Question

You have preferences described by u(x,y)=2x+7y. Your income is I and prices are px =1, py =4.

a) Decompose the effect of a change in the price of px from 1 to 3 into an Income and Substitution Effect for x and y. Note: Unless specified otherwise, you can assume that the price of the other good remains unchanged, i.e. here the price of y remains unchanged at 4.

b) Suppose the government gives you enough income so that you can just afford the original bundle when you face the new prices. Does this compensation make you better off compared to before the price change? Explain your reasoning.

Answer 1

Fve feverieAv tenonces ven byU(xy)2x+ 7yexamaua Aubititul Now, a)ty Houa, MRSxy 2 O.28 #O.25 7 Px Cleay Cwa Cnp u nlygood X Eapation to Bur Liue: "hM th adjaueur diayran ti is pmest by ABo ihal ibnum ou or Bote ar We w, Cornidw an Cumase i trom P to B3 New B.L, Th U iogranm, tr hao ban pnesu ABy- T/2 2-0.28 < 0.75=3 4 Heur MRSy= Ty Clowy cEnaunn rhi Toand ody e eutine Price ve an Heur, ubtitutian er Zevo ts aptune tte Hickpiau B, L ttu ofply on old bundle au corsuning Heus, zubatitutim eer maho we OH bau btou te yes baip peualion et oy Price clhauge a my Wal inomeDhas tunnsu I IAI Cin Tovma P)