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Universidad Carlos III

Microeconomic Theory
Final Exam
May 24, 2023
Marco Celentani

Instructions: Please, read carefully the following instructions.

• You have120 minutes.
• On the desk, apart from this booklet, you can only have: a calculator, a couple of pens and/or pencils,
a ruler, a piece of identification. Please, leave everything else (e.g., laptops, mobile phones, backpacks,
purses, folders, jackets, sweaters, scarves, etc.) on the hangers or near the blackboard.

• Do not separate any sheet from this booklet. Do not talk to any other student during the exam. Do not
give any material to any other student.
• Check that this booklet contains 10 stapled sheets, numbered from 1 to 10.
• Attempt to answer each question in the space reserved for it (you can use both sides of pages). You can
use pens and/or pencils. Notice that you will not be given any additional paper.

1
 1 Equilibrium and efficiency in an exchange economy
Consider an economy with two consumers, A and B, and two goods, X and Y .
1. Suppose that utility functions are UA (xA , yA ) = xA yA
3
, UB (xB , yB ) = xB + yB and that total initial
endowments are X, Y = (2, 2).
7 (a) Find Pareto optimal allocations and represent them in an Edgeworth box.
7 (b) Suppose that initial endowments are (xA , y A , xB , y B ) = (1, 1, 1, 1). Find Walrasian equilibrium
allocation and prices and represent the Walrasian equilibrium in the Edgeworth box.
7 (c) Are there initial endowments (xA , y A , xB , y B ) that lead to a Walrasian equilibrium in which (p⇤X , p⇤Y ) =
(1, 2)? If so, find all such initial endowments, otherwise explain why not.
7 (d) Are there initial endowments (xA , y A , xB , y B ) that lead to a Walrasian equilibrium in which (p⇤X , p⇤Y ) =
(2, 1)? If so, find all such initial endowments, otherwise explain why not.
7 (e) Suppose again that (xA , y A , xB , y B ) = (1, 1, 1, 1) but suppose now that there are three individuals of
type A and two of type B. Find Walrasian equilibrium prices and allocation.

2. Suppose that utility functions are UA (xA , yA ) = min {xA , yA }, UB (xB , yB ) = (xB + 1) (yB + 1) and total
initial endowments are X, Y = (2, 4).
7 (a) Find Pareto optimal allocations and represent them in an Edgeworth box.
8 (b) Suppose that initial endowments are (xA , y A , xB , y B ) = (0, 3, 2, 1). Find Walrasian equilibrium
allocation and prices and represent the Walrasian equilibrium in the Edgeworth box.
3

1. (e) MRS?"(XA,y): -- -- 1 MRS,* (x, y) <=)

ya 3XA
=
=
-

xB -

z
XB

XB 1 OB
2 I
XA XB
=
+

2
S
allocation
WE y=3/2 7
I y,=

2
ya 7i3
=
+

B
L

Ja 1
= 1 =

INSTAL
ENDOWMENT
7

price line
WE
2
with slope >
XA

En
-
Px =
-
1 2

48 allocation
OA
conjecture:WE interior I
(b) is

(1) Ya3xA
=

Nermalize 4x =
1 =
41
Px Py
=
=

Px YA P-ya
+

(2)
+

substitute (PY, PY)=(1,1) into (2) 2(3)

XA+YA=

(1) into (i) xa 3 x

a +
2
=
4XA 2
=

x I. x*
= =
into (1)
I G=
Conjecture is verified. From market
clearing (x3,45): (=E)
(c) + (0)) For interior PO allocations (y 3 xA):
=

i MRS?"(XA, 21) MIS,s,a

-
= = -

1
=

allocations (YA*2, 4(3,1]):-i MRS"(x1,2) xa

=

For
= -

corner PO

Given thatfor 40 allocations MRs*"(**,2a) e)-1, 5], (1x,) (1,2)

=
-

corner

is possible but (F,,P?)=(2,1) is impossible.

x=
From
* - -

- -
-MRS"
(x2), ** 2 =

of initial endowments
set
xaI Xa
6()2yz B
=

prices
- =

WE
price line:a 2
leading to WEwith
=

2ya
= =

+
2
+ -
=

(P,,i,) (1,2). =
 (e) xaC4x,R) 4*
=
"CAx 8m SPx,Py) =

* y

3xA 2xB
+
5
=

(Mx)

33A+2y3 5
=
(MY)

conjecture:WEis
interior ->
I = -1 MRS,"" (x5.33)
=

Normalize Px*=1 => B 1.

