Part A (40% of the marks)
Consider an economy with two consumers, Indigo and Jamal, who each have two tradable goods: food and clothing.
1. State the first and second theorems of welfare economics. Explain the implications of these theorems for the use of competitive markets to distribute goods between Indigo and Jamal and for the use of competitive markets more generally. (8 marks)
2. Draw an Edgeworth exchange box for food on the horizontal axis and clothing on the vertical axis for Indigo and Jamal. On your diagram, illustrate Indigo’s and Jamal’s preferences for food and clothing using an indifference curve map for each consumer, showing at least two indifference curves for each. With the aid of these indifference maps, show also a contract curve and explain its economic significance. Make sure you label all the elements of your diagram. (8 marks)
3. Assume an initial endowment in which Indigo has most of the food and Jamal has most of the clothing. Reproduce your diagram for Question 2, and show this initial endowment and the core of this two-person exchange economy. Fully label your diagram, including the initial endowment and the core. Explain the economic significance of the core. (8 marks)
4. Now reproduce two versions of your diagram from Question 3. Use one diagram to show a disequilibrium price (budget constraint) and excess demand for food, and use the second to show a different set of relative prices for food and clothing in which supply is equal to demand. Explain in full what your diagrams show. (8 marks)
5. Write an equation that summarises the relations between the marginal rate of substitution, relative prices and the marginal rate of transformation in equilibrium for an economy with exchange and production of food (F) and clothing (C).
Explain in full these relations and illustrate your answer with a fully labelled and explained production possibility frontier (PPF) diagram with food on the horizontal axis and clothing on the vertical axis. (8 marks)
Word limit: 800 words
Part B (60% of the marks)
Government has three primary functions. It should provide for military defense of the nation. It should enforce contracts between individuals. It should protect citizens from crimes against themselves or their property. When government – in pursuit of good intentions – tries to rearrange the economy, legislate morality, or help special interests, the cost comes in inefficiency, lack of motivation, and loss of freedom. Government should be a referee, not an active player.
(M. Friedman, 1979)
Using economic theories discussed in Block 3, and providing examples, critically discuss Friedman’s claim that inefficiency results from active Government intervention.Word limit: 1500 words
(60 marks)
