Financa Publike Analiza Normative

CHAPTER 10 General Equilibrium and Economic Welfare

MULTIPLE CHOICE Choose the one alternative that best completes the statement or answers the question.

1) General equilbrium analysis is the study ofA) how an equilibrium is determined in all markets simultaneously.B) how an equilibrium is determined in all closely related markets.C) the effects of a change in a market, and all spillover effects in all related markets.D) All of the above.

Answer: DDiff: 0Topic: General Equilibrium

2) Joe and Rita each have some cookies and milk. Joe is willing to trade 2 cookies for anadditional ounce of milk. Rita is willing to trade 4 cookies for an additional ounce of milk. If trading is possible, which of the following is most likely to occur?A) Joe will give some milk to Rita in exchange for cookies. B) Rita will give some milk to Joe in exchange for cookies. C) No trade will take place since they both prefer to have more milk and fewer cookies. D) There is not enough information to make any predictions.

Answer: A Diff: 1Topic: Trading Between Two People

3) Joe and Rita each have some milk and cookies. Joe's MRS of cookies for milk is 2. Rita's MRS of cookies for milk is 4. Which of the following statements is TRUE? A) No gains from trade are possible. B) Both Rita and Joe can be made better off if Rita gives Joe some cookies in exchange for milk. C) Rita and Joe are on the contract curve. D) Both Rita and Joe can be made better off if Joe gives Rita some cookies in exchange for milk.

Answer: B Diff: 1Topic: Trading Between Two People

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Chapter 10/General Equilibrium and Economic Welfare

4) Gains from trade can only occur when A) marginal rates of substitutions differ across people. B) marginal rates of substitution are equal across people. C) indifference curves are convex. D) people find themselves on the contract curve.


5) Moving away from the contract curve will A) harm both parties. B) harm only one of the parties. C) harm at least one of the parties. D) harm neither of the parties.

Answer: C Diff: 1Topic: Trading Between Two People

Figure 10.1

6) Figure 10.1 depicts the Edgeworth box for two individuals, Al and Bruce. The contract curve can found by connecting points A) a and b. B) a and c. C) b and d. D) c and d.

Answer: D Diff: 1Topic: Trading Between Two People

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7) If only two people are trading their endowments and no production is possible, then the equilibrium they reach willA) be on their contract curve.B) result in unequal marginal rates of substitution for the two people.C) result in one person being worse off than with his or her endowment.D) All of the above.

Answer: ADiff: 1Topic: Trading Between Two People

8) Figure 10.1 depicts the Edgeworth box for two individuals, Al and Bruce. If the endowment is at point a and trade is possible, which of the following points are possible equilibria? A) a and bB) a and c C) b and d D) c and d


9) Figure 10.1 depicts the Edgeworth box for two individuals, Al and Bruce. Considering only the labeled points, point c is a possible equilibrium A) only if it was the endowment. B) only if point a is the endowment. C) if either point a or b is the endowment. D) only if point d is the endowment.


10) Figure 10.1 depicts the Edgeworth box for two individuals, Al and Bruce. If the endowment is at point a, and Al has no ability to bargain, the final allocation will be at point A) a. B) b. C) c. D) d.


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11) Figure 10.1 depicts the Edgeworth box for two individuals, Al and Bruce. Point a is not Pareto efficient because A) Al's MRS exceeds Bruce's MRS. B) the point is not near the center of the box. C) Al's indifference curve is not far enough away from the origin. D) All of the above.


12) Figure 10.1 depicts the Edgeworth Box for two individuals, Al and Bruce. Point c is Pareto efficient because A) the MRS's are equal. B) the indifference curves are tangent. C) no mutual gains from trade exist. D) All of the above.


13) Gains from trade will be possible as long as A) people have different endowments. B) people place different values on some goods. C) marginal rates of substitution are equal across individuals. D) excess supply equals excess demand.

Answer: B Diff: 1Topic: Trading Between Two People

14) Gains from trade will be possible as long as A) levels of utility differ. B) utility functions differ. C) marginal rates of substitution differ. D) endowments differ.


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15) In a competitive marketplace, prices adjust until A) MRS's are equal to zero. B) excess supply equals excess demand equals zero in all markets. C) each consumer has maximized utility subject to his budget constraint. D) all firms earn zero profit.

Answer: B Diff: 1Topic: Competitive Exchange

16) A competitive equilibrium is Pareto efficient because at the competitive equilibrium A) prices have been allowed to adjust. B) there are no further gains from trade. C) the final outcome is different from the original inefficient endowment. D) all members of society can be made better off.