=

substitute(P2,4):(1,1) into (ax) and (BX)

xa 4* (4)
=

=
2 2* (5)
=
=

substitute (4) and (5) into (MX), (MY)

3.2 2.xB
+

5()2x
= 5
= -

z E( 3x3=
=

E(6)
=

3.2 2y5 5
z I2 I (7)
)2y
=

5
= =
+

= - =

Because (43-(7) conjecture

verify the In WE (Px,R,)=(1,1) and

(x, y, x5,y5) (, =

=,t)
2. (a) (3) Optimality for A: YATPx, P4) pe
=

a(x, py)
=

YA a xB* optimally for B

XB 2 I OB
·
S
4 MRSpY(XB, yb) =

-, * =
-
6,
*

*** + 1) 1-

PxYB PyB 24x P(9)

+
+

INITIAL 37

4y(*(, 1) 24x Py
ENDOWMENT
18) into (9) 1)
+

+
=

4xxB +
-

2
Py 24x Py
=

PxYB PxYB 4x
+

price line
7 + + -

WE
with slope
-* 2

24xxB Px 2Py
=-

Es
=
+

WEallocation
X=1 3 y,
=

24"
7

xB =
(10)

I 2
4
>
10) into 187 y, *** (+)-
*

XA 3
(x24 35x 24 24
0 11
+
-

1
=
- =
-

ya* 2
Py
V 2Py

Xa(4x,4y)
=>

= ya(4x, 44) 32
=

for Y
YAx, 4y) and y,(4x, Py) into
market clearing
6 34x(4x 1)
3P, 3Px
+

4y=12 8Px 8
4,6
=

I
+
+

4,
= +

Normalize
+
=

4
=

↑x +

1 2(Px 1) +

=(25
=(4,x,) (2,1)
24 2
5
5 17 -
+

344 z 0 Px
=
=

54x
=
-
-
=
=
6 6
--,x
substitute (PI,1) into xA(Px, Py) => Xa(2,1) 23
=
1
=

x y
=
= (X,,y,) (1,3)
=
=
 2 Equilibrium and efficiency in a production economy
Consider an economy with one individual, A, and one firm X. A has 24 hours available that he can distribute
between leisure and work. The individual’s preferences are represented by utility function UA (lA , xA ), where lA
represents time allocated to leisure and xA the quantity consumed of good X. Good X is produced by firm X
with labor as the only input according to production function xX = fX (lX ), where xX represents the quantity
produced and lX represents labor input (in hours). Individual A is the owner of firm X. Let w represent the
wage (or price of one hour) and p represent the price of good X.
p
1. Suppose that UA (lA , xA ) = lA xA and that xX = fX (lX ) = 2 lX .
10 (a) Derive the Pareto optimal allocation.
6 (b) Represent the consumption possibilities set (set of feasible allocations (lA , xA )) on a graph with lA
on the horizontal axis and xA on the vertical axis. Locate the Pareto optimal allocation on the
consumption possibilities set.
8 (c) Find Walrasian equilibrium prices and allocation.
2 (d) Represent the Walrasian equilibrium in the graph.

2. Suppose that UA (lA , xA ) = lA + 2xA and that xX = fX (lX ) = lX .

(a) Derive the Pareto optimal allocation.
14 ( (b) Represent the consumption possibilities set (set of feasible allocations (l
A , xA )) on a graph with lA
on the horizontal axis and xA on the vertical axis. Locate the Pareto optimal allocation on the
consumption possibilities set.
8 (c) Find Walrasian equilibrium prices and allocation.
2 (d) Represent the Walrasian equilibrium in the graph.

