Econ 100A Ans to PS1

Econ 100A Ans to PS1 - Department of Economics University...

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Department of Economics Spring 2008 University of California, Berkeley Prof. Woroch Economics 100A PROBLEM SET 1 ANSWER SHEET I. TRUE or FALSE and EXPLAIN : For each statement below, decide whether it is true or false, and explain the reasoning behind your answer in a few sentences . When appropriate, provide a diagram. 1. Theresa likes coffee from Starbucks and bagels from Noah’s, but only together in specific proportions, and so her marginal rate of substitution between coffee and bagels is constant. False. Theresa’s indifference curves are L-shaped with the corner located where the two goods— coffee and bagels—are in the desired proportions. Accordingly, her “MRS of coffee for bagels” is zero or infinite depending on whether there are too many or too few bagels relative to cups of coffee given her desired proportions. At the corner, the MRS is undefined because the slope of the indifference curve is not defined. 2. If Jennifer’s income elasticity for potatoes is negative, then she violates the assumption of “more is better.” False. Negative income elasticity means potatoes are an inferior good but that does not mean she prefers less to more. In fact, increased income will result in more consumption of some good other than potatoes while her consumption of potatoes falls. 3. Joaquin buys life insurance but also is known to play the lottery regularly, and so he cannot be an expected utility maximizer. False. If Joaquin’s utility functions was convex (risk-seeking) over some final income levels and concave (risk-averse) over others (e.g., u(I) = (100 +I) 3 ), this could explain why he might avoid a fair bet and on another occasion accept a sub-fair bet. But this would not explain simultaneous risk avoidance and risk seeking behavior. One possibility is that there is another source of utility besides money payoff, e.g., the thrill of a big personal win and a huge cost to leaving one’s family without income. Another possibility is that Joaquin has a distorted perception of the risk of his death and of his winning the lottery—relative to the statistical averages—leading him to buy insurance (greater risk of death than the life insurance company uses to compute its premium) and buy lottery tickets (greater chance of jackpot than the lottery pays off). 4. If the price of good X, the price of good Y, and Ahmad’s income all change by the same proportion, relative prices will be the unchanged and the budget constraint will stay the same. True. The budget shifts out with the increase in income, and then shifts back to its original position as all prices (i.e., X and Y) increase by the same proportion. The budget constraint stays the same: ