 = 23 . The preferences of a representative consumer is given by the following utility function:

U (x1 , x2 ) = β ln x1 + (1 − β) ln x2

where β = 21 .

(a) Find optimal factor ratios (K/L) in both sectors as a function of wages.
(b) Find employment level L1 in sector 1 as a function of labour and capital endowments and the ratio factor wages. Use
the resource constraint.
(c) Find the final good price ratio P1 /P2 as a function of factor wages.
(d) Write the production level of good 1 as a function of P1 /P2 and factor endowments (use your previous findings from
(a)-(c).
(e) Write down the consumer demand as a function of P1 and P2 and factor endowments.
(f) Using the market clearing condition for good 1 (x1 = Q1 ) find the resulting price ratio P1 /P2 as a function of factor
endowments.
(g) If there is a second economy (Foreign, denoted by ∗ ) that differs only by endowments. When will our Home economy
be an exporter of good 1 (eg. when good 1 will be relatively cheaper in Home than in Foreign)

11. For the following question you need to use the provided GAMS code (as discussed in the lecture on 21.12.2011). Once you
have completed the assignment, send me you .gms file.
Instructions:

• Open the file provided HW3.zip file and open the soe producer.gms file in GAMSIDE.

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 • This is a small open economy model with 2 Cobb-Douglas producers. There are two goods in the economy Q1
and Q2 and two inputs Z1 and Z2. The initial production vector is q = (100, 200) and the input use at all prices and
factor wages equal to 1 is
Q1 Q2
Z1 70 60
Z2 30 140
The endowments of Z1 and Z2 are the sums of the rows Z1 and Z2 separately.
• The initial world prices of goods are p = (1, 1).
• The code is already complete and calibrated.

(a) Allow the price of good one to go up by 10 percent. What happens to the equilibrium factor wages? Why?
(b) Allow the endowment of Z1 to go up by 10 percent. What happened to the output levels? What happens to the
equilibrium factor wages? Why?

12. For the following question you need to use the provided GAMS code (as discussed in the lecture on 21.12.2011). Once you
have completed the assignment, send me you .gms file.
Instructions:

• Open the file provided HW3.zip file and open the closed consumer producer.gms file in GAMSIDE.
• This is a closed economy model with 2 Cobb-Douglas producers and 1 consumer. There are two goods in the
economy Q1 and Q2 and two inputs Z1 and Z2. The initial production vector is q = (100, 200) and the input use at
all prices and factor wages equal to 1 is
Q1 Q2
Z1 70 60
Z2 30 140
The endowments of Z1 and Z2 are the sums of the rows Z1 and Z2 separately.
• The consumer has a Cobb-Douglas function U = AC1α1 C2α2 , where C1 and C2 are the consumption levels of
good Q1 and Q2. Consumer owns the inputs Z1 and Z2 and rents them to the firm. The initial consumption level
C = (100, 200), so the initial equilibrium is exactly the same as in question 11.
• Consumers demand equals supply. Prices are endogeneous.
• The code is already complete and calibrated.

(a) Allow the endowment of Z1 to go up by 10 percent. What happened to the output levels? What happened to the
factor wages? Why?
(b) (for extra points) Introduce a tax on the input use of factor 1 in the production of good 2. Make the consumer the
recipient of the tax (so he can spend the tax receipts on consumption goods). Set the tax equal to 20 percent. What
happened to the overall utility of the consumer?

13. For the following question you need to use the provided GAMS code (as discussed in the lecture on 21.12.2011). Once you
have completed the assignment, send me you .gms file.
Instructions:

• Open the file provided HW3.zip file and open the soe producer consumer open.gms file in GAMSIDE.
• This is a small open economy model with 2 Cobb-Douglas producers and 1 consumer. There are two goods in the
economy Q1 and Q2 and two inputs Z1 and Z2. The initial production vector is q = (100, 200) and the input use at
all prices and factor wages equal to 1 is
Q1 Q2
Z1 70 60
Z2 30 140
. The endowments of Z1 and Z2 are the sums of the rows Z1 and Z2 separately.
• The consumer has a Cobb-Douglas function U = AC1α1 C2α2 , where C1 and C2 are the consumption levels of
good Q1 and Q2. Consumer owns the inputs Z1 and Z2 and rents them to the firm. The initial consumption level
C = (100, 200), so the initial equilibrium is exactly the same as in question 11.
• World prices are exogeneous and initially set at p = (1, 1). Therefore net exports of each good are a difference between
the production and consumption.
• The code is already complete and calibrated.

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 (a) Allow the endowment of Z1 to go up by 10 percent. What happened to exports? Why?
(b) Allow the price of good one to go up by 10 percent. What happened to exports? Why?

14. Look for conditions of interior solution Pareto optimality (use the same assumptions as chapter 16.F in MWG), by:

(a) setting up and finding the first order conditions of the following problem using the given Lagrange multiplier (Pareto
optimal solutions given initial level utility of consumers i = 2, . . . , I):

M ax u1 (x11 , . . . , xL1 )
st Pi 1i , . . . , xLiP
u (x ) ≥ ūi i = 2, . . . , I multiplier δi
x
i `i ≤ ω̄ ` + j y`j ` = 1, . . . , L multiplier µ`
Fj (y1j , . . . , yLj ) ≤ 0 j = 1, . . . , L multiplier γj

(b) deriving conditions:

∂ui /∂x`i ∂ui0 /∂x`i0
∂ui /∂x`0 i = ∂ui0 /∂x`0 i0 for all i, i0 , `, `0
∂Fj /∂y`j ∂F 0 /∂y 0
∂Fj /∂y`0 j = ∂F j0 /∂y `j0 0 for all j, j 0 , `, `0
j ` j
∂ui /∂x`i ∂F /∂y
∂ui /∂x`0 i = ∂Fjj/∂y `j0 for all i, j, `, `0
` j

(c) Explain in words, what the above conditions mean.

(d) Derive the above first order conditions from either:
i. finding the “social planner solution” as in the lecture slides (one maximization problem)
or:
ii. finding the “competitive equilibrium solution” as in the lecture slides (two separate sets of problems - for the firms
and for the consumers)