Suppose there are 10 apples and 10 oranges in the economy. Joe is currently consuming 4 apples and 5 oranges, and Jane is consuming 6 apples and 5 oranges. At this allocation, Joe's marginal utility of apples is 3, and his marginal utility of oranges is 5. Jane's marginal utility of apples is 6, and her marginal utility of oranges is 10. The current price of apples is $4 and the current price of oranges is $5. To reach a competitive equilibrium, the required price adjustment is:
A) a decrease in the apple price relative to the orange price.
B) a decrease in the orange price relative to the apple price.
C) no change in the relative prices.
D) an increase in both prices.

Question

Quizplus · Accepted Answer

In a competitive equilibrium, the ratio of the marginal utilities should equal the ratio of the prices for each consumer. Here, Joe's ratio of marginal utility (MU) of apples to oranges is 3/5, and Jane's is 6/10, which simplifies to 3/5, indicating they value the goods similarly per unit of utility. However, the price ratio of apples to oranges is 4/5, which does not match the MU ratio. Since consumers value oranges more than the current price ratio suggests (MU ratio > price ratio), the price of apples should decrease relative to oranges to match the MU ratio to the price ratio, leading to a competitive equilibrium.

Suppose There Are 10 Apples and 10 Oranges in the Economy