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Unformatted text preview: Eco11, Fall 2008 Simon Board Economics 11: Solutions to Practice Midterm October 22, 2008 Short Questions Question 1 A consumer spends his entire budget on two goods: X and Y. (i) True or false: An increase in the price of X will lead the consumer to purchase less X. (ii) True or false: An increase in the price of X will always lead a consumer to purchase more Y. Solution (i) False: It will depend on good X. If X is a Giffen good, the negative substitution effect of the price increase is more than outweighed by the positive income effect, thus the demand for X is increasing in the price. (ii) False: X and Y could be either gross complements or gross substitutes. If they are gross complements, the negative income effect always outweighs the substitution effect, and the overall demand for Y is decreasing in the price of X. If they are gross substitutes, the substitution effect outweighs the income effect, and the demand for Y is increasing in the price of X. Question 2 Graphically explain the effect in the budget constraint of an increase in an individual’s income without changing relative prices. Explain the impact on the quantity demanded of both goods. Solution The budget line shifts parallel when the income changes and the price ratio remains the same. The impact on the quantity demanded will depend on the type of good. If X is inferior the quantity demanded decreases when the income of the consumer increases: dX/dm < 0. If X is normal the quantity demanded increases when the income of the consumer increases: dX/dm > 0....
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- Fall '08
- Economics, p1, Simon Board