Externalities And General Equilibrium Consider The Case Of Ed And Fi

externalities and general equilibrium

Consider the case of Ed and Fiona, whose utility is defined over two ‘goods’, beans and tobacco smoke. Both Ed and Fiona like beans. Ed likes to smoke (a little, not too much) and has an unlimited supply of free tobacco. Fiona hates smoke. Ed’s smoking poses an externality on Fiona. So ‘tobacco’ is a good for Ed and a ‘bad’ for Fiona. We can represent their utility function as

Beans are the numéraire good, we can normalize its price to one. The initial endowment of beans can be denoted (W_E, W_F ). Assume that the indifference curves of Ed and Fiona are the represented in Figure 1. Ed’s indifference curves start on the lower left and his utility increases as we move north east. Fiona’s indifference curves start from the upper right and her utility increases as we move southwest. Let W₀ equal their initial endowment.