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1. Competitive equilibria, Pareto efficient allocations and the First Welfare Theorem. (15 points)
Consider the following pure exchange economy. There are 2 consumers and 2 goods, apples and oranges. Both
consumers have the same preferences u(ca , co ) with u strictly increasing in both arguments. Initial endowments
are e1a , e1o , e2a , e2o ; they are all strictly greater than 0.
(a) (2 points) Define the competitive equilibrium for this economy. Denote the set of competitive equilibrium
allocations CE.
(b) (2 points) Explain why we can set the price of one good to one, i.e. use it as numeraire.
(c) (2 points) What is Walras law? Does it apply to this economy?
(d) (2 points) Define the set of feasible allocations and denote it Z.
(e) (2 points) Define the set of Pareto efficient allocations and denote it P E.
(f) (5 points) State and prove the First Welfare Theorem for this economy. Clearly explain how you use the
assumption on u. Can we relax this assumption?
2. This section is worth 15 points. Answer only one question in this section, either 2a or 2b, but NOT both.
2a. Solving the one sector growth model using the guess and verify method. (15 points)
Consider the following growth model with inelastic labor supply, full depreciation, log utility and CRS technology.
The Bellman equation is:
v(k)
max
log(k k 0 ) + v(k 0 )
0
k
k0 0
k k 0 0
(a) (5 points) Guess that the value function has the form v(k) = a1 + a2 log k. Plug the guess into the
maximization problem:
max
log(k k 0 ) + (a1 + a2 log k 0 )
0
k
max
t=0
X
At
P (At )
ct (At )1
s.t.
1
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X
t u(ct , lt )
t=0
There is also one representative firm facing a time stationary CRS technology, and a government that finances
a given stream of expenditures {gt }
t=0 by proportional taxes on capital and labor income, i.e. the budget
constraints for the two agents are:
pt (c1t + x1t )
t=0
(1 kt )rt kt1 .
(1)
t=0
X
t=0
pt c2t
X
(1 nt )wt n2t .
(2)
t=0
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