Econ 301 October 24 2004 Peter Norman

Homework 6
1. Leif consumes only three goods: pickled herring (x1 ), Swedish meatballs (x2 ), and coee (x3 ). Suppose we know that the demand functions for pickled herring and Swedish meatballs are: x1 (p1 , p2 , p3 , m) = x2 (p1 , p2 , p3 , m) = what is the demand function for coee? 2. A demand change due to a change in the price of good x1 can be decomposed into:
0 0 Substitution eect: xS 1 = x1 (p1 , p2 , m ) x1 (p1 , p1 , m) 0 0 0 Income eect: xN 1 = x1 (p1 , p2 , m) x1 (p1 , p2 , m )

3m 8p1 2m . 8p2

0 where (p1 , p1 , m) are the original prices and income p0 1 is the new price and m is the income that makes the demanded bundle given the original prices and income exactly aordable after the change in the price. 1a Suppose the utility function is given by u (x1 , x2 ) = xa . 1 x2

a. Derive the demand functions. b. Calculate the income and substitution eects for good x1 given a price change from (3, 3) to (3, 4) if the income is 100. (you may stick in your favorite number for a if that helps). c. Redo the same exercise with u (x1 , x2 ) = min {x1 , x2 } 3. Consider a consumer/worker with no non-labor income. Assume that the endowment of time is L = 24, and denote labor supply by L (say in hours). Let the wage be 5 dollars/hour and the dollar price of the consumption good be 1 dollar/unit Suppose that the optimal labor supply (given the (p, w) = (1, 5) is L = 8 a. Suppose that consumption and leisure are both normal goods and that the wage increases to 10 dollars/hour. Show carefully in a graph how the change in labor supply may be decomposed in a substitution and an income eect. Can you say for sure whether labor supply will increase or decrease? b. Suppose instead that the worker is oered the contract: 5L if L 8 w (L) = , 5L + 10 (L L ) if L > 8 In a new graph, depict the budget set corresponding to this wage contract (still assuming p = 1). Can you say whether labor supply will increase or decrease relative the case with the wage being 5 dollars/hour?

4. Tweedeldum and Tweedeldee consume two goods only: weekday wireless minutes and weekend wireless minutes. Tweedeldum has signed on with a service that gives him 1000 weekday minutes, but no weekend minutes and Tweedeldee has a service that gives him 1000 weekend minutes, but no weekend minutes. If you want to make life easy, assume that weekday minutes cannot be used in the weekend and the other way around. a. In a carefully labeled graph, put in the endowment described above together with some preferences for Tweedeldee and Tweedeldum. Draw the preferences in such a way that both Tweedeldee and Tweedeldum prefers 500 weekday minutes and 500 weekend minutes to their initial endowment. b. Explain carefully what a competitive equilibrium is in this environment and illustrate how a competitive equilibrium would look like graphically in a NEW GRAPH. Dont change the preferences or the endowment! c. Consider the following alternative trading institution. Tweedeldum rst suggests an allocation. Then Tweedeldee either agrees, in which case they consume the allocation suggested by Tweedeldum. If Tweedeldee doesnt agree, they both consume their respective endowments. In a new graph, show how Tweedeldum will choose the allocation. Will this trading institution result in a Pareto Optimal equilibrium? 5. Consider an economy with two consumers, a and b, who live for two periods, which we index by period 1 a a a and 2. Denote by ca 1 and c2 the consumption in each period for consumer a and by e1 and e2 the initial b b b b endowment in each period for consumer a and let c1 , c2 , e1 and e2 be the consumption and endowment for consumer b. Finally, suppose that the consumers have preferences given by U a (c1 , c2 ) = ua (c1 ) + ua (c2 ) U b (c1 , c2 ) = ub (c1 ) + ub (c2 ) and that they can borrow and lend at interest rate i a. Set up the relevant consumer choice problem for one of the agents and derive the rst order condition. b. Illustrate the consumer choice problem in a graph where you should be explicit about i) the intercept, ii) the endowment, iii) the slope of the budget line and iv) the slope of the indierence curve at points j where cj 1 = c2 for agent j.
a b b c. Suppose that ua (c) = ub (c) = ln c and that ea 1 = e2 = e1 = e2 = k. Will there be any trade in equilibrium? (explain)

d. For the preferences and endowments above, derive the equilibrium consumptions and the equilibrium interest rate. 6. (Optional) Gunnlaug and Einar are the only persons living on a small island outside Iceland. In the waters outside the island (good there is only cod (good 1) and herring 2) After a day of shing Gunnlaug G E E E has a catch eG = eG 1 , e2 = (5, 5) and Einar has a catch e = e1 , e2 = (10, 0) . The sh cant be stored to the next day, so the equilibrium can be determined without any reference to the future. a. Carefully, draw an Edgeworth box where you should be explicit about where the endowment point is in the graph. In this graph you should also sketch some preferences and indicate which points in your graph are better for both Gunnlaug and Einar than the endowment. 2

b. In a NEW Edgeworth box, depict a situation with a relative price which is not consistent with (Walrasian) equilibrium because there is excess demand for one of the goods given this price. Explain! c. Explain verbally what conditions must hold in an equilibrium and depict an equilibrium in a NEW Edgeworth box. In a few sentences explain how each equilibrium condition can be read o from the graph. d. What does it mean for an allocation to be Pareto ecient? Draw a NEW Edgeworth box where you depict the set of ALL Pareto optimal allocations and explain the construction in a few sentences. Is the competitive equilibrium depicted in part b. Pareto ecient? Explain! 7. (Optional) Suppose that Mrs A has preferences given by uA (x, y ) = x + (1 ) y and Mr B has preferences given by uB (x, y ) = x + (1 ) y, where has nothing at all to do with circles, but is an arbitrary number between 0 and 1 (which is naturally interpreted as a probability). Also suppose that A has an endowment of (10, 10) and B has an endowment of (5, 15) . If it helps you, you may consider the case with = 1/2. Notive that you may think of as the probability that B suers a loss of 10.
x a. Suppose that p py > 1 . Can this be an equilibrium? Hint: Use the edgeworth box. You need to be explicit about the slope of the indierence curve for A. For B you only need to gure out the general shape of the indierence curve. Alternatively, you may use the indierence curve for A to gure out what the equilibrium allocation would have to be and then check how the utility of this allocation compares to the endowment point for B.

b. Suppose that c. Suppose that

px py px py

< =

1 . Can this be an equilibrium? 1 . Can this be an equilibrium?

Hint: Same as above.

d. In the equilibrium, how does xB relate to y B ? e. Interpret good x as the consumption in the case that the teenage son of Mr B wrecks his Ford Explorer and y as the consumption in the case that the car survives the drive to Florida (these should be thought of as mutually exclusive events). What in the specication of the endowments makes this interpretation sensible? With this interpreation in mind, how can you interpret the shape of the preferences for A and B ? What is the intuitive reason for the equilibrium characterization obtained above?