2. Maude spends all of her income on delphiniums and hollyhocks. She thinks that
ID: 1148622 • Letter: 2
Question
2. Maude spends all of her income on delphiniums and hollyhocks. She thinks that delphiniums and hollyhocks are perfect substitutes; one delphinium is just as good as one hollyhock. Delphiniums cost $4 a unit and hollyhocks cost S5 a unit. HRS1+ 1 a. If the price of delphiniums decreases to $3 a unit, will Maude buy more of them? Yes. What part of ne change in consumption is due to the income etfect and what part is due to the substitution effect? of delphiniums and hollyhocks are respectively Ps $4 and p $5 and if Maude has $120 hat she can attain in red to spend, draw her budget line in blue ink. Draw the highest indifference curve t ink, and label the point that she chooses as A. c. Now let the price of hollyhocks fall to $3 a unit, while the price of delphiniums does not change. Draw her new budget line in black ink. Draw the highest indifference curve that she can now reach with red ink. Label the point she chooses now as B. d. How much would Maude's income have to be after the price of hollyhocks fell, so that she could just exactly afford her old commodity bundle A? e. When the price of hollyhocks fell to $3, what part of the change in Maude's demand was due to the income effect and what part was due to the substitution effect?Explanation / Answer
The two goods are assumed to be X(delphiniums) and Y(hollyhocks), The utility function is therefore U = X + Y. This is because 1 X is as good as 1 Y so the utility provided by 1 X is same as utility provided by 1 Y. Prices are Px = 4 and Py = 5. Now Px becomes 3.
We see that Px/Py < 1 and |MRS| = 1. Since |MRS| > Px/Py, Maude believes that only X should be consumed. Hence before the price change he was consuming X only. After the price change, he still buy only X because the condition |MRS| > Px/Py still persists. This indicates that there is no income effect (income effect measures the change in quantity of a good when its price changes due to change in real income)
Hence there is no increase in X due to income effect and the entire income is now being spent on X as before, so all the change is brought about by substitution effect. There is no income given so how much is spent on X is not known.
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