Gallaway
ECO 515
Spring 2005

Homework #1

All homework is to be typed. Hand-written graphs and equations are acceptable as long as they are neat.  You do not need to answer the red parts of the questions, but you should spend some time thinking about them.

(I suggest you cut and paste these questions into a Word document and then start from there.)

 1.      Assume there is a world with only two goods (milk & cookies) and two people (Bill & Sue).  There is no production in this world and the finite quantities of the two goods have been divvied up between Bill & Sue.  At this initial endowment of goods, E, Bill’s MRS_{milk, cookies} = 3 and Sue’s MRS_{milk, cookies} = 1.

·        Explain why there is room for Pareto improvement.

·        Explain who will trade will trade what for what. What will happen to Bill & Sue’s MRS_{milk, cookies}?   Use a diagram to illustrate your answer.

·        Describe what you expect to happen to each person’s marginal utility for each good.

·        How long will Bill and Sue continue to trade?  What assumptions, if any, are you making here?

·        What is a contract curve?

·        Can you determine exactly where on the contract curve Bill & Sue will end up? Why or why not?

2.      The First Fundamental Theorem of Welfare Economics

·        What is this theorem?

·        Use equations to explain how the profit and utility maximization rules lead to the  efficient results suggested by the theorem.

·        How does this theorem relate to Adam Smith’s Invisible Hand?

·        List at least three types of market failures and describe how these problems interfere with the First Fundamental Theorem of Welfare Economics.

3.      Public Goods

·        Describe, in equation form, the necessary condition for the Pareto-efficient provision of a public good.

·        How does this compare to the necessary condition for the Pareto-efficient provision of a private good?

·        Explain how the market demand curve for each type of good is derived.

·        For both types of goods, explain how the market equilibrium relates to the efficiency criteria discussed above.

·        Explain how perfect price discrimination could allow the free market to provide efficient levels of  public goods.

4.      Externalities

·         Explain how the Coase Theorem could be used to correct the problem of externalities.

·        What assumptions does the Coase Theorem make?  Explain why, in circumstances where these assumptions are not realistic, the Coase Theorem will fail to work.