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BUAD 351 - Economic Analysis for Business Decisions Homework 2 due: Wed 02/13/2008 PART (i): multiple choice question 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 answer d b a,d b b a b d b b c a b b c PART (ii) short questions Compensating variation measures the amount of monetary compensation that a consumer needs to receive (or would be willing to pay) following a change in market conditions, such as a change in prices to leave him or her as well o± as she was with her original bundle (before the change in market conditions). 2. De²ne consumer surplus. Knowing the equilibrium market price and the demand curve, how would you measure consumer surplus? Consumer surplus measures the total bene²t a consumer derives from consuming a particular prod- uct minus the price paid. Consumer surplus is measured by the area below the (inverse) demand curve and above the price paid. That is, the di±erence between marginal bene²t and price for each unit of consumption. 3. Suppose that Frank is considering giving Mike eight paper back books in exchange for 2 CDs. Explain the conditions under which this trade would be mutually bene²cial. Also explain the con- ditions under which Frank and Mike won³t make the trade. The e±ective trade "price" is 4 books per CD. This trade would then be bene²cial as long as Frank³s marginal rate of substitution MRS CD;book is greater than 4 books per CD and Mike³s marginal rate of substitution of paperback books for CD is less than 4 paperbacks per CD. If Frank³s MRS of paperbacks for CD³s is less than 4, he won³t agree to the trade. If Mike³s MRS of paperbacks for CD³s is greater that 4, he won³t agree to the trade. Of course, the trade could still take place under other terms 1

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Part (iii) slightly longer questions U ( W ) = p W: There are two potential outcomes, drought and rainy season. In the case of drought, his water bundle is W d = 100 and in the case of rainy season, his water bundle is W r = 400 : The probability of drought is 3 = 4 : (a) Calculate the expected consumption of water 3 4 100 + 1 4 400 = 75 + 100 = 175 3 4 10 + 1 4 20 = 7 : 5 + 5 = 12 1 2 12 1 2 = p W ! W = 25 2 ± 2 = 625 4 (d) What is Tom&s risk-premium (in units of water)?
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