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Intermediate Micro test 1

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What are the four basic assumptions about individual preferences? Briefly explain the meaning of each.

(1) Preferences are complete: this means consumers are able to compare and rank all possible baskets of goods and services. (2) Preferences are transitive: this means preferences are consistent, in the sense that if bundle A is preferred to bundle B and bundle B is preferred to bundle C, then bundle A is preferred to bundle C. (3) More is preferred to less: this means all goods are desirable, and that consumers always prefer to have more of each good. (4) Diminishing marginal rate of substitution: this means that indifference curves are convex, and that the slope of the indifference curve increases (becomes less negative) as we move down along the curve. As a consumer moves down her indifference curve she is willing to give up fewer units of the good on the vertical axis in exchange for one more unit of the good on the horizontal axis. This assumption also means that balanced market baskets are generally preferred to baskets that have a lot of one good and little of the other.

Use supply and demand curves to illustrate how each of the following events would affect the price of butter and the quantity of butter bought and sold: a. An increase in the price of margarine. b. An increase in the price of milk. c. A decrease in average income levels.

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question 5 hw 1

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4. You run a small business and would like to predict what will happen to the quantity demanded for your product if you raise your price. While you do not know the exact demand curve for your product, you do know that in the first year you charged $45 and sold 1200 units and that in the second year you charged $30 and sold 1800 units. a. If you plan to raise your price by 10%, what would be a reasonable estimate of what will happen to quantity demanded in percentage terms? We must first find the price elasticity of demand. Because the price and quantity changes are large in percentage terms, it is best to use the arc elasticity measure. EP = (ΔQ/ΔP) × (average P/average Q) = (600/−15) × (37.50/1500) = −1. With an elasticity of −1, a 10% increase in price will lead to a 10% decrease in quantity. Note: The above elasticity formula is arc-elasticity. b. If you raise your price by 10%, will revenue increase or decrease? Hint: % change in Revenue = % change in P + % change in Q. % change in Revenue = 10% + (-10%) = 0. When elasticity is −1, revenue will remain constant if price is increased.

5. Suppose you are in charge of a toll bridge that costs essentially nothing to operate. The demand for bridge crossings Q is given by a. Draw the demand curve for bridge crossings. b. How many people would cross the bridge if there were no toll? c. What is the loss of consumer surplus associated with a bridge toll of $5? d. The toll-bridge operator is considering an increase in the toll to $7. At this higher price, how many people would cross the bridge? Would the toll-bridge revenue increase or decrease? What does your answer tell you about the elasticity of demand? e. Find the lost consumer surplus associated with the increase in the price of the toll from $5 to $7.

5. Suppose you are in charge of a toll bridge that costs essentially nothing to operate. The demand for bridge crossings Q is given by a. Draw the demand curve for bridge crossings. The demand curve is linear and downward sloping. The vertical intercept is 15 and the horizontal intercept is 30.b. How many people would cross the bridge if there were no toll? At a price of zero, 0 = 15 − (1/2)Q, so Q = 30. The quantity demanded would be 30. c. What is the loss of consumer surplus associated with a bridge toll of $5? If the toll is $5 then the quantity demanded is 20. The lost consumer surplus is the difference between the consumer surplus when price is zero and the consumer surplus when price is $5. When the toll is zero, consumer surplus is the entire area under the demand curve, which is (1/2)(30)(15) = 225. When P = 5, consumer surplus is area A + B + C in the graph above. The base of this triangle is 20 and the height is 10, so consumer surplus = (1/2)(20)(10) = 100. The loss of consumer surplus is therefore $225 − 100 = $125. d. The toll-bridge operator is considering an increase in the toll to $7. At this higher price, how many people would cross the bridge? Would the toll-bridge revenue increase or decrease? What does your answer tell you about the elasticity of demand? At a toll of $7, the quantity demanded would be 16. The initial toll revenue was $5(20) = $100. The new toll revenue is $7(16) = $112, so revenue increases by $12. Since the revenue goes up when the toll is increased, demand is inelastic (the 40% increase in price outweighs the 20% decline in quantity demanded). e. Find the lost consumer surplus associated with the increase in the price of the toll from $5 to $7. The lost consumer surplus is area B + C in the graph above. Thus, the loss in consumer surplus is (16) × (7 − 5) + (1/2) × (20 − 16) × (7 − 5) = $36.