1. (a) mx Un SCA, XA7=lAXA

max (A(224 2A) -

&A, XA A
( =]
o
1x, xx

S.t. x
x
=

fx(lx) 2
=

x(i) a
FOC 2 24-la-la (24-ea)

la ex 24
+ =
eA(2)
=

2(24 2)* ea(24 2a)

-
=
-
=

(3)
xA x
=16
=

x
48 39A
2(24 2A) 2A
=

substituting
=
-

(2) into (1)

result
the
substitute A 16 into (2)
=
=
>
,
8.
=

and
into (3)
substitute ex=8 into (1) Yx 5.66 YA.
=
=
=

(b) (0))
+

As indifference curve
XA a

WEallocation
L PO allocation:
fx(24) 9.8
=

price lime
WE with

x =x xx 4x 5.66
= =
=
L slope -

=-0.416
CPF
with
E
equation
>
x= 2V24 -lA
=

0
" 24 /A
Ex TA

"n*
-

x Ta 5
=
-

8
=

x)(2,x,lX,xx) (ea,Xa,ex,xx) (16,5.66,8,5.66)

=

5
A

-- .
5.66 Normalize P=1 => W* 0.416

MRS*(e,x)
=

-0.416
=
= -

= -

16
(a) (b) ())
+
+

X a PO allocation WE
:
allocation
A
L
with slope
fx(24) 24
=

As indifference curve

MRS*(Xa,2)
= -

I
2

with
CPF

equation xA=24-1A

>
0
24
CA

PO allocation (In,Ya, x, xx) (0,24,24,24)

=

x) (X,15,xi) (e,Ya,ex,Yx) (0,24,24,24)

=
=

To obtain WE notice thatfirm X has interior optimum

prices

(x420) and was returns

constant to scale and therefore
w*
0( 24p 24w0( )p*
w*.1,
=

profit p*xY*
=
= -
=
-
zero

Normalize wt 1= >
=
p*I
=

6
 3 Externalities
Consider two individuals A and B whose utilities depend on their consumption of money, denoted by xA for
individual A and xB for individual B, and the speeds at which they drive, denoted by sA for individual A
and sB for individual B. Assume that initial endowments of money for xA for A and B are (xA , xB ) = (2, 1).
p
Assume that the utility function for A is UA (sA , sB , xA ) = sA + xA sA 2 (sA + sB ), where the first term,
p p
sA , denotes the (gross) utility of driving at speed sA , the third term, sA , denotes A’s fuel cost from driving
at speed sA and the fourth term 2 (sA + sB ) indicates that when individuals A and B drive at speeds sA and
sB there is probability sA + sB of an accident and in this case individual A bears a cost 2 (for example, the
cost of fixing his car or health-care expenses). Similarly, assume that the utility function for individual B is
p
UB (sA , sB , xB ) = sB + xB sB 2 (sA + sB ).
10 1. Suppose that A and B choose simultaneously and independently their driving speeds. Find the equilibrium
driving speeds s⇤A = s⇤B = s⇤ . Compute total equilibrium utility, U ⇤ = UA⇤ + UB⇤ .

10 b =
2. Find the Pareto optimal driving speeds sbA = sbB = sb. Compute the corresponding total utility U
bA + U
U bB .

3. Consider now the following alternative remedies to attain Pareto optimality.

10 (a) A gasoline tax is introduced such that, for i = A, B,driving at speed si has cost (1 + ⌧ ) si , (rather
than si ). Find the value of the tax ⌧e such that in equilibrium A and B choose driving speeds
e=U
sA , sbB ). Compute the corresponding total equilibrium utilities U
sA , seB ) = (b
(e eA + U
eB , total tax
e f e
revenue, R, and total surplus T S = U + R. e
10 (b) In case of an accident each driver bears his own cost, but also has to pay the government an ad-
ministrative fine ↵; in other words, in case of an accident the cost to each driver is 2 + ↵ (rather
than 2) and therefore the expected cost of an accident is (2 + ↵) (sA + sB ) (rather than 2 (sA + sB )).
Find the value of the administrative fine ↵ e such that in equilibrium A and B choose driving speeds
sA , sbB ). Compute the corresponding total equilibrium utilities U
sA , seB ) = (b
(e e = UeA + U eB , total
administrative fine revenue, R,e and total surplus TfS = Ue + R.
e

