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Chapter 16: Problem 6

In the analysis of an exchange between two people, suppose both people have identical preferences. Will the contract curve be a straight line? Explain. Can you think of a counterexample?

Short Answer

Expert verified
No, the contract curve will not be a straight line. It will be shaped as per the shape of their identical indifference curves which can be concave or convex. A counterexample could be if they have convex preferences, their contract curve could be a curve line starting from the origin towards the top right corner.

Step by step solution

01

Understanding the concept

In exchange theory of economics, the contract curve represents all allocation of goods that are mutually beneficial to all the trading parties. Here, two people are assumed to have identical preferences.
02

Analyzing the Possibility

In case of identical preferences, the indifference curves of both individuals would be exactly the same. Indifference curves represent all points of utility that are indifferent to the individual. So, if two people have identical preferences, their indifference curves would coincide.
03

Conclusion on Contract Curve

Since their indifference curves coincide, their contract curve would also coincide with their identical indifference curves. However, these i.e. the contract curve and indifference curves do not need to be a straight line as the preferences can be convex or concave.
04

Counterexample

Assuming they have convex preferences: The contract curve could be a curve line starting from the origin towards the top right corner, reflecting that larger consumption bundles are preferred.

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Most popular questions from this chapter

Suppose gold \((G)\) and silver \((S)\) are substitutes for each other because both serve as hedges against inflation. Suppose also that the supplies of both are fixed in the short run \(\left(Q_{G}=75 \text { and } Q_{S}=300\right)\) and that the demands for gold and silver are given by the following equations: \\[ P_{G}=975-Q_{G}+0.5 P_{S} \text { and } P_{S}=600-Q_{S}+0.5 P_{G} \\] a. What are the equilibrium prices of gold and silver? b. What if a new discovery of gold doubles the quantity supplied to \(150 ?\) How will this discovery affect the prices of both gold and silver?

Give an example of conditions when the production possibilities frontier might not be concave.

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