6. Suppose the average cost of raising children in the US is $10,000 per child per year and the average family income is $60,000 per year. a. Putting kids on the horizontal axis and consumption of all other goods (AOG) ($) on the vertical axis, draw the budget line for the average family. Suppose the average number of kids is 2. Label this point A. b. Due to an increase in daycare cost, the cost of raising children increases to $15,000 per child per year. To help out families with children, the government decides to pay the average family exactly enough money (in lump-sum) to make them just as happy as they were before the daycare cost increase. A certain economist dislikes this policy, arguing that because of the cash payment, parents will have less kids than they had before the policy. Do you agree? Illustrate your answer by drawing the new optimal point under this policy (label this point B). c. The economist succeeds in having the lump-sum cash payment to families removed (the increased daycare cost remains). As a result, we observed that the average number of children in a family increases beyond the original level (2 kids). Label this point C. d. Can you tell whether kids are a normal goods, an inferior good, or a Giffen good?

6. Suppose the average cost of raising children in the US is $10,000 per child per year and the average family income is $60,000 per year. a. Putting kids on the horizontal axis and consumption of all other goods (AOG) ($) on the vertical axis, draw the budget line for the average family. Suppose the average number of kids is 2. Label this point A. b. Due to an increase in daycare cost, the cost of raising children increases to $15,000 per child per year. To help out families with children, the government decides to pay the average family exactly enough money (in lump-sum) to make them just as happy as they were before the daycare cost increase. A certain economist dislikes this policy, arguing that because of the cash payment, parents will have less kids than they had before the policy. Do you agree? Illustrate your answer by drawing the new optimal point under this policy (label this point B). Ans: I agree, by providing the lump-sum payment we are isolating the substitution effect from the increased daycare cost (A->B). This must go in the direction of the good that has become relatively cheaper and away from the good that has become relatively more expensive. The number of kids must decrease. c. The economist succeeds in having the lump-sum cash payment to families removed (the increased daycare cost remains). As a result, we observed that the average number of children in a family increases beyond the original level (2 kids). Label this point C. d. Can you tell whether kids are a normal goods, an inferior good, or a Giffen good? Ans: Giffen good.

8. Although he was a prolific artist, Pablo Picasso painted only 1,000 canvases during his "Blue Period." Picasso is now dead, and all of his Blue Period works are currently on display in museums and private galleries throughout Europe and the United States. a. Draw a supply curve for Picasso Blue Period works. Why is this supply curve different from ones you have seen? b. Given the supply curve from part a, the price of a Picasso Blue Period work will be entirely dependent on what factor(s)? Draw a diagram showing how the equilibrium price of such a work is determined. c. Suppose rich art collectors decide that it is essential to acquire Picasso Blue Period art for their collections. Show the impact of this on the market for these paintings. Ans: a. There are no more Picasso blue period works available. Hence the supply curve is a vertical line at the quantity 1,000. b. Since supply is fixed, the price of a Picasso Blue Period work is entirely determined by demand. Any change in demand is fully reflected in a change in price. c. This results in a rightward shift of the demand curve for these works from D1 to D2, and the equilibrium changes from E1 to E2. But since no more works are available, this increase in demand simply results in an increase in the equilibrium price.

Suppose that the average household in a state consumes 800 gallons of gasoline per year. A 20-cent gasoline tax is introduced, coupled with a $160 annual tax rebate per household. Will the household be better or worse off under the new program?