10 (c) A speeding fine ' is imposed for driving at a speed above sb. Find the minimum fine ' e such that
in equilibrium A and B choose driving speeds (e sA , seB ) = (bsA , sbB ). [Hint: Suppose that driver B
drives at speed sb and consider the utilities driver A obtains in the following two scenario: (i) Also
drive at speed sb and pay no fine; (ii) Pay fine ' and drive at the speed he prefers.] Compute the
corresponding total equilibrium utilities Ue = U eA + U eB , total revenue from speeding fines, R,e and
total surplus TfS = Ue + R.
e

1. max Up (SA, SB, XA) Y5A

= + XA-SA-2/SA+SB)
SA
FOC
I S -1 - 2 0
=
) s 6
=
= S* 5
=

s
=

4
55 5
6 72
5 2.03
1 -

2(555) 5
-
+
=

2
=(3,5,Ya) 6 55
-
-
= =
+

2
=
-

36
-
+

4
55 5
6 36
2 1.03
1 -

2(5 55) 5
-
+
=

1
n (2,5,y,) 6 55
-
-
= =
+
=

1
-

36
-
+

=
=

u* u+4
=

E515
=
+ = = 3.66
=

Xa+YB-Sa-Sis 4 (Sa + Si)

UACSA, Si, XAL+Ui(SA, SB, XB) YA Bis
-

=
+ +
2. max

SA, S4

FOC
ISR-1-4 0
= SE co a =Si =

5-
=Foto +2+ 1-
to to -4(ti)= + -- *
-
3
50- 55==
=
3.

8
 (External cost
3. (a) E 2
=
marginal
10 200-1-4-2_203
(iooio) id +2 -
+

2.05

Ya Ua)5a,
-2 - =

5B, YA) E.5A i

- =

2 100
-

100
-
+
=
-
=

10 100-1-4-2_10
(ioioo)-2 id" is do g=
+

- -
1.05
=

Y 4)5a, E5 i 1 100
-

100
55, x)
-
+
=
-

Y Ya 4p 5
=
+
=

5
5
= 3.06
=

- 50
UACSA, XA)-a(SA+Sis) VSA XA-SA-(2 1) (SATSB)
+
+

(b) max SB,

=

SA

FOC S*
I
-
1-12 2) + 0
=

(1)

substitute into into (1) I -s-6 0

=

4 05 3 0 2
1.10
=

1 2
-
- -
- = =

inesis asses 250-2000-200-o-i2 too-twoo-i e

100 100

=
1.01
100 100

Y Ya 4p 2
=
+
=

2
= 3.02
=

-2 -5-oe
10
200-1-4_5=
+

Fo+2-too-2/it) to +2-o
= 2.5
100
U5.5, XA)
-

(C) (i)
=

Samario

-Sa-2(SA+ 52)-4
UnCSA, Si, XA) 4 5A+2
=

Scenario (ii)
-

max

SA
S*-1 Sa 5s
=

2 0 =
FOC
- =

I
68
y 25 p 6 9
24 4
-

2.063

55 25 6) 4 5 55
= - -
-
=

UA(S.5A,Xa) -p 5
- -
+ - =
-
=

2
+
-

900
= -
+

scenarios the
(and therefore respect speed limiti
indifferentbetween
two
to make A
Minimum P
Xa) P
Un5, 5B, XA) UACS.A,
-

619
5 5 0.013
615
y 5 28
-
=

45 5
= =
-

pc
= -

-
,
300
=

or

- icoi) +
200- 1- 4
10 205 2.05
+

Yaa) 5a,
2
5B, YA) i6
-
- =
=

2
=
-

100 100
=
+

- icoio) 18-
10 +
105
- 1.05
45Up)5,55,YA) i
- I =

1
=
-

100
=
+

I Ya 4 y 3.1
=

= =
=
+

R =
0

9
Is 4 R =
+

B
=
3.1
=