Microeconomics An Intuitive Approach With Calculus 2nd Edition by Thomas Nechyba – Test Bank A+

$35.00
Microeconomics An Intuitive Approach With Calculus 2nd Edition by Thomas Nechyba – Test Bank A+

Microeconomics An Intuitive Approach With Calculus 2nd Edition by Thomas Nechyba – Test Bank A+

$35.00
Microeconomics An Intuitive Approach With Calculus 2nd Edition by Thomas Nechyba – Test Bank A+
1. Quasilinear goods are borderline goods between the set of normal and the set of inferior goods.

a.True
b.False

ANSWER: True
RATIONALE: A quasilinear good is a good whose consumption remains unchanged with changes in income — whereas an inferior good is a good whose consumption moves in the direction opposite to income and a normal good is a good whose consumption moves in the same direction as income.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

2. Every necessity is a normal good, but not all normal goods are necessities.

a.True
b.False

ANSWER: False
RATIONALE: Necessities can be normal or inferior.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

3. Every luxury good is a normal good but not every normal good is a luxury.

a.True
b.False

ANSWER: True
RATIONALE: Luxuries are goods whose consumption increases with income by a bigger percentage than income — so they are normal goods (whose consumption moves in the same direction as income). But a good whose consumption increases with income at a rate less than income is still a normal good without being a luxury good.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

4. Every Giffen good is a necessity but not every interior good is a necessity.

a.True
b.False

ANSWER: False
RATIONALE: All inferior goods — including Giffen goods — are goods whose consumption moves in the opposite direction from income. Necessities are goods whose consumption increases by less than the percentage increase in income, which is the case if consumption decreases with increases in income.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

5. All homothetic goods are normal goods.

a.True
b.False

ANSWER: True
RATIONALE: Homothetic goods are goods whose consumption changes at the same rate (and in the same direction) as income — which makes them normal goods.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

6. All quasilinear goods are necessities.

a.True
b.False

ANSWER: True
RATIONALE: Consumption of quasilinear goods does not depend on income — which means that, as income increases, consumption does not change. Necessities are goods whose consumption increases by less than the percentage increase in income, which is true if consumption does not change at all with income.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

7. Goods with small substitution effects tend to be normal goods.

a.True
b.False

ANSWER: False
RATIONALE: The definition of normal goods relates to income effects, not substitution effects. Normal goods can have large or small substitution effects.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

8. A change in the price of one good cannot leave utility unchanged unless the price change is accompanies by a change in income.

a.True
b.False

ANSWER: False
RATIONALE: There are several types of counterexamples to this. For instance, it a consumer consumes at a corner solution and the price of the good that is not consumed increases, the consumer’s utility is unchanged. Or, if a consumer consumes at an interior solution, an increase in the price of one good could be accompanied by a decrease in the price of the other good such that the consumer’s utility remains unchanged.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

9. Except for the case of Giffen goods, the substitution effect always tells us that a consumer will consume less (or at least no more) of a good whose price has increased.

a.True
b.False

ANSWER: False
RATIONALE: The statement is true — except that it applies to Giffen goods as well.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

10. The price of peaches goes up and I observe you buying more strawberries. This implies strawberries must be a normal good.

a.True
b.False

ANSWER: False
RATIONALE: When the price of peaches goes up, the substitution effect (from A to B) clearly suggests the purchase of more strawberries. But the optimal final bundle could be bundle C, which would make strawberries an inferior good.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

11. The price of peaches goes up and I observe you buying more strawberries. This implies that strawberries must be an inferior good.

a.True
b.False

ANSWER: False
RATIONALE: Below is a case where strawberries are a normal good.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

12. The price of peaches goes up and I observe you buying fewer strawberries. This implies strawberries must be a normal good.

a.True
b.False

ANSWER: True
RATIONALE: In the graph below, the substitution effect (from A to B) tells us that more strawberries should be consumed. If strawberry consumption decreases from the original A when we get to the final budget, the final bundle C lies below A — implying it also lies below B. Thus, as income falls (from the dashed compensated to the final budget), strawberry consumption falls, making strawberries a normal good.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

13. Bottles of Coca-Cola and equally-sized bottles of Pepsi Cola are perfect substitutes for a consumer, but a bottle of Coke costs 10 cents less than bottles of Pepsi. The income effect of a 15 cent increase in the price of Pepsi will be for the consumer to drink less cola.