If the household does not change its consumption of gasoline, it will be unaffected by the tax-rebate program, because the household pays ($0.20)(800) = $160 in taxes and receives $160 as an annual tax rebate. The two effects cancel each other out. However, the utility maximization model predicts that the household will not continue to purchase 800 gallons of gasoline but rather will reduce its gasoline consumption because of the substitution effect.

Antonio buys five new college textbooks during his first year at school at a cost of $80 each. Used books cost only $50 each. When the bookstore announces that there will be a 10% increase in the price of new books and a 5% increase in the price of used books, Antonio's father offers him $40 extra. a. What happens to Antonio's budget line? Illustrate the change with new books on the vertical axis. In the first year Antonio spends $80 each on 5 new books for a total of $400. For the same amount of money he could have bought 8 used textbooks. His budget line is therefore 80N + 50U = 400, where N is the number of new books and U is the number of used books. After the price change, new books cost $88, used books cost $52.50, and he has an income of $440. If he spends all of his income on new books, he can still afford to buy 5 new books, but he can now afford to buy 8.4 used books if he buys only used books. The new budget line is 88N + 52.50U = 440. The line has rotated out to the right and become slightly flatter as shown in the diagram. b. Is Antonio worse or better off after the price change? Explain. The first year he bought 5 new books at a cost of $80 each, which is a corner solution. The new price of new books is $88 and the cost of 5 new books is now $440. The $40 extra income will cover the price increase. Antonio is definitely not worse off since he can still afford the same number of new books. He may in fact be better off if he decides to switch to some used books, although the slight shift in his budget line suggests that the new optimum will most likely be at the same corner solution as before.

Real price of college tuition. a. Write down the tuition you pay for the first year at Howard. Find out the CPI for that year and calculate the real price in terms of 2019 dollar. Please write down the formula that you use. Provide the government institution where you find the CPI information. b. Write down the tuition you paid in 2019 Fall. What's the percentage change of the tuition (real price) from the first year and 2019 fall? Do you think the tuition is cheaper or more expensive? Collect CPI from Bureau of Labor Statistics. CPI 2019 = 255.759 and CPI 2018 = 251.631. In 2018 the nominal price for HU tuition is $24,966. The tuition for 2019 fall is $26,756.

Collect CPI from Bureau of Labor Statistics. CPI 2019 = 255.759 and CPI 2018 = 251.631. In 2018 the nominal price for HU tuition is $24,966. The real price of 2018 tuition in 2019 dollar is nominal price in 2018*(CPI 2019/ CPI 2018) =24,966 x (255.759/251.631)=$25,375. The tuition for 2019 fall is $26,756. The % change in the real price of tuition is (26,765 - 25,375)/ 25,375*100% =5.44%. The college tuition in 2019 is more expensive than in 2018.

True and False: Engel curves always slope upward.

False. If the good is an inferior good, quantity demanded decreases as income increases, and therefore the Engel curve slopes downward.

7. Find the flaws in reasoning in the following statements, paying particular attention to the distinction between shifts of and movements along the supply and demand curves. Draw a diagram to illustrate what actually happens in each situation. a. "A technological innovation that lowers the cost of producing a good might seem at first to result in a reduction in the price of the good to consumers. But a fall in price will increase demand for the good, and higher demand will send the price up again. It is not certain, therefore, that an innovation will really reduce price in the end." b. "A study shows that eating a clove of garlic a day can help prevent heart disease, causing many consumers to demand more garlic. This increase in demand results in a rise in the price of garlic. Consumers, seeing that the price of garlic has gone up, reduce their demand for garlic. This causes the demand for garlic to decrease and the price of garlic to fall. Therefore, the ultimate effect of the study on the price of garlic is uncertain."

