ECO 305 — Fall 2003

Precept Week 7 material

Questions

Question 1 — Pareto-Efficient Allocations

Consider a two-good, two-person exchange situation. There is one (perfectly divisible) unit
of each of two goods, food (F ) and clothing (C). There are two consumers, Ann and Betty.
Denoting their consumption quantities by FA for Ann’s consumption of food etc., their utility
functions are
UA (FA , CA ) = FA CA , UB (FB , CB ) = (FB )2 CB .
Find expressions for their marginal rates of substitution. For Pareto efficiency, the two MRSs
should be equal. This gives you one equation linking the four quantities FA , CA , FB , CB .
There are two other equations, namely the “material balance” requirements that for each
good, the amount allocated to the two consumers should add up to the total available:

FA + FB = 1, CA + CB = 1 .

Use these to solve for CA , FB , and CB , each of them as a function of FA .

Draw a graph with FA on the horizontal axis and CA on the vertical axis. Remember
that the total amounts of each are 1, so only the portion of the graph in the unit square
(0 ≤ FA ≤ 1, 0 ≤ CA ≤ 1) has economic significance.
This graph is in fact an Edgeworth box (textbook Ch. 9 pp. 216—221), whose sides equal
the total quantities of food and clothing available in the economy. With Ann’s quantities
measured from the usual origin, Betty’s quantities are automatically the residuals, as if they
were measured from an origin at the diagonally opposite point (1, 1) and axes going to the
left and downward. In this box, note that the graph you drew lies above the 45-degree line?
What is the intuition for this?

Question 2 — Competitive Equilibrium

Suppose that in the above example, Ann initially owns the unit of food and Betty owns the
unit of clothing. They can exchange these goods, acting as price-takers. Denote the price of
food by PF and the price of clothing by PC .
(1) Write down their demand functions.
(2) Using the demand functions, find their price-consumption curves, also called offer
curves, and show them in a diagram.
(3) You will have found that the offer curves are horizontal and vertical. Explain the
intuition for this.

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Question 3 — Extreme Cases of Offer (Price-Consumption) Curves
Here the indifference curves have kinks or flat segments, so calculus methods cannot easily
be used to find optima. It is much easier to use geometric intuition.
(a) Ethan Ol gets his utility from alcohol, the more the better. There are two sources
of alcohol, Gin and Vermouth. Each bottle of Gin has twice as much alcohol as a bottle
of Vermouth. Draw Ethan’s indifference curves. Find a utility function to represent his
preferences.
Suppose Ethan has 2 bottles of Gin and 3 bottles of Vermouth, and can trade with
someone else (fractional and even irrational bottles are OK). Draw Ethan’s offer curve.
(b) Gatsby drinks martinis, which have to be in fixed proportions of 4 parts Gin to 1
part Vermouth. For example, if he gets 5 bottles of Gin and 1 of Vermouth, then he can
make and drink martinis from 4 bottles of Gin and 1 of Vermouth, and the extra bottle of
Gin goes to waste. It doesn’t do him any harm, but doesn’t do him any good either. Draw
Gatsby’s indifference curves. Find a utility function to represent his preferences.
Suppose Gatsby starts out with 4 bottles of Gin and 2 bottles of Vermouth, and can
trade with someone else (again fractional and even irrational bottles are OK). Draw Gatsby’s
price-consumption curve.

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 ECO 305 — Fall 2003
Precept Week 7 material

Answers

Question 1 — Pareto-Efficient Allocations

Ann’s MRS is

dCA

∂UA /∂FA CA
−
= = .
dFA UA =constant ∂UA /∂CA

FA
Betty’s MRS is


dCB

∂UB /∂FB 2 FB CB 2 CB
−
= = 2 = .
dFB UB =constant ∂UB /∂CB

(FB ) FB

Equating the two, the efficiency condition is

CA / FA = 2 CB / FB .