17) A competitive equilibrium is Pareto efficient because at the competitive equilibrium A) prices reflect the differences in marginal rates of substitution across individuals. B) there are no further gains from trade. C) there is an equal distribution of the goods. D) everyone has the same level of utility.


18) Any competitive equilibrium is Pareto efficient because, with a competitive equilibriumA) the marginal rates of substitution are equal for all consumers.B) the price line is the contract curve.C) mutual gains from trade exist.D) the slope of the price line equals the ratio of the MRS for all consumers.

Answer: ADiff: 1Topic: Competitive Exchange

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19) For a given set of prices, two consumers choose bundles that are off the contract curve. In a competitive market, A) prices will adjust until the consumers choose bundles that are on the contract curve. B) the indifference curves will shift back to the contract curve. C) the contract curve will shift to connect these bundles. D) no adjustments need to be made.

Answer: A Diff: 2Topic: Competitive Exchange

20) In a competitive market, prices adjust until all consumers find themselves A) maximizing utility. B) on the contract curve. C) happy with their original endowment. D) with many opportunities to gain from additional exchange.


21) If pizza is measured on the horizontal axis and pretzels are measured on the vertical axis, the slope of the production possibility frontier at a given combination reflects A) the total cost of producing that combination. B) the total cost of producing that quantity of pizza in terms of pretzels. C) the cost of making the last pizza in terms of pretzels. D) the cost of making the last pretzel in terms of pizza.

Answer: C Diff: 1Topic: Production and Trading

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Figure 10.2

22) Suppose the production possibilities for two countries, producing either food or clothing, are shown in Figure 10.2. They can each produce any linear combination as well. Measuring food on the horizontal axis, the joint production possibility frontier A) will kink away from the origin at 20 units of food. B) will kink toward the origin at 20 units of food. C) will kink toward the origin at 10 units of food. D) will kink away from the origin at 10 units of food.

Answer: B Diff: 1Topic: Production and Trading

23) Suppose the production possibilities for two countries, producing either food or clothing, are shown in Figure 10.2. The USA has a comparative advantage in producingA) food.B) clothing.C) food and clothing.D) neither good.

Answer: ADiff: 1Topic: Production and Trading

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24) Suppose the production possibilities for two countries, producing either food or clothing, are shown in Figure 10.2. They can each produce any linear combination as well. Measuring food on the horizontal axis, the joint production possibility frontier A) will have a slope of -3/4 over the entire frontier. B) will have a slope of -2 when less than 20 units of food are produced. C) will have a slope of -1 when less than 20 units of food are produced. D) will have a slope of -1/2 when less than 20 units of food are produced.

Answer: D Diff: 1Topic: Production and Trading

25) Suppose the production possibilities for two countries, producing either food or clothing, are shown in Figure 10.2. They can each produce any linear combination as well. Assuming free trade between these two countries, Canada will produce food A) as long as any positive amount of food is demanded. B) as long as more than 10 units of food are demanded. C) as long as people are willing to give up at least 1 unit of clothing to get a unit of food. D) as long as people are willing to give up more than 1/2 a unit of clothing to get a unit of food.


26) Suppose the production possibilities for two countries, producing either food or clothing, are shown in Figure 10.2. They can each produce any linear combination as well. If production occurs at the kink on the joint production possibility frontier, A) the USA will specialize in food and Canada will specialize in clothing. B) the USA will specialize in clothing and Canada will specialize in food. C) each country will devote half of its resources to each industry. D) joint output is minimized.

Answer: A Diff: 1Topic: Production and Trading

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27) Suppose the production possibilities for two countries, producing either food or clothing, are shown in Figure 10.2. They can each produce any linear combination as well. Suppose each country is in competitive equilibrium prior to free trade being allowed. Once free trade is allowed, the price of food will be A) two times the price of clothing. B) equal to the price of clothing. C) one-half the price of clothing. D) somewhere between one-half the price of clothing and the price of clothing, depending upon the relative bargaining power of the two countries.

Answer: D Diff: 1Topic: Production and Trading

28) Suppose the production possibilities for two countries, producing either food or clothing, are shown in Figure 10.2. They can each produce any linear combination as well. Once free trade is allowed, Canada will produce A) no clothing. B) 10 units of clothing. C) 20 units of clothing. D) 5 units of clothing.


29) Suppose the production possibilities for two countries, producing either food or clothing, are shown in Figure 10.2. They can each produce any linear combination as well. Assuming that consumers place equal value on both of these goods and that free trade between these two countries is possible, gains from trade A) are not possible. B) exist because food is more expensive to produce in Canada than in the USA. C) exist because food is more expensive to produce in the USA than in Canada. D) do not exist because the consumers in each country have set their marginal rate of substitution equal to their country's marginal rate of transformation.