Find the flaws in reasoning in the following statements, paying particular attention to the distinction between shifts of and movements along the supply and demand curves. Draw a diagram to illustrate what actually happens in each situation. a. "A technological innovation that lowers the cost of producing a good might seem at first to result in a reduction in the price of the good to consumers. But a fall in price will increase demand for the good, and higher demand will send the price up again. It is not certain, therefore, that an innovation will really reduce price in the end." b. "A study shows that eating a clove of garlic a day can help prevent heart disease, causing many consumers to demand more garlic. This increase in demand results in a rise in the price of garlic. Consumers, seeing that the price of garlic has gone up, reduce their demand for garlic. This causes the demand for garlic to decrease and the price of garlic to fall. Therefore, the ultimate effect of the study on the price of garlic is uncertain." Ans: a. This statement confuses a shift of a curve with a movement along a curve. A technological innovation lowers the cost of producing the good, leading producers to offer more of the good at any given price. This is represented by a rightward shift of the supply curve from S1 to S2. As a result, the equilibrium price falls and the equilibrium quantity rises, as shown by the change from E1 to E2. The statement "but a fall in price will increase demand for the good, and higher demand will send the price up again" is wrong for the following reasons. A fall in price does increase the quantity demanded and leads to an increase in the equilibrium quantity as one moves down along the demand curve. But it does not lead to an increase in demand—a rightward shift of the demand curve—and therefore does not cause the price to go up again. b. This statement also confuses a shift of a curve with a movement along a curve. The health report generates an increase in demand—a rightward shift of the demand curve from D1 to D2. This leads to a higher equilibrium price and quantity as we move up along the supply curve, and the equilibrium changes from E1 to E2. The following statements are wrong: "Consumers, seeing that the price of garlic has gone up, reduce their demand for garlic. This causes the demand for garlic to decrease and the price of garlic to fall." They are wrong because they imply that the rise in the equilibrium price causes the demand for garlic to decrease—a leftward shift of the demand curve. But a rise in the equilibrium price via a movement along the supply curve does not cause the demand curve to shift leftward.

Explain why an MRS between two goods must equal the ratio of the price of the goods for the consumer to achieve maximum satisfaction.

MRS describes the rate at which the consumer is willing to trade off one good for another to maintain the same level of satisfaction. The ratio of prices describes the trade-off that the consumer is able to make between the same two goods in the market. The tangency of the indifference curve with the budget line represents the point at which the trade-offs are equal and consumer satisfaction is maximized. If the MRS between two goods is not equal to the ratio of prices, then the consumer could trade one good for another at market prices to obtain higher levels of satisfaction. For example, if the slope of the budget line (the ratio of the prices) is -4, the consumer can trade 4 units of Y (the good on the vertical axis) for one unit of X (the good on the horizontal axis). If the MRS at the current bundle is 6, then the consumer is willing to trade 6 units of Y for one unit of X. Since the two slopes are not equal the consumer is not maximizing her satisfaction. The consumer is willing to trade 6 but only has to trade 4, so she should make the trade. This trading continues until the highest level of satisfaction is achieved. As trades are made, the MRS will change and eventually become equal to the price ratio.

What's the definition of marginal rate of substitution? What happens to the marginal rate of substitution as you move along a convex indifference curve? A linear indifference curve?

MRS measures how much of a good you are willing to give up in exchange for one more unit of the other good, keeping utility constant. The MRS diminishes along a convex indifference curve. This occurs because as you move down along the indifference curve, you are willing to give up less and less of the good on the vertical axis in exchange for one more unit of the good on the horizontal axis. The MRS is also the negative of the slope of the indifference curve, which decreases (becomes closer to zero) as you move down along the indifference curve. The MRS is constant along a linear indifference curve because the slope does not change. The consumer is always willing to trade the same number of units of one good in exchange for the other.

4. Suppose the demand curve for a product is given by Q = 300 − 2P + 4I, where I is average income measured in thousands of dollars. The supply curve is Q = 3P − 50. a. If I = 25, find the market-clearing price and quantity for the product. b. If I = 50, find the market-clearing price and quantity for the product. c. Draw a graph to illustrate your answers. Hint: Draw the supply and the two demand curves in part a and b.

