TUTORIAL 4

Pareto Efficiency and General Competitive Equilibrium

Arooj Fatima

I202521052
—
Microeconomics
—
Dr. Jin Di Zheng

School of Economics
Huazhong University of Science and Technology
(HUST)
 Question # 1
Consumer A has utility function U(xA, yA) = xAyA and consumer B has utility function U(xB, yB) = 2xByB. A is
endowed with is 20 units of x and 5 units of y and B is endowed with 20 units of x and 3 units of y.
a) Draw an Edgeworth box with x on the horizontal axis and y on the vertical axis. Measure goods for
consumer A by the distance from the lower left corner of the box. Label the endowment allocation.
Endowment:
Consumer A = (20 , 5)
Consumer B = (20 , 3)
Total x in the economy = 20 + 20 = 40
Total y in the economy = 5 + 3 = 8
Total x and y = (40, 8)

b) Derive the equation of the contract curve in terms of xA and yA. Draw the contract curve in your
graph.
UA = xA yA
UB = 2.xB yB
Pareto Efficiency requires
MRSAx,y = MRSBx,y
𝑀𝑈 𝐴 𝑦𝐴
MRSAx,y = 𝑀𝑈𝑥𝐴 = 𝑥 𝐴
𝑦

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 𝑀𝑈 𝐵 𝑦𝐵
MRSBx,y = 𝑀𝑈𝑥𝐵 = 𝑥 𝐵 xB = 40 – xA , yB = 8 – yA
𝑦

𝑦𝐴 8− yA
𝑥𝐴
= 40−xA

xA = 5yA
In A’s coordinates (lower-left origin):
• xA ranges from 0 to 40
• yA ranges from 0 to 8
The equation xA = 5yA means:
• if yA = 0, xA = 0 for consumer A (0,0) and consumer B (40, 8)
• if yA = 8, xA = 40 for consumer A (40, 8) and consumer B (0, 0)
So, the contract curve is the straight line from (0,0) to (40,8) in A’s coordinates.

c) Is the endowment allocation Pareto efficient?

Endowment:
𝑦𝐴
• A has (20,5) → 𝑥 𝐴 = 0.25
𝑦𝐵
• B has (20,3) → 𝑥 𝐵 = 0.15

MRSAx,y ≠ MRSBx,y (not efficient)

So, A has a higher MRS of x for y → A values y more relative to x than B does.
That means: A wants more y, B wants more x.

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 They can trade: A gives x to B, gets y from B.

Is moving from the allocation (xA = 16, yA = 6, xB = 24, yB = 2) to the endowment allocation a Pareto
improvement?
Utility at (xA = 16, yA = 6, xB = 24, yB = 2):
• For A, UA = 16*6 = 96
• For B UB = 2*24*2 = 96
Utility at endowment:
• For A, UA = 20*5 = 100
• For B UB = 2*20*3 = 120
Both utilities increase; neither is worse off, and both are better off. Thus, it is a Pareto improvement.
Question # 2
Continuing from question 1, suppose the price of x is $1 and the price of y is $2.
a) What is the utility-maximizing basket for each consumer?
Px = 1. Py = 2
• Budget for A:
Value of endowment = (20×1)+(5×2) = 30.
Budget constraint: xA + 2yA = 30
A’s utility maximization:
UA = xA yA
𝑦𝐴 𝑃𝑥 1
MRS = 𝑥 𝐴 = 𝑃𝑦 = = 2

𝑦𝐴 1
𝑥𝐴
=2

2yA = xA
By substituting it into the budget line, we get,
xA = 15, yA = 7.5
• Budget for B:
Value of endowment = (20×1) + (3×2) = 26
Budget constraint: xB + 2yB = 26
B’s utility maximization:
UB = 2.xByB

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 𝑦𝐵 𝑃𝑥 1
MRS = 𝑥 𝐵 = 𝑃𝑦 = = 2

𝑦𝐵 1
𝑥𝐵
=2

2yB = xB
By substituting it into budget line we get,
xB = 13, yB = 6.5

b) How much of each good does each consumer want to buy or sell? Are the markets in equilibrium
at the given prices?
• Consumer A
Final: (15, 7.5)
Endowment: (20, 5)
This consumer will sell 5 units of x and will buy 2.5 units of y.
• Consumer B
Final: (13, 6.5)
Endowment: (20, 3)
This consumer will sell 7 units of x and will buy 3.5.5 units of y.
• Both Consumer A and Consumer B find it beneficial to sell good X and buy good Y, leading to a situation
where there is excess supply in the X-market (12 units for sale with no buyers) and excess demand in the
Y-market (6 units desired with no sellers). So that’s why markets are not in equilibrium at the given prices.
Question # 3
There are two consumers, Tom and Jerry, in an exchange economy. Each of them consumes two goods,
cheese and ham. There are in total 10 units of cheese and 12 units of ham available in the economy. Suppose
both Tom and Jerry like cheese and ham. That is, for each consumer, the marginal utility of cheese and the
marginal utility of ham are both positive.
a) Is the allocation where Tom consumes nothing while Jerry consumes 10 units of cheese and 12 units
of ham Pareto efficient?
This allocation is Pareto efficient.
Tom has zero goods, so the only way to make him better off is to give him some cheese or ham. But that
would hurt Jerry, no Pareto improvement is possible.

