You live in a world where the marginal rate of substitution of food for clothing is two and the price ratio between food and clothing is one. Your world also has labor and capital that has marginal products respectively of two and five. The price of capital is ten and the price of labor is 8. Finally, your world can transform two units of food into one unit of clothing or vice versa. Assuming that all the conditions of general equilibrium are present, what will happen in the various sectors of the economy to bring about general equilibrium?

What will be an ideal response?

First, since the price of food is one unit of clothing but people are willing to give up two units of clothing for one food, there will be great demand for food and exchanges will occur until the market imbalance between food and clothing is reached with more food consumed. Second, the economy is too labor intensive because the marginal product of labor is too low relative to its price. Finally, food is only half as expensive to produce as clothing and since it is priced as equal, firms will move toward more food production. After these adjustments all three conditions for efficiency will be met and your world will be at a higher level of utility.