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30) Suppose the production possibilities for two countries, producing either food or clothing, are shown in Figure 10.2. They can each produce any linear combination as well. Measuring food on the horizontal axis, the joint production possibility frontier has a horizontal intercept of A) 10. B) 20. C) 30. D) 50.


31) Suppose the production possibilities for two countries, producing either food or clothing, are shown in Figure 10.2. They can each produce any linear combination as well. Measuring food on the horizontal axis, the joint production possibility frontier has a vertical intercept of A) 10. B) 20. C) 30. D) 50.


32) Suppose the production possibilities for two countries, producing either food or clothing, are shown in Figure 10.2. They can each produce any linear combination as well. Measuring food on the horizontal axis, the joint production possibility frontier will have a slope of -1 A) only when 20 - 30 units of food are produced. B) only when 10 - 20 units of food are produced. C) only when 10 - 20 units of clothing are produced. D) throughout the entire PPF.


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33) Suppose the production possibilities for two countries, producing either food or clothing, are shown in Figure 10.2. They can each produce any linear combination as well. Measuring food on the horizontal axis, the joint production possibility frontier has a kink because A) each country has a constant marginal rate of transformation that differs from the other country. B) each country has a marginal rate of transformation that varies with the product mix. C) all production possibility frontiers have kinks. D) the two countries have the same marginal rate of transformation.


34) Competition results in the efficient product mix because A) producers are setting MRT equal to minus the price ratio while consumers are setting MRS equal to minus the price ratio ensuring that MRT will equal MRS. B) consumers are on the contract curve. C) the slope of the production possibility frontier will equal the slope of the contract curve. D) the distribution of the final output is Pareto efficient.


35) By saying that MRS = MRT, an economist means that A) for all goods, the value that society places on the last unit produced equals the cost of making that unit. B) for all goods, the value that a consumer places on the last unit consumed equals the value that all consumers would place on that unit. C) society is able to produce more output of one good without reducing the output of any other good. D) no other output mix is technically feasible.


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36) A cake is to be shared by two people. Both desire the largest piece possible. One of the two will cut the cake. Under which of the following situations will the cutter adopt a Rawlsian social welfare function? A) The person cutting the cake chooses the first piece. B) The person not cutting the cake chooses the first piece. C) The two individuals will bid for the right to cut the cake and choose first. D) The two individuals will toss a coin for the right to cut the cake and choose first.

Answer: B Diff: 2Topic: Efficiency and Equity

37) Suppose in a democratic society, all voters prefer choice G over choice B; however, when the two choices are presented along with a third choice, R, B wins the election. This violates the assumption of A) transitivity. B) non-dictatorship. C) independence of irrelevant alternatives. D) completeness.

Answer: C Diff: 1Topic: Efficiency and Equity

38) If everyone's utility is given equal weight and a change in resource allocation results in one person's gain exceeding another person's loss, we can say that the new allocation A) is Pareto superior to the original one. B) increases social welfare. C) decreases social welfare. D) is efficient.


39) If a society only cares about efficiency and not equity, then A) all points on the contract curve yield the same level of social welfare. B) it will not rely on competitive markets to allocate goods. C) it will maximize the utility of its worst-off member. D) an equitable outcome is impossible.

Answer: A Diff: 1Topic: Efficiency and Equity

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40) If a society relies on competitive markets to allocate goods, then A) an equitable distribution is assured. B) an equitable distribution is certain to not occur. C) the competitive equilibrium will be Pareto superior to any other. D) social welfare as measured by consumer surplus plus producer surplus will equal zero.

Answer: C Diff: 1Topic: Efficiency and Equity

41) A dictator is most likely to A) adopt a Rawlsian social welfare function. B) maximize her own utility. C) place equal weight on everyone's utility function. D) have nontransitive preferences.


42) If society were to maximize the utility of its worst-off member, the final allocation would most likely be A) relatively egalitarian. B) on the contract curve. C) Pareto efficient. D) one in which one person gets everything.

Answer: A Diff: 1Topic: Efficiency and Equity

43) If society were to maximize the utility of its best-off member, the final allocation would be A) perfect equity. B) on the contract curve. C) Pareto efficient. D) one in which one person gets everything.

Answer: D Diff: 1Topic: Efficiency and Equity

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44) For most commonly used social welfare functions, an efficient allocation isA) always preferred over any inefficient allocation.B) not possible.C) usually preferred.D) never preferred.