To solve for the other three variables in terms of FA , begin with FB = 1 − FA . Then the
efficiency condition gives
2 FA
CA = CB .
1 − FA
Therefore  
2 FA 1 + FA
1 = CA + CB = + 1 CB = CB .
1 − FA 1 − FA
Then
1 − FA
CB = ,
1 + FA
and substituting into the above equation for CA in terms of CB , finally
2 FA
CA = .
1 + FA
Figure 1 shows the graph of this, as the thick curve extending from OA to OB . It lies above
the 45-degree line. The reason is that Betty has a relatively stronger preference for food over
clothing than does Ann. Therefore it is efficient to give Betty an appropriately lower ratio
of clothing to food than is given to Ann (CB /FB < CA /FA ). In fact the mathematics gives
a more precise relationship: CA /FA is exactly two times CB /FB .

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 FB
O
B
OC
A
OC
B C
B
C
A

O F
A A

Figure 1: Pareto-efficient allocations and competitive equilibrium

Question 2 — Competitive Equilibrium

Ann’s budget constraint is
PF FA + PC CA = 1 × PF .
She has a Cobb-Douglas utility function with powers 1 and 1. Therefore her demand func-
tions are
1 PF 1 1 PF PF
FA = = CA = = .
1 + 1 PF 2 1 + 1 PC 2 PC
Her price-consumption curve is found by eliminating PF /PC between these to leave a rela-
tionship between FA and CA ; here it becomes simply FA = 12 , a vertical line in the figure.
Betty’s budget constraint is

P F FB + PC CB = 1 × PC .

She has a Cobb-Douglas utility function with powers 2 for food and 1 for clothing. Therefore
her demand functions are
2 PC 2 PC 2 PC 1 PC 1
FB = = = CB = = .
2 + 1 PF 3 PF 3 PF 2 + 1 PC 3
Her price-consumption curve is found by eliminating PC /PF between these to leave a re-
lationship between FB and CB ; here it becomes simply CB = 13 , a horizontal line in the
figure.
The reason is that in Ann’s demand for food, the income effect of a price change exactly
offsets the substitution effect, leaving a perfectly inelastic Marshallian demand. Similarly
for Betty’s demand for clothing. (Note that a similar thing happens with the labor supply
of a consumer for whom wages are the only source of income, and whose utility function is
Cobb-Douglas in consumption and leisure.)

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Question 3 — Extreme Cases of Offer (Price-Consumption) Curves
(a) Straight Line Indifference Curves: Perfect substitutes
The indifference map is shown in Figure 2:
V
slope = 2

G
Figure 2: Indifference curves with perfect substitutes

A utility function to represent these preferences is

U (G, V ) = 2 G + V

but any monotone increasing transformation, for example (2 G + V )3 or e2 G+V , will do just
as well.
All budget lines pass through the initial ownership (endowment) point (2,3). For those
with slope < 2, the optimum is along the G-axis; for those with slope > 2, the optimum is
along the V -axis; for the one with slope = 2, all points on the initial indifference line are
equally good. Therefore the price-consumption curve consists of three line-segments, shown
thick (and red in the color version) in Figure 3.

(2,3)

Figure 3: Offer curve with perfect substitutes

(b) L-shaped Indifference Curves (Zero substitution; “perfect complements”)

(Note: Since there are only two goods, they cannot be complements. That is why I prefer
the term “zero substitution,” although I know that “perfect complements” is often used in
this context.) See the explanation in the handout of Oct. 21 titled Midterm Review Session,
item (1) near top of p. 5.)

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 V

G=4V

Figure 4: Indifference curves with zero substitution

The indifference map is shown in Figure 4:

A utility function to represent these preferences is

U (G, V ) = min(G/4, V )

but any monotone increasing transform of this will do just as well.

All budget lines pass through the initial ownership (endowment) point (4,2). For all
positive prices, the optima are along the line G = 4 V , stretching from (4,1) when the
budget line goes vertical, to (8,2) when the budget line goes horizontal. This is shown in
Figure 5. The vertical and horizontal portions correspond to the extreme situation where the
price of one of the goods is zero. Then the consumer can get more of that good at zero cost.
The amounts to the right or above the corner of the L do not give him any extra utility, but
when the price is zero they do not cost him anything either. Therefore they are all equally
optimal. It is usually pedantic to show these portions of the offer curve, but sometimes offer
curves may intersect on such a portion, leading to an equilibrium where one of the goods
has zero price.

(4,2)

G=4V

Figure 5: Offer curve with zero substitution