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 b) Is the allocation where Tom consumes 10 units of cheese and 12 units of ham while Jerry consumes
nothing Pareto efficient?
This allocation is also Pareto efficient.
Jerry has zero goods, so the only way to improve his situation is to give him some cheese or ham. But this
would require taking goods from Tom, making Tom worse off. Again, no one can be made better off
without hurting the other.
Question # 4
Consumer A has utility function U(xA, yA) = (xA)2(yA)3 and consumer B has utility function U(xB, yB) =
(xB)3(yB)2. A is endowed with is 10 units of x and 10 units of y and B is endowed with 5 units of x and 5 units
of y.
a) Derive the equation of the contract curve in terms of xA and yA.
Pareto Efficiency requires
MRSAx,y = MRSBx,y
1 3
𝑀𝑈 𝐴 2𝑥𝐴 .𝑦𝐴 2𝑦
MRSAx,y = 𝑀𝑈𝑥𝐴 = 2 𝑦2
3𝑥𝐴
= 3𝑥𝐴
𝑦 𝐴 𝐴

2 2
𝑀𝑈𝑥𝐵 3𝑥𝐵 .𝑦𝐵 3𝑦
MRSBx,y = 𝑀𝑈𝑦𝐵
= 3 𝑦1
2𝑥𝐵
= 2𝑥𝐵
𝐵 𝐵

2𝑦𝐴 3𝑦𝐵
=
3𝑥𝐴 2𝑥𝐵

x = xA + xB = 15 so, xB = 15 - xA
y = yA + yB = 15 so, yB = 15 - yA
2𝑦𝐴 3(15 − xA)
3𝑥𝐴
= 2( 15 − yA )

By solving the above equation, we get the contract curve in terms of xA and yA.
Contract curve = 27xA – xAyA – 12yA

b) Set x as a numeraire. That is, assume the price of x is $1. Find the competitive equilibrium allocation
and the equilibrium price of y.
Px = 1
Budget constraint for A: xA + P.yA = 10 + 10Py
Budget constraint for B xB + P.yB = 5 + 5Py
According to the tangency condition:

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 𝑃
MRSAx,y = MRSBx,y = 𝑃𝑥
𝑦

For Consumer A:
2𝑦𝐴 1
3𝑥𝐴
=𝑃
𝑦

𝟐
𝟑
PyA = xA eq 1

Put this into the budget constraint.

2
3
Py yA + Py .yA = 10 + 10Py
5
3
Py yA = 10 + 10Py

Py yA = 6 + 6Py
𝟔+𝟔𝑷𝒚
yA = 𝐏𝐲
𝒆𝒒 𝟐 Substitute it in 1
2
3
PyA = xA
2 6+6𝑃𝑦
Py ( ) = xA
3 Py

xA = 4 + 4Py eq 3
For consumer B:
3𝑦𝐵 1
=
2𝑥𝐵 𝑃𝑦

𝟑
PyB = xB eq 4
𝟐

Put this into the budget constraint.

xB + P.yB = 5 + 5Py
3
2
Py yB + Py yB = 5 + 5Py
5
2
Py yB = 5 + 5Py

Py yB = 2 + 2Py
𝟐+𝟐𝑷𝒚
yB = 𝐏𝐲
eq 5 substitute it in eq 4
3
2
Py yB = x B
3 𝟐+𝟐𝑷𝒚
2
Py 𝐏𝐲 = xB

xB = 3 + 3Py eq 6
for market clearing

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 xA + xB = 15
(4 + 4Py) + (3 + 3Py) = 15
𝟖
Py = 𝟕

Equilibrium Allocation:
8 60
• For xA = 4 + 4Py = 4 + 4(7) = 7
8
𝟔+𝟔𝑷𝒚 6+6( ) 45
• For yA = 𝐏𝐲
= 8
7
= 4
7

8 45
• For xB = 3 + 3Py = 3 + 3(7) = 7
8
𝟐+𝟐𝑷𝒚 2+2( ) 15
• For yB = = 8
7
=
𝐏𝐲 4
7

*******the end*******

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