Answer: CDiff: 1Topic: Efficiency and Equity

TRUE/FALSE/EXPLAIN

1) Any point on the contract curve is Pareto efficient regardless of the initial endowment.

Answer: True. Efficiency requires that no gains from trade are possible. This true along the contract curve. Diff: 1Topic: Trading Between Two People

2) If two grade-school children willingly trade their lunches with one another, we can conclude that at least one of them preferred the other's lunch to his own.

Answer: True. Either one or both preferred the other's. If only one preferred the other's, then the other must have been indifferent between the two lunches. Diff: 1Topic: Trading Between Two People

3) A competitive equilibrium is not Pareto efficient if some members of society are unable to afford a necessary good.

Answer: False. The competitive equilibrium described is efficient since all consumers set MRS equal to the price ratio. The problem with the described equilibrium is one of distributive justice not efficiency. Diff: 1Topic: Competitive Exchange

4) If MRS's are equal across all consumers, then the efficient product mix has been achieved.

Answer: False. Consumption efficiency has been achieved for the given product mix, but the given product mix is efficient only if MRT equals the MRS for all pairs of goods. Diff: 1Topic: Production and Trading

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5) At a given point in time, the Rawlsian welfare function gives equal weight to each individual's utility.

Answer: False. The Rawlsian welfare function gives a weight of 1 to the utility of the worst-off person and a weight of zero to the utilities of all others. Diff: 2Topic: Efficiency and Equity

PROBLEMS

1) Employing a general equilibrium approach, describe the effect of a new law that prohibits steel imports.

Answer: The initial effect is that the supply curve for steel shifts leftward. This raises the price of steel. The largest users of steel are the automobile industry, the construction industry and the appliance industry. The increased cost of inputs will raise the price of the goods produced by these industries. Given time, these industries will look to substitute plastic or aluminum in place of steel, raising the prices of these materials. Diff: 0Topic: General Equilibrium

Figure 10.3

2) Suppose that the minimum wage covers all sectors of the economy; however, for unionized laborers, the minimum wage is ineffective. That is, the union wage is already above the minimum wage. Analyze the impact of an increase in the minimum wage on both the unionized and non-unionized labor markets. (Assume that the higher minimum wage is still ineffective in the unionized sector and that union and nonunion labor are substitutable.)

Answer: See Figure 10.3. The higher minimum wage from min1 to min2 reduces the quantity demanded of nonunion labor from L1 to L2. This causes a rightward shift of the demand curve for union labor from D1 to D2. The equilibrium union wage rises from w1 to w2. This explains

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why unions typically support increases in the minimum wage even though it does not directly affect their members. Diff: 0Topic: General Equilibrium

3) Explain why having different marginal rates of substitution is necessary for trade to occur.

Answer: The marginal rate of substitution is the rate at which a person is willing to trade one good for another. If these rates are not equal for all people, trade can occur. With different marginal rates of substitution at least one person gains by trading. When the marginal rates of substitution are the same for everyone, everyone is willing to trade goods at the same rate, so no one can gain by trading.Diff: 1Topic: Trading Between Two People

4) Explain why Robin Hood’s practice of stealing from the rich to give to the poor is never Pareto-efficient.

Answer: When Robin steals from the rich, those people are made worse off. This cannot be Pareto-efficient.Diff; 1Topic: Competitive Exchange

5) Consider a society consisting of just a farmer and a tailor. The farmer has 10 units of food but no clothing. The tailor has 20 units of clothing but no food. Suppose each has the utility function U = F * C. Derive the contract curve.

Answer: Let F and C denote the farmer’s final allotment of food and clothing. Setting MRS's equal yields F/C = (10 - F)/(20 - C) or F/C = 1/2. The contract curve is a ray from the origin with a slope of 1/2 (assuming food is on the vertical axis). Diff: 2Topic: Trading Between Two People

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Figure 10.4

6) Robinson starts out with 10 lobsters and 5 coconuts. Friday starts out with 10 lobsters and 15 coconuts. After trading, Robinson ends up with 8 lobsters and 10 coconuts. Robinson feels neither better nor worse off than when he started but cannot get Friday to agree to any more trades. Friday feels better off than when he started. Draw the Edgeworth box consistent with this story.

Answer: See Figure 10.4 Diff: 2Topic: Trading Between Two People

7) Consider a society consisting of just a farmer and a tailor. The farmer has 10 units of food but no clothing. The tailor has 20 units of clothing but no food. Suppose each has the utility function U = F * C. The price of clothing is always $1. If the price of food is $3, does a competitive equilibrium exist? If not, what will happen to the price of food?

