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Unformatted text preview: Intermediate Microeconomics (Econ 101) Spring, 2009 Solutions to Additional Problems in Assignment 2 Solution to Question 1. Since the consumer has a constant MRS, the two goods must be perfect substitutes. Since good 2 is twice as expensive as good 1, we have p 1 p 2 = 1 2 > 1 3 =  MRS  . Therefore the consumers gross demand for good 1 is 0 and he only consumes good 2. This means she would sell all her endowment of good 1 and buys good 2. Solution to Question 2. (1) True. Since p 2 decreases, the relative price for good 1 ( p 1 p 2 ) increases. The substitution effect for good 1 is negative. But since the total effect for good 1 is an increase in demand, the income effect must be positive (and big enough to offset the negative substitution effect), which means the demand for good 1 increases as income increases, and hence good 1 must be a normal good. Alternatively, you can use a graph to explain this. Draw a budget line for the new price ratio through the initial optimal choice (as you would do when decomposing the substitu tion effect and income effect for good 2). The argument for the negative sign of substitution effect leads us to conclude the new optimal choice must be a point to the left of the initial optimal choice, i.e., x 1 decreases. Since the total effect on good 1 is an increase in con sumption, when the intermediate budget line moves out to the new budget line under the new price ratio and the initial income, x 1 must increase. This means good 1 is a normal good. (2) False. It is easy to construct examples where good 2 is normal. In fact, we cannot conclude whether good 2 is normal or inferior. Both cases are consistent with the information given.whether good 2 is normal or inferior....
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 Spring '08
 DANNICATAMBAY
 Microeconomics

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