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Using the Edgeworth box

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Simple Example: Elvis and Costello Elvis and Costello are two consumers who like X and Y only:

Elvis: UE(xE,yE) = xE2yE Costello: UC(xC,yC) = xCyC No-trade allocation

Elvis: (XEE,YEE)=(7,2) Costello: (XEC,YEC)=(2,4)

(a)

(b)

Draw an Edgeworth box with the contract curve Indicate what the core of this economy is.

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Steps for Answering These Sort of Problems

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1. 2. 3.
1. 2. 3.

Determine the size of the Edgeworth box by adding up the total amount of X and Y in the economy Label each axis and the point where consumption is equal to zero and the X and Y axis for each trader Determine the contract curve
by setting the MRS of each trader equal using the fact each persons consumption of each good is limited to amount of the good in total Solving for one traders X in terms of the same traders Y

4. 5.

Graph the endowment point. Graph each individuals IC through the endowment point The gap between the two IC in between where they cross, along the contract curve is the core

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Simple Example: Step 1 and 2

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= + = 7 + 2 = 9; = + = 2 + 4
X for Costello

9 6

Y for Elvis

X for Elvis

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Simple Example: Step 3

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1. 2.

2 2

+ = 9 + = 6 = 9 = 6 then substitute into 1

2 9 = 6 = and we have an equation of 18 in terms of which represents the contract curve

3.

We can determine its shape by taking the first and second derivative:

6 18 1 6 18 2 2 18 1 18 4

108 18 2

> 0 (upward sloping)

This is first condition. equation 1.

2 2

> 0 (increasing at an increasing rate)

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Simple Example: Step 3

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X for Costello

9 6

Y for Elvis

X for Elvis

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Simple Example: Step 4

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X for Costello

9 6

Y for Elvis

X for Elvis

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Simple Example: Step 4

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X for Costello

9 6

Y for Elvis

2
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X for Elvis

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Simple Example: Step 5

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X for Costello

9 6

Y for Elvis

3 2

X for Elvis

This is another condition: MRS for Elvis=2YE/XE slope of red line=(YE-2)/(XE-7). They are equal. 2YE/XE=(YE-2)/(XE-7). This is second condition .This condition plus first condition: equation 1. We have two equations and two unknowns and we can resolve the

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Y for Costello