a.True
b.False

ANSWER: False
RATIONALE: The consumer is at a corners solution — consuming only Coke — before the price of Pepsi increases. The increase in the price of Pepsi therefore has no impact on the consumer.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

14. Bag of chips and bottles of salsa are perfect complements for consumer who eats only chips and salsa, but a bottle of salsa costs $1 more than a bag of chips. The income effect of a 50 cent increase in the price of a bag of chips will be fore the consumer to eat fewer chips and less salsa.

a.True
b.False

ANSWER: True
RATIONALE: When two goods are perfect complements (in a 2-good model), both are normal goods.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

15. Income effects are negative for normal goods, and positive for inferior goods.

a.True
b.False

ANSWER: False
RATIONALE: Income effects are positive for normal goods and negative for inferior goods.
POINTS: 1
DIFFICULTY: A section material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 10/7/2015 2:42 PM
DATE MODIFIED: 10/7/2015 2:45 PM

16. Homothetic goods are neither necessities nor luxuries, but rather lie on the borderline between them.

a.True
b.False

ANSWER: True
RATIONALE: Homothetic goods are those for which the marginal rates of substitution are constant along any ray emanating from the origin. As a result, homothetic tastes represent the borderline tastes between necessary and luxury goods.
POINTS: 1
DIFFICULTY: A section material
QUESTION TYPE: True / False
HAS VARIABLES: False
DATE CREATED: 10/7/2015 2:42 PM
DATE MODIFIED: 10/7/2015 2:49 PM

Multiple Choice

17. The price of peaches goes up and I observe you buying fewer strawberries. Which of the following is consistent with this observation:

a.Strawberries are inferior and peaches are normal.
b.Strawberries are normal and peaches are inferior.
c.Both strawberries and peaches are inferior.
d.Both (a) and (b).
e.Both (a) and (c).
f.Both (b) and (c).
g.All of the above.

ANSWER: f
RATIONALE: Since the substitution effect (from A to B) tells us to buy more strawberries, and since we end up buying fewer than at A, the final bundle lies below B and thus involves a decrease in strawberry consumption as income falls (from the dashed compensated to the final budget). Thus, strawberries must be normal and thus (a) can’t be true. Peaches, on the other hand, could be normal (as when the final optimal bundle is C) or inferior (as when the final optimal bundle is D).
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: Multiple Choice
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

18. You and I both have homothetic tastes. When the price of peaches goes up, you buy more strawberries and I buy fewer. Which of the following must be true.

a.Peaches are more substitutable with strawberries for me than they are for you.
b.Peaches are more substitutable with strawberries for you than they are for me.
c.Strawberries are normal goods for you and inferior goods for me.
d.Strawberries are normal goods for me and inferior goods for you.
e.Both (a) and (c).
f.Both (b) and (c).
g.Both (a) and (d)
h.Both (b) and (d)

ANSWER: b
RATIONALE: When tastes are homothetic, all goods are normal. Thus, (c) and (d) must be false. The two graphs below then illustrate (b).
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: Multiple Choice
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

19. At most museums, you can either buy a year-long membership that gives you free access to the museum any time, or you can pay a daily fee every time you visit. (Assume for purposes of this exercise that everyone can in principle afford the year-long membership.)

a.Those who choose to pay the daily fees all place the same value on their marginal museum visit.
b.We cannot tell how much value anyone places on the marginal museum visit because we cannot compare utility across individuals.
c.If someone is indifferent between the two options, she will go to the museum at least as much if she chooses the year-long membership than if she does not.
d.Both (a) and (c) are true.
e.Both (b) and (c) are true.

ANSWER: d
RATIONALE: The consumer chooses between two budgets –the solid budget (with daily fees) and the dashed budget (with one lump sum fee and then no fee per visit). Those who choose the solid budget (i.e. the daily fees) will all optimize at a point like A — a point where their MRS is equal to the (negative) price of a daily entrance fee. Thus, they all place the same value on the marginal museum visit — and (a) is true. Answer (b) is therefore false — we can often tell what the marginal value is that someone places on a good, because the marginal value is equal to the price. Finally, if someone is indifferent between the two options, the graph below shows that she will visit less frequently under the daily fee.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: Multiple Choice
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

20. Wholesale clubs charge a fixed monthly fee but then offer goods at discount prices. For purposes of this question, suppose a wholesale club and a supermarket offer the same composite grocery item, with the supermarket charging no fixed fee but a higher price for the item. (Assume no corner solutions.)

a.Anyone shopping at the wholesale club places less value on the marginal item bought than anyone shopping at the supermarket.
b.Anyone indifferent between the two stores buys more (or at least no less) if she chooses the wholesale club.
c.We cannot predict how much value different individuals place on the marginal item in each store because we cannot measure utility objectively.
d.Both (a) and (b) are true.
e.Both (b) and (c) are true.

