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Question 6

The document discusses the First Theorem of Welfare Economics, also known as the Pareto Efficiency Theorem. It states that in competitive markets where consumers are price-takers, the competitive equilibrium will result in a Pareto efficient allocation. This is demonstrated using indifference curves, budget constraints, and the condition that the marginal rate of substitution must equal the price ratio for consumers to maximize utility. The competitive equilibrium occurs at the tangency point between indifference curves and the price line on an Edgeworth box diagram, resulting in an efficient allocation where no consumer can be made better off without making another worse off.

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21 views

Question 6

The document discusses the First Theorem of Welfare Economics, also known as the Pareto Efficiency Theorem. It states that in competitive markets where consumers are price-takers, the competitive equilibrium will result in a Pareto efficient allocation. This is demonstrated using indifference curves, budget constraints, and the condition that the marginal rate of substitution must equal the price ratio for consumers to maximize utility. The competitive equilibrium occurs at the tangency point between indifference curves and the price line on an Edgeworth box diagram, resulting in an efficient allocation where no consumer can be made better off without making another worse off.

Uploaded by

arsenengimbwa
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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QUESTION 6.

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Solution

i. The aim is to minimize expenditure (cost) with the utility level


U(X, Y) =XY² subjective
C= Px.X+Py.YObjective

ii. Derive Jennifer Hicksian demand

Solution.

L = Px. X +Py. Y+ ƛ (U-XY²)

Taking partial derivative of L with respect to (X), (Y) and (ƛ) and setting them to zero
will give us Hicksian demand functions for (X) and (Y)

ʠL/ʠx=Px-y² ƛ=0
PX=Y²ƛ ……………………………………... (i)

ʠL/ʠY=Py-2xyƛ=0
Py=2xyƛ ……………………………… (ii)

ʠL/ʠƛ= (U-xy²) =0
U-xy²=0
U=xy² ………………………. (iii)

Divide equation (i) and equation (ii)

PX=Y²ƛ /Py=2xyƛ

Px/Py=y²ƛ/2xyƛ

Px/Py=y/2x

Y=2X. Px/Py…………(iv)

Substitute equation (iv) into utility function (U=XY²)

U=XY²

U= X. (2x. Px/Py) ²

U=X.4X² (Px/Py) ²

U=4X³ (Px/Py) ²
4X³=U/(Px/Py) ²

4X³/4=U/4(Px/Py) ²

(X³)⅓=¿(U/4. (Py/Px) ²) ⅓

X = (U/4. (Py/Px) ²) ⅓

From equation (iv)

Y=2X.Px/Py

But, X = (U/4. (Py/Px) ²) ⅓

Then;

Y = 2(U/4. (Py/Px) ²) ⅓.Px/Py

Y = 2/4⅓. U⅓.Py⅔/Py.Px/Px⅔

Y = 2⅓U⅓. (Px/Py)⅓

Y= (2U Px/Py) ⅓

iii. Derive expenditure function

Consider, C = Px. X+ Py. Y

Whereby; X = (U/4. (Py/Px) ²) ⅓ and Y = (2U Px/Py) ⅓

Then;

C=Px. (U/4 (Py/Px) ²) ⅓ +Py (2UPx/Py) ⅓

C= Px/Px ⅔. (U/4. Py²) ⅓ +Py/Py⅓. (2UPx) ⅓

C=Px⅓ (U/4. Py²) ⅓+Py⅔ (2UPx) ⅓

C= (Px. U/4.Py²) ⅓ + (Py².2UPx) ⅓

C = (Px. UPy²) ⅓ (1/4 + 2) ⅓

C = (Px. UPy²) ⅓ (9/4) ⅓

C = 3 (Px. UPy²)/4) ⅓
QUESTION 4

The First Theorem of Welfare Economics, also known as the Pareto Efficiency
Theorem, states that in perfectly competitive markets with price-taking consumers, the
competitive equilibrium is Pareto efficient.

Consider consumers 1 and 2 with endowments (W1^x, W1^y) and (W2^x, W2^y)
respectively, and prices p1 and p2 for goods X and Y. In a competitive equilibrium, each
consumer maximizes their utility subject to their budget constraint.

Let's denote the utility functions as U1 and U2 for consumers 1 and 2. The budget constraints
can be expressed as:

p1 * X1 + p2 * Y1 = W1^x * p1 + W1^y * p2

p1 * X2 + p2 * Y2 = W2^x * p1 + W2^y * p2

In equilibrium, the marginal rate of substitution (MRS) for each consumer must equal
the price ratio (p1/p2). This ensures that consumers are allocating their resources efficiently.

The diagram would show the budget constraint and the indifference curve for each
consumer, with the tangency point representing the equilibrium where the MRS equals the price
ratio.

In this equilibrium, the allocation is Pareto efficient because no further reallocation of


goods can make one consumer better off without making another worse off. This is a key result
of the First Theorem of Welfare Economics, highlighting the efficiency of competitive markets
when certain conditions are met.
Now, according to the first theorem of welfare economics, assuming we have perfect
competition and price-taking behavior, the competitive equilibrium will occur where the
consumers' indifference curves are tangential to the price line, representing the ratio of prices of
goods X and Y.

At the competitive equilibrium, the consumers' marginal rates of substitution (MRS) will be
equal to the price ratios for both consumers. This means that they are consuming in a way that
maximizes their individual utilities given the market prices.

On the Edgeworth Box diagram, the competitive equilibrium is the point where the
consumers' indifference curves are tangent to the price line, and the contract curve generated by
this equilibrium will represent the Pareto-efficient allocation of resources.

Generally, This illustrates the first theorem of welfare economics, as it demonstrates how in
a perfectly competitive market, under certain conditions, the equilibrium allocation of resources
will maximize social welfare, leading to a Pareto-efficient outcome where no further trades can
make any consumer better off without making another worse off.

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