Suppose the demand curve for a product is given by Q = 300 − 2P + 4I, where I is average income measured in thousands of dollars. The supply curve is Q = 3P − 50. a. If I = 25, find the market-clearing price and quantity for the product. Given I = 25, the demand curve becomes Q = 300 − 2P + 4(25), or Q = 400 − 2P. Set demand equal to supply and solve for P and then Q: 400 − 2P = 3P − 50 P = 90 Q = 400 − 2(90) = 220. b. If I = 50, find the market-clearing price and quantity for the product. Given I = 50, the demand curve becomes Q = 300 − 2P + 4(50), or Q = 500 − 2P. Setting demand equal to supply, solve for P and then Q: 500 − 2P = 3P − 50 P = 110 Q = 500 − 2(110) = 280. c. Draw a graph to illustrate your answers. Hint: Draw the supply and the two demand curves in part a and b. It is easier to draw the demand and supply curves if you first solve for the inverse demand and supply functions, i.e., solve the functions for P. Demand in part a is P = 200 − 0.5Q and supplyis P = 16.67 + 0.333Q. These are shown on the graph as Da and S. Equilibrium price and quantity are found at the intersection of these demand and supply curves. When the income level increases in part b, the demand curve shifts up and to the right. Inverse demand is P = 250 − 0.5Q and is labeled Db. The intersection of the new demand curve and original supply curve is the new equilibrium point.

4. Suppose the demand curve for a product is given by Q = 300 − 2P + 4I, where I is average income measured in thousands of dollars. The supply curve is Q = 3P − 50.a. If I = 25, find the market-clearing price and quantity for the product.b. If I = 50, find the market-clearing price and quantity for the product.c. Draw a graph to illustrate your answers. Hint: Draw the supply and the two demand curves in part a and b.

What's equal marginal principle? What's the intuition behind it?

The equation for the equal marginal principle is as follows: Consumers will allocate spending their incomes across goods/services so that the marginal utility per dollar of expenditure on the final unit of each good purchased will be equal to all other goods purchased. It explains the way in which each consumer will spend portions of their income across a variety of different goods in such a way as to maximize their overall satisfaction.

5. If Jane is currently willing to trade 4 movie tickets for 1 basketball ticket, then she must like basketball better than movies. True or false? Explain.

This statement is not necessarily true. If she is always willing to trade 4 movie tickets for 1 basketball ticket then yes, she likes basketball better because she will always gain the same satisfaction from 4 movie tickets as she does from 1 basketball ticket. However, it could be that she has convex preferences (diminishing MRS) and is at a bundle where she has a lot of movie tickets relative to basketball tickets. As she gives up movie tickets and acquires more basketball tickets, her MRS will fall. If MRS falls far enough she might get to the point where she would require, say, two basketball tickets to give up another movie ticket. It would not mean though that she liked movies better, just that she had a lot of basketball tickets relative to movie tickets. Her willingness to give up a good depends on the quantity of each good in her current basket.

True or False: The level of utility increases as an individual moves downward along the demand curve.

True. As the price of a good falls, the budget line pivots outward, and the consumer is able to move to a higher indifference curve.

True or False: The marginal rate of substitution diminishes as an individual moves downward along the demand curve.

True. The consumer maximizes his utility by choosing the bundle on his budget line where the price ratio is equal to the MRS. For goods 1 and 2, P1/P2 = MRS. As the price of good 1 falls, the consumer moves downward along the demand curve for good 1, and the price ratio (P1/P2) becomes smaller. Therefore, MRS must also become smaller, and thus MRS diminishes as an individual moves downward along the demand curve.