ANSWER: d
RATIONALE: Since there are no corner solution, we know that those in the wholesale club as well as those in the supermarket will by the composite item until their MRS is equal to the negative price — but the price is higher in the supermarket. Thus, those choosing to shop in the supermarket place a higher value on the marginal item bought. We can make these comparisons even though we cannot measure utility objectively — because we know what the MRS is at the margin for those at interior solutions. Furthermore, anyone indifferent between the stores must shop less at the supermarket because of the substitution effect.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: Multiple Choice
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

21. Suppose the government spends the same for a particular consumer under two different policies: One subsidizes the price of good x while the other is a lump sum subsidy. Which of the following is true.

a.Compared to the lump sum subsidy, the consumer will purchase more x under the price subsidy if and only if x is a normal good.
b.Compared to the lump sum subsidy, the consumer will purchase less of x under the price subsidy if x is an inferior good.
c.Compared to the lump sum subsidy, the consumer will purchase less of x under the price subsidy if x is a Giffen good.
d.The consumer will spend the same on x under the two policy if and only if her indifference curves are kinked.
e.Both (a) and (c).
f.Both (b) and (c).
g.All of the above.
h.None of the above.

ANSWER: d
RATIONALE: The solid lines in the graphs below are the budget constraints under the two policies. If the government spends the same amount, it must be that A is optimal under the price subsidy — which implies the indifference curve crosses the lump-sum subsidy budget in a way that implies the optimal bundle under the lump sum subsidy B lies to the left of A regardless of what kind of good x is (so long as there is some curvature at A). If there is a kink at A (as in the second graph), the two policies can result in the same choice.
POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: Multiple Choice
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

Subjective Short Answer

22. Currently. the price of consuming housing is lowered by the fact that home mortgage interest is tax deductible. Suppose the government proposed to eliminate this implicit subsidy of your housing consumption, raising the price from to . At the same time, the government lowers the tax on other consumption, lowering the price from to .

a. Write down your original budget constraint assuming the consumer has income I.
b. Suppose the utility function captures your tastes, and suppose , , , and . Write out the utility maximization problem for this consumer prior to any policy change.
c. How much housing and other goods will this consumer consume prior to any policy change?
d. How much would this consumer be willing to pay to get the policy change implemented?

ANSWER: a.
b.
c.
d. We first have to solve for the bundle the consumer would consume if she paid the maximum amount she is willing to pay to get the policy change implemented. The maximum she is willing to pay is an amount that will leave her with the same utility that she had before the policy — and that utility is . At the post-policy prices, the expenditure necessary to reach this utility level is determined by solving.

This gives us the bundle At the post-policy prices, this bundle costs — which implies that the consumer is willing to pay as much as to get the policy implemented. (Without rounding errors, this amount comes out to be $2523.26.)

POINTS: 1
DIFFICULTY: B-Section Material
QUESTION TYPE: Subjective Short Answer
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

23. Suppose your tastes are defined by the utility function .

a. Suppose your income is $1,000, the price of is 1 and the price of is . Set up your utility maximization problem.
b. Derive the quantity of you will consume.
c. What happens to your consumption of if increases?
d. Now suppose that your and my tastes are captured by the utility function , with the parameter different for you than it is for me. When increases, you consume more than before and I consume less. What range of is consistent with your behavior, and what range is consistent with mine? Use your answer to (b) to explain.

