Homework #10 Econ 611, Prof. Hanson

1. In the following Edgeworth diagram,

a. (2pt) Is B Pareto optimal? Does B Pareto dominate A?

b. (6pt) If the endowment is A, show the set of possible contracts that make both people better off? What subset of this set cannot be so improved on?

EXTRA CREDIT. John is hiring Mary to attempt a project. If the project succeeds, John gets 100, while if it fails he gets 0. If Mary does not try, the project has a 1/4 chance of success, while Mary tries it has a 3/4 chance of success. While John is risk neutral, Mary’s utility is (√ cash) – [3 if effort, 0 if not]. Mary starts out with 10 in cash, and can not have negative cash. Assuming Mary can reject an offer, how much should John offer to pay Mary if the project succeeds, and if it fails?