Draw a budget line and then draw an indifference curve to illustrate the satisfaction-maximizing choice associated with two products. Use your graph to answer the following questions. a. Suppose that one of the products is rationed. Explain why the consumer is likely to be worse off. Hint: Fig 3.22 b. Suppose that the price of one of the products is fixed at a level below the current price. As a result, the consumer is not able to purchase as much as she would like. Can you tell if the consumer is better off or worse off? Hint: Fig. 3.23.

When goods are not rationed, the consumer is able to choose the satisfaction-maximizing bundle where the slope of the budget line is equal to the slope of the indifference curve, or the price ratio is equal to the MRS. This is point A in the diagram below where the c onsumer buys G1 of good 1 and G2 of good 2 and achieves utility level U2. If good 1 is now rationed at G* the consumer will no longer be able to attain the utility-maximizing bundle A. He or she cannot purchase amounts of good 1 exceeding G*. As a result, the consumer will have to purchase more of the other good instead. The highest utility level the consumer can achieve with rationing is U1 at point B. This is not a point of tangency, and the consumer's utility is lower than at point A, so the consumer is worse off as a result of rationing. b. Suppose that the price of one of the products is fixed at a level below the current price. As a result, the consumer is not able to purchase as much as she would like. Can you tell if the consumer is better off or worse off? Hint: Fig. 3.23. No, the consumer could be better off or worse off. When the price of one good is fixed at a level below the current (equilibrium) price, there will be a shortage of that good, and the good will be effectively rationed. In the diagram below, the price of good 1 has been reduced, and the consumer's budget line has rotated out to the right. The consumer would like to purchase bundle B, but the amount of good 1 is restricted because of a shortage. If the most the consumer can purchase is G*, she will be exactly as well off as before, because she will be able to purchase bundle C on her original indifference curve. If there is more than G* of good 1 available, the consumer will be better off, and if there is less than G*, the consumer will be worse off.

What's the difference between change along the demand curve and change in the demand curve? In the airline market, give an example of why the demand might change. And draw two graphs for changing along the demand curve and change in the demand curve.

When the price changes, quantity demanded changes and this is a movement along the demand curve. When something else other than price changes, the entire demand curve may change (shift). For example, if people expect the coronavirus outbreak to get worse, people's consumption behavior change (less tourism and less air travel). The demand will decrease, i.e. the demand will shift to the left.

The rent control agency of New York City has found that aggregate demand is QD = 160 - 8P. Quantity is measured in tens of thousands of apartments. Price, the average monthly rental rate, is measured in hundreds of dollars. The agency also noted that the increase in Q at lower P results from more three-person families coming into the city from Long Island and demanding apartments. The city's board of realtors acknowledges that this is a good demand estimate and has shown that supply is QS = 70 +7P. a. What is the market equilibrium price and quantity? b. Is the following statement true or false? Explain your answers. The supply of apartments is more inelastic in the short run than the long run.

a. If both the agency and the board are right about demand and supply, what is the free-market price? Set supply equal to demand to find the free-market price for apartments: 160 − 8P = 70 + 7P, or P = 6, which means the rental price is $600 since price is measured in hundreds of dollars. Substituting the equilibrium price into either the demand or supply equation to determine the equilibrium quantity: QD = 160 − 8(6) = 112 and QS = 70 + 7(6) = 112. The quantity of apartments rented is 1,120,000 since Q is measured in tens of thousands of apartments. b. Is the following statement true or false? Explain your answers. The supply of apartments is more inelastic in the short run than the long run. True. In the short run it is difficult to change the supply of apartments in response to a change in price. Increasing the supply requires constructing new apartment buildings, which can take a year or more. Therefore, the elasticity of supply is more inelastic in the short run than in the long run.

