Question

Oscar and Elmo make up a simple exchange economy where the only goods are books and cookies.

                  Total books = 10

                  Total cookies = 5

a) Elmo has 7 books and 2 cookies. Draw the Edgeworth box. Label the endowment with ω and how much each person is consuming (or reading) at that point. Also label Elmo’s origin (O_E) and Oscar’s origin (O_O), and label along which axis each good is increasing for each person.

b) On your graph from part a, draw an indifference curve for each person (label them I_E and I_O) such that the endowment is NOT Pareto Efficient.

c) On your graph from part a, draw a point that represents a Pareto improvement relative to the endowment. Label it P₁.

d) Define Pareto improvement and explain how P1 satisfies that definition.

e) At a Pareto Efficient allocation in this type of exchange economy, what must be true of the agents’ Marginal Rates of Substitution (MRS)?

f) Given the following marginal rates of substitution for the two individuals over the two goods, is the allocation where Elmo has 2 cookies and 7 books Pareto efficient? Justify your answer fully.

                  MRS^E_bc = 2b + c

                  MRS^O_bc = 2c/b

g) What does the First Fundamental Theorem of Welfare Economics tell us about all initial allocations in a simple exchange economy? Under what (2) assumptions?

Answer 1