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PS 2 - Department of Economics University of California...

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Department of Economics University of California, Berkeley ECON 100A – Microeconomic Analysis Fall 2009 Problem Set 2 Due: Tuesday, September 29, 2009, 11:00 AM (in lecture) True or False and explain For each statement below, decide whether it is true or false, and explain the reasoning behind your answers in a few sentences. When appropriate, provide a diagram. (a) The following diagram shows choices by a consumer choosing between x and y , which are both desirable. When the budget line is L 1 , the consumer selects basket A , and when the budget line is L 2 , she selects basket B . Based on revealed preference, we can conclude that A is strongly preferred to C . True: when this individual has the budget of L 2 , he chooses B ; therefore, B is weakly preferred to C . Moreover, when his budget is L 1 , he can afford B but chooses A ; therefore, A is strongly preferred to B . Using transitivity, we can conclude that A is strongly preferred to C . (b) Suppose there are two economies, say A and B . In both economies the cost of living is computed using a Laspeyres Index. However, the preferences of the inhabitants of both countries are different: in economy A the degree of substitutability among goods is relatively higher than in economy B . As a result, we should expect that the measured 1
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Department of Economics University of California, Berkeley cost of living overestimates the true cost of living more in economy A than in economy B . True: the Laspeyres Index overestimates the true cost of living because it assumes that individuals do not alter their consumption patterns as price changes. Thus, the bias will be more important when preferences are such that the response of consumption to prices is relatively high, i.e. when the degree of substitution among goods is high. Since the degree of substitution is relatively higher in country A , the degree of bias will be consequently higher. (c) 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. As result, the household will be worse off under the new program. False: 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. However, the household will not continue to purchase 800 gallons of gasoline but rather will reduce its gasoline consumption because of the substitution effect. As a result, it will be better off after the tax and
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