Financial Economics – Tutorial 5 – General Equilibrium

1. The industry analysts have long recognized that there is a high degree of complementarity
between automobile tires and gasoline. A recent study done by an automobile industry trade
group estimated the following supply and demand functions:
QDT = 5,250 - 125PT - 750PG
QST = -350 + 1175PT
QDG = 80,500- 30,000, PG - 250PT
QSG = 35,000+ 15,000PG,
where ODT and QST refer to quantities of tires demand and supplied each month measured in
sets of four, QDG and QSG refer to quantities of gasoline demanded and supplied each month
measured in gallons, PG is the price of gasoline per gallon, and PT is the price per set of four
tires.

a. Calculate the equilibrium price and quantity that will prevail in both the tire and gasoline
markets. (Hint: Recall that QD must equal QS in each market.)

b. Assume that a recession causes the demand curve for gasoline to shift leftward as follows:
QDG = 76,000- 30,000PG - 250PT
Calculate the initial impact of this change in demand on the gasoline and tire markets. (You need
calculate only one change in P and Q for each market.)

c. Discuss the changes that will occur after the initial round to move each market back to a
stable equilibrium. Your answer to part (c) requires no calculations, but graphs would help
convey your understanding of the process.

2. Jane has 3 liters of soft drinks and 9 sandwiches. Bob, on the other hand, has 8 liters of soft
drinks and 4 sandwiches. With these endowments, Jane’s marginal rate of substitution (MRS)
of soft drinks for sandwiches is 4 and Bob’s MRS is equal to 2. Draw an Edgeworth box
diagram to show whether this allocation of resources is efficient. If it is, explain why. If it is
not, what exchanges will make both parties better off?

3. Two individuals, A and B, are free to engage in trade of clothing and food. Initially, A has 12
units of clothing and 9 units of food, and B has 8 units of clothing and 11 units of food. The
individuals have the following utility functions in clothing C and food F:
UA = 0.15QC ∙ QF
UB = 0.08QC ∙ QF
where QF represents units of food, QC represents units of clothing, and U represents utility.
Determine if a mutually beneficial trade is possible between A and B. If so, who would trade for
what?
4. Sarah and Jane are two representative individuals living in an economy that produces two
goods, X and Y. Sarah's and Jane's utility functions are given as:
Sarah: US = 100X0.5Y0.5
Jane: UJ = 50X0.4Y0.6
The market determined prices of X and Y are $10 and $20, respectively. Current outputs are 58
units of X per time period and 36 units of Y. Jane's current income is $600 per time period, while
Sarah's income is $700 per time period.

a. Write expressions for Sarah and Jane's marginal rates of substitution.

b. Determine the quantities of X and Y that Sarah and Jane should consume in equilibrium.
c. Do the values calculated in part (b) satisfy the conditions for equilibrium in exchange?
Explain using numbers.
d. Examine your answers in parts (b) and (c). If equilibrium has not been achieved, what
would be necessary to reach equilibrium? If equilibrium has been achieved, comment on the
process by which equilibrium was reached

5. Consider a potential, voluntary exchange between two people. Assume that both people have
complete information about each other's preferences and that there are no transaction costs.
Consumers A and B have between them 9 units of X and 15 units of Y. Initially, A has 6 of
X and 10 of Y, and B has 3 of X and 5 of Y. Consumer A's marginal rate of substitution of X
for Y is 2 and B's marginal rate of substitution of X for Y is 1/3. Is there room for a mutually
beneficial, voluntary exchange? Determine which consumer would trade for more X and
which consumer would trade for more Y. If trade takes place, can you explain the terms of
trade?

6. Refer to the diagram below to answer this question.

Suppose the Edgeworth box diagram above pertains to trade between Mexico and the U.S. Befor
the ratification of the North American Free Trade Agreement (NAFTA), the consumption of
computer chips and textiles in both countries is given by point A. At point A, what is true
regarding the relative price of computer chips in the U.S. versus Mexico? If the ratification of
NAFTA allows trade to bring about the efficient equilibrium, which point in the diagram
indicates the level of consumption by each country? At the new equilibrium, what has happened
to the price of chips in the U.S.? How do we know both countries are better off by free trade?

7. Refer to the following two diagrams to answer this question.

The production possibilities frontier for Autos and Chips are given above for the two countries
Blib and Flib. Initially, there is no trade between Blib and Flib. As a result, Blib is maximizing
societal welfare by producing and consuming at point A. Flib is maximizing societal welfare by
producing and consuming at point B. The ratio of prices in Blib is given by line while the

ratio of prices in Flib is given by line What is true about the relative price of Autos in Blib
versus Flib? Explain how it may be possible for both countries to be made better off by trading
Autos for Chips.

8. On planet Economus, the countries Blib and Flib can produce the amounts of string and rope
indicated in the table below with one unit of land. The country of Blib has 20 units of land
available while the country of Flib has 10 units of land. Does either country have an absolute
advantage? Which country has a comparative advantage in string production? Which
country has a comparative advantage in rope production? Is it possible for the two countries
to benefit from trade?

Country String Rope

Blib 10 20
Flib 25 10

9. On the planet Economus, there are only two goods in the economy. One of the goods is
econoapples. The quantity supplied of econoapples is fixed at 30. The second type of good
is the econoseed. The quantity supplied of econoseeds is fixed at 60. The demand for

econoapples is: The demand for econoseeds is: If

the Economus world government institutes a tax of $1 on the price of econoapples, what is
the effect on the amount econoapple consumers pay? Determine the equilibrium price and
quantity of each good in the Economus economy.
10. Refer to the diagram below to answer this question.

The Edgeworth Box diagram above refers to input usage in the automobile industry and the
computer chip industry. The contract curve is given by . All points on this curve
correspond to input prices being equivalent across industries. For example, the line segment AC
indicates the input price ratio at point B in the two industries. Also, line segment DF indicates
the input price ratio at point E in the two industries. The diagram below presents the production
possibilities frontier for automobiles and computer chips.

The labeled points in the production possibilities frontier diagram correspond to the points A, B,
E, and F in the Edgeworth Box diagram above. Which points in the production possibilities
frontier diagram correspond to which points in the Edgeworth Box diagram? Why?
11. Residents in the city of Econoville enjoy only two types of recreational activities. The
activities are biking and attending concerts. The demand for concert tickets is:

The supply of biking trail permits is set at: The

demand for biking trail permits is The city wishes to expand

seating capacity at concert events. To finance the concert hall expansion, the city is considering
a tax of $20 on biking permits. Given the city institutes this plan, the supply of concert tickets

will become Before the expansion of the concert hall, the supply of concert tickets
was fixed at 60,000. What is the effect on equilibrium prices of the additional seating capacity
and the $20 tax on biking permits? How much revenue does the tax generate? Did concert ticket
revenue increase due to adding seating capacity and the tax?