Answer: The farmer will have $30. His budget line is 30 = 3F + C. His budget line is tangent to an indifference curve when C/F =3. Substituting yields 30 = 6F or F = 5 and C =15. The tailor's budget line is 20 = 3F + C. His budget line is tangent to an indifference curve when C/F =3. Substituting yields 20 = 6F or F = 3.33 and C = 10. In total 8.33 units of food and 25 units of clothing are demanded. There is excess demand for clothing and excess supply of food. The price of food will fall. When the price of food is $2, both markets clear. Diff: 2Topic: Competitive Exchange

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Figure 10.1

8) Figure 10.1 depicts the Edgeworth box for two consumers, Al and Bruce. Explain why point "a" cannot be a competitive equilibrium.

Answer: Point "a" cannot be a competitive equilibrium because at point "a", Al and Bruce each have a different marginal rate of substitution. Since they both face the same prices in a competitive market, at least one of them is not in equilibrium. Diff: 2Topic: Competitive Exchange

9) Explain how it is possible for one of two people in a two-good economy to have an absolute advantage in producing both goods, but trade can still benefit both people.

Answer: One person, when she spends all of her time producing one good or the other, can produce more of either good than the other person. This person has an absolute advantage in producing both goods. However, gains from trade exist when the opportunity costs associated with each good are different for both people. If the costs of producing one good in terms of the forgone production of the other good differ for the two people, then they can gain from trade.Diff: 1Topic: Production and Trading

10) Suppose a society's PPF for food (F) and clothing (C) can be written as 25 = F2 + C2. If all consumers have the same endowment and the same utility function Ui = Fi*Ci, what is the efficient product mix of food and clothing?

Answer: The marginal rate of substitution of food for clothing (dF/dC) equals F/C. The marginal rate of transformation of food for clothing (dF/dC) equals C/F. The efficient product mix occurs when F/C = C/F or C = F. Given the PPF, food and clothing will both equal sqrt(12.5). Diff: 2Topic: Production and Trading

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11) Can consumption efficiency be achieved even if the efficient product mix is not achieved?

Answer: Efficiency in consumption implies that all consumers have the same MRS. This can be achieved with any product mix. Thus, consumers can be as well off as possible for any given product mix. If the product mix is inefficient, consumers can still make the best of it even though a different product mix could make them even better off. Diff: 2Topic: Production and Trading

12) How does competition ensure that the efficient product mix is attained?

Answer: In a competitive market, producers choose an output level where marginal cost equals price. Thus, Px/Py = MCx/MCy. Each consumer maximizes her own utility subject to the given prices by setting MUx/MUy = px/py. Even though each is acting independently and in her own interest, the final outcome is that px/py = MRS = MRT, which is the condition for efficient product mix. Diff: 2Topic: Production and Trading

Figure 10.5

13) Figure 10.5 shows a production possibility frontier for a society with two members, Al and Bruce. If point "a" is the efficient product mix, draw a possible Edgeworth box and indifference curves.

Answer: The Edgeworth box has 0,0 as the southwest corner and point "a" as the northwest corner. The indifference curves must be tangent where their slopes equal the slope of the PPF at point "a". Diff: 2Topic: Production and Trading

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14) Suppose the USA can produce 10 units of food and 5 units of clothing (or any linear combination) and Canada can produce 6 units of food and 3 units of clothing (or any linear combination). What type of trade will occur between these two countries? Explain.

Answer: In both countries, 2 units of food must be sacrificed to produce a unit of clothing. Since each country has the same MRT, there are no gains from trade to be made. Diff: 2Topic: Production and Trading

15) If a market is controlled by one perfect price discriminator who is able to charge each consumer the highest price that consumer is willing to pay, the seller will produce output until the price paid by the last consumer is equal to the marginal cost of making the good. That is, the price of the last good equals the marginal cost of making the good. If welfare is measured as consumer surplus plus producer surplus, compare this market structure to a competitive market in terms of efficiency and equity.

Answer: A perfect price discriminator is Pareto efficient. Producer surplus plus consumer surplus is the same as in a competitive market. From an equity standpoint, however, there is much less equity than in a competitive market. A perfect price discriminator can capture all of the consumer surplus for herself, leaving consumer surplus equal to zero. Diff: 2Topic: Efficiency and Equity

16) Explain why a government may select an inefficient allocation.

Answer: A government may decide the equity of an allocation makes it preferable to all possible efficient allocationsDiff: 1Topic: Efficiency and Equity

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Financa Publike Analiza Normative