Suppose the demand curve for a product is given by Q = 10 − 2P + PS, where P is the price of the product and PS is the price of a substitute good. The price of the substitute good is $2.00. a. Suppose P = $1.00. What is the price elasticity of demand? What is the cross-price elasticity of demand? b. Suppose the price of the good, P, goes to $2.00. Now what is the price elasticity of demand? What is the cross-price elasticity of demand?

a. Suppose P = $1.00. What is the price elasticity of demand? What is the cross-price elasticity of demand? Find quantity demanded when P = $1.00 and PS = $2.00. Q = 10 − 2(1) + 2 = 10. Price elasticity of demand =-0.2 Cross-price elasticity of demand =0.2 b. Suppose the price of the good, P, goes to $2.00. Now what is the price elasticity of demand? What is the cross-price elasticity of demand? When P = $2.00, Q = 10 − 2(2) + 2 = 8. Price elasticity of demand = -0.5 Cross-price elasticity of demand =0 .25

question 3 hw 1 ch 1

a. The real price of butter decreased from $1.88 in 1980 to $1.21 in 2000, and it decreased from $1.88 in 1980 to $1.32 in 2010, although it did increase between 2000 and 2010.

1. Are the following topics ones that would be covered in microeconomics or macroeconomics? a. effects of an increase in the supply of lumber on the home-building industry b. changes in the national unemployment rate c. changes in the inflation rate d. changes in the country's economic growth rate e. price of concert tickets

a. microeconomics b. macroeconomics c. macroeconomics d. macroeconomics e. microeconomics

2. Are the following statements normative or positive, or do they contain both normative and positive statements? a. A higher income tax rate would generate increased tax revenues. a1. The extra revenues should be used to give more government aid to the poor. b. The study of physics is more valuable than the study of sociology, but both should be studied by all college students. c. An increase in the price of corn will decrease the amount of corn purchased. However, it will increase the amount of wheat purchased. d. A decrease in the price of butter will increase the amount of butter purchased, but that would be bad because it would increase Americans' cholesterol levels. e. The birth rate is reduced as economies urbanize, but it also leads to a decreased average age of developing countries' populations.

a. positive statements. A1. Normative statements. b. normative statements c. positive statements d. both normative and positive statements e. positive statements

1. Harry drives to work. When the price of gasoline is $2.00 per gallon, Harry consumes 1000 gallons per year. Harry has a yearly income of $4,000. -Draw Harry's budget constraint for gasoline and all other goods. Graph his optimal bundle A, if the price of gasoline is $2.00. Put gallons of gasoline on the X axis and consumption of all other goods AOG ($) on the Y axis. Label all intercepts. -The price of gasoline increases to $2.50 per gallon. Draw his new budget constraint. Label all intercepts. -Harry and many other citizens call their Senators to complain about the higher prices. The government is sensitive to the many problems caused by higher gas prices. To offset the harm to Harry and other citizens, the government gives him and everyone else a cash transfer of $500 a year. Illustrate his budget constraint now. (Make it a dashed line.) Label all intercepts. -Is Harry better off after the price of gasoline increased and he received the transfer than he was before at point A? Explain. -What will happen to his gasoline consumption with the higher price and transfer when compared to point A?

d. Yes. Harry is better off. He can still afford point A. However, he can now achieve a higher utility level such as at a point E. e. At E, we see that gasoline consumption is lower.

Consumers in Georgia pay twice as much for avocados as they do for peaches. However, avocados and peaches are the same price in California. If consumers in both states maximize utility, will the marginal rate of substitution of peaches for avocados be the same for consumers in both states? If not, which will be higher?

where A is the number of avocados and P the number of peaches. When consumers maximize utility, they set their MRS equal to the price ratio, , where is the price of a peach and is the price of an avocado. In Georgia, avocados cost twice as much as peaches, so the price ratio is ½, but in California, the prices are the same, so the price ratio is 1. Therefore, when consumers are maximizing utility (assuming they buy positive amounts of both goods), the marginal rates of substitution will not be the same for consumers in both states. Consumers in California will have an MRS that is twice as large as consumers in Georgia.

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