This problem helps you understand why some agents in an economy may gain from trade while others may lose and helps x some basic concepts in general equilibrium. Consider an Endowment economy. That is, nothing is produced, rather supply is whatever people are endowed with. There are two agents, Robinson and Friday, who live on separate islands, and two goods, Coconuts and Bananas. Robinson owns 8 coconuts and 2 bananas while Friday owns 2 coconuts and 8 bananas. Both Robinson and Friday have identical homothetic preferences and have identical demand functions as a result.
PART 1
a. Draw their endowment points and indi¤erence curves in the same graph.
b. If they live on separate islands, and cannot trade with each other, can you explain what the equilibrium price would be on each island? (Draw the budget set through the endowment point. At what price will they demand what is supplied?)
c. Depict equilibrium on both Islands using relative demand and relative supply. Will the price of Bananas be higher on Robinsons Island or Fridays Island?
d. Draw an Edgeworth box and place the endowment point in it. Depict the equilibrium under trade in the Edgeworth box.
e. Depict equilibrium under trade using relative demand and relative supply. Will the price of Bananas be higher on Robinsons Island or Fridays Island? Why?
f. Now suppose that Robinson and Friday are discovered by the world which o¤ers to trade at a slightly higher relative price for coconuts than you solved for in d: Are both Robinson and Friday better o¤? Who gains who loses? Why? Again, use a diagram to illustrate your answer. (Hint: if you are a net buyer of a good (seller), an increase in its price hurts (helps) you.)
g. Suppose that instead of trading the goods Robinson and Friday had traded the trees that gave coconuts and bananas. In other words suppose their endowments were their consumption under trade. Now if the world discovers them would both gain from being discovered by the world? Explain why. (Hint: what is the e¤ect of a price change if you are neither a borrower or a lender?)
h. Trade makes some people better o¤ and others worse o¤ in practice. However, by combining trade with redistribution, everyone could be made better o¤ due to trade." Comment on this statement in the light of your answer to the earlier parts.