Problem Set 8.

General equilibrium analysis

EconS 526

1. We have two agents with indirect utility functions: 1 = ln1 ln (1 )ln and 2 =
ln2 ln (1 )ln where 1 and 2 are income levels for person 1 and person 2
respectively, while and are the prices of goods and , respectively. The initial
endowments for person 1 and person 2 are 1 = ( = 1, = 1) and 2 = ( = 1, = 1),
respectively. Calculate the market clearing prices.

We only need to do this for one good since only relative prices matter. First, derive demand for good 1
using Roys identity,
1 2
Person 1: 1 = and Person 2: 2 = . Wealth of person 1 is 1 = 1 + 1 = + and for

person 2 it is 2 = 1 + 1 = + .

So aggregate demand is,

1 2 ( + ) ( + )
1 + 2 = + = + = + + ( + )

Since aggregate supply is 2, we will have,

+ + ( + ) =2

Which means,

2
= 1
+

2. Consider an economy with 15 consumers and 2 goods. Consumer 3 has a Cobb- Douglas utility
function = ln + ln. At a certain Pareto efficient allocation, x*, consumer 3 holds (x=10,
y=5). What are the competitive prices that support the allocation x*?

In equilibrium the MRS for all consumers will be equal to each other and the relative price. In this case,

1

3
= = = =
1

Since x=10, y=5 we have,

 5
= = 0.5
10

3. Person A has a utility function = x + y and person B has a utility function = max(, ).
a. Illustrate the situation in an Edgeworth box diagram.
b. What is the equilibrium relationship between px and py?
c. What is the equilibrium allocation?

a
B

b.

Here, since there is going to be a corner solution and preferences for one good over the other are
equally weighted in the utility function, we expect Px=Py.

c. We expect at least one of the goods to all go to one person. If they end up in the corner of the box, all
will go to one person, while the other gets the rest.