Econ402_Solutions_Set3 - Economics 402 Winter 2009 Problem...

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Economics 402, Winter 2009 Problem Set 3 Suggested Solutions 1. Credit Constraints Alex currently makes $500 at his lousy job. He is promised $5,000 at his sales job after he graduates from college. Alex currently spends all his income, but would like to throw a big party for his friends before graduation. Unfortunately, his credit card limit is exhausted and his bank refuses to give him a loan. 1. Draw Alex°s budget set and consumption levels he chooses today and in the future. How much does Alex save? Alex would like to throw a party and consume more than his income today, but he cannot borrow. The most he can consume today is his current income, so Alex consumes his income today and his future income tomorrow. He is at a corner solution at the kink of his budget set. Since Alex neither borrows nor saves, his saving is zero. See Figure 1. c’ c $5000 $500 Figure 1: Alex°s budget set and consumption levels 2. Suppose now that Alex°s future boss calls him up and tells him that he raised his salary to $6,000 per month. How does Alex°s consumption mix between today and the future as well as his saving change? Is he better or worse o/ than before, or does his welfare not change? Draw the graph and explain brie±y. See Figure 2. Alex°s lifetime wealth increases, so he would like to consume more in both periods. Unfortunately, he still cannot borrow, so he consumes
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