ANSWER: a.
b.
c. It remains the same.
d. Cobb-Douglas tastes are CES tastes with elasticity of substitution equal to 1. The elasticity of substitution in the CES function is given by , with Cobb-Douglas tastes therefore having .If , the elasticity of substitution is less than 1, and if , the elasticity of substitution is greater than 1. The graphs below illustrate two scenarios — the first with a high elasticity of substitution and the second with a low elasticity of substitution. In both cases, tastes are homothetic (as they are for CES preferences). A high elasticity of substitution implies that consumption increases with an increase in , and a low elasticity of substitution implies that consumption decreases with an increase in . In part (c), we found that Cobb-Douglas tastes fall at the border of these scenarios, which implies that divides the two cases. For you, therefore lies between 0 and , while for me lies between 0 and -1.
POINTS: 1
DIFFICULTY: B-Section Material
QUESTION TYPE: Subjective Short Answer
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

24. Suppose you collect stamps and coins for the sheer fun of it. Currently, your collection contains both. For purposes of this problem, suppose that stamps all sell for one price and coins all sell for another, and both are normal goods.

a. Begin by illustrating your current budget constraint (with stamps on the horizontal and coins on the vertical) as well as the bundle A you currently own. Assume that you have done the best you can given your circumstances.
b. The stamp industry has recently marketed its product as a safe way of investing and insuring against inflation. As a result, the price of stamps has been driven up since you chose your current bundle. Show how this changes your budget constraint given that you can buy and sell both stamps and coins — and assuming you have no additional funds to spend on your collections.
c. Are you happy about the stamp industry’s marketing campaign? In what way will you adjust your collection?
d. After a while (and after you have made your desired adjustments), it turns out that the marketing campaign only produced a temporary “bubble” in the stamp market — and prices fall back to what they were before. Are you happy when the bubble bursts? Will you have more or fewer coins and stamps than you had before the marketing campaign started?
e. True or False: For collectors that collect to satisfy their passion (rather than as an investment strategy), volatility in prices is good.

ANSWER: a.
b. This changes the budget to the dashed budget in the second graph.
c. A portion of the new dashed budget lies above the original indifference curve — implying that there are now bundles available that are preferred to the original bundle A. So you are happy about the marketing campaign. All of these bundles have more coins and fewer stamps — so you will end up selling stamps and buying coins.d. When the bubble bursts, we are at bundle B — and the new budget now passes through B with a shallower slope. Again, new bundles emerge that lie above the indifference curve that contains B — implying you are happy about the bubble bursting. All of the potentially more preferred bundles contain more stamps and fewer shirts. Since we know stamps and coins are both normal goods, we know that bundle C where you end up will have more stamps and more coins than you had at A. (This is because the original and final budgets both have the same slope.)

e. This is true — price fluctuations open up new bundles that are preferred, as items that have become relatively more expensive are sold to purchase items that have become relatively cheaper,

POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: Subjective Short Answer
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

25. Your drink budget is entirely split between bottled water and fancy liqueurs, and your tastes are quasilinear in bottled water. In an attempt to get people to drink more water, the government introduces a subsidy that lowers the price of bottled water.

a. In a graph with bottled water on the horizontal and fancy liqueurs on the vertical axis, illustrate your before-subsidy budget and your optimal bundle A.
b. As a result of the water subsidy, I notice you consume more fancy liqueur. Illustrate this in your graph using income and substitution effects.
c. You and I are good friends, in part because I confided in you some time ago that I, too, have tastes that are quasilinear in water. (Nothing bonds like quasilinearity!) But, after the subsidy is introduced, you observe that I, unlike you, have reduced my consumption of fancy liqueurs. Your other friends claim that this is proof that our friendship is based on a fiction — that I cannot possibly also have quasilinear tastes. Illustrate in a graph why your friends are wrong.
d. If we both have quasilinear tastes, can you explain what the fundamental difference in our tastes is that accounts for the difference in behavior?

ANSWER: a. This is illustrated in the first graph with the steeper solid budget and the optimal bundle A that lies on that budget.

b. The substitution effect takes you from A to B, and the income effect takes you vertically up to C (from B) because of the quasilinearity of bottled water. Since C is higher than A, we have illustrated the case of you consuming more liqueurs as a result of the lower price for bottled water.

c. Below we illustrate the same graph as above except that the substitution effect is bigger. As a result, C ends up below A — illustrating a case where bottled water is still quasilinear but my consumption of liqueurs falls when the price of bottled water falls.

d. The fundamental difference in our tastes is the degree of substitutability of water for liqueur at the original bundle A. The two are relatively complementary for you — resulting in a small substitution effect, while they are relatively substitutable for me, resulting in larger substitution effect.

POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: Subjective Short Answer
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

26. Suppose a relatively low income family has a monthly budget of $1,000 to allocate between food and a non-food composite good. In this problem, assume food is aggregated into a “composite food” good that is modeled on the horizontal axis, and the non-food composite good is denominated in “dollars of other consumption”. The price of food is $10 per unit. Suppose further that this family’s tastes exhibit kinks in indifference curves, with one such indifference curve graphed below.

a. Draw the family’s budget constraint and label the optimal consumption bundle.

b. Due to unexpected droughts, the price of food rises to $20. A cash subsidy S that leaves our family with the same level of happiness as it enjoyed prior to the price increase is proposed. How much would this subsidy cost for this family?

c. An alternative proposal suggests a price subsidy s that lowers the price of food for this family from $20 to ($20-s), with s set sufficiently high to allow the family to reach its original utility level.

d. Yet a third proposal suggests a price subsidy that leaves in tact the new price of $20 for the first 20 units of food bought by the family but then lowers the price for this family to $(20-s’) while also making the family just as happy as it was before. How high does s’ have to be to accomplish this?

e. If cost is all you care about, how would you rank these three policies? What if you care about food consumption for this family and believe a policy is better if it results in more food consumption?

ANSWER: a. The budget, illustrated below, is “tangent” at B — making B the optimal consumption bundle.

b. This would change the slope of the budget from -10 to -20 — which is steeper than the portion of the indifference curve that connects A and B. Bundle A will therefore be the optimum under the cash subsidy — and the family will need $1,400 to reach A at the new price. Thus, S=$400.

c. For the family to reach its original indifference curve, the price of food would have to go back to $10 for the family — with B again optimal. Thus, s=10.

d. This is pictured in the last panel — where the least cost way of reaching the original indifference curve now implies getting the family to bundle C. The slope of the dashed line is -5 — implying that s’=15.

e. The cash subsidy program costs $400; the straight subsidy costs $500; and the modified subsidy (in part d) is $900. If all you care about is cost, you would prefer the cash subsidy to the straight subsidy to the modified subsidy. If, however, you care about how much food the family eats — and you think more is better, the preference ordering over the three policies would be reversed.

POINTS: 1
DIFFICULTY: A-Section Material
QUESTION TYPE: Subjective Short Answer
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

27. Suppose the only two goods you care about in the world are French wine (x) and Cuban cigars (y) and your utility function is given by u(x,y)=xy. You have no income, and the only thing in the world you possess is a large box you have just inherited from your rich uncle who passed away last week (of liver and lung cancer.) You open the box, and much to your liking, you find it contains 9 bottles of fine French wine and 3 boxes of exquisite Cuban cigars. Currently, the wine sells for $1 per bottle, and the cigars sell for $9 per box. Just as you receive the inheritance, you read the headline: “President Lifts Embargo – Price of Cuban Cigars Falls to $4 per Box!”

a. Determine the income (or wealth) and substitution effects of a decrease of the price of cigars from 9 to 4. (Assume fractions of bottles and cigars can be bought.)
b. Are cigars a normal or inferior good for you?
c. How much would you have been willing to pay the President in order not to lift the embargo?

ANSWER: a. Cobb-Douglas tastes with equal exponents result in demand functions of . Income in our case is based on the value of the endowment — which is 36 before the price change and 21 afterwards. Thus, to total change in the consumption bundle is from an initial (18,2) to a final .

To isolate the substitution effect, we need to start by finding the utility level before the price change — which is 18(2)=36. We then solve

to get the bundle (12,3).

The substitution effect therefore takes us from (18,2) to (12,3) while the wealth effect takes us from (12,3) to (11.5, 2.625).

b. Cigars are normal goods. It may appear like the income effect is negative, but that’s because the budget is endogenous — Cobb-Douglas tastes are always over normal goods.

c. If embargo is lifted, utility will be (11.5)(2.625)=30.1875. If prices remained at the pre-embargo levels and you had just enough income E to reach this utility level, it would have to be that (because you would be consuming according to the demand functions in (a) with the price of wine at 1 and the price of cigars at 9). Solving this equation, we get while the initial value of your endowment is 36. Thus, you would be willing to pay approximately $3 to avoid the lifting of the embargo.

POINTS: 1
DIFFICULTY: B-Section Material
QUESTION TYPE: Subjective Short Answer
HAS VARIABLES: False
DATE CREATED: 2/11/2015 10:52 PM
DATE MODIFIED: 2/11/2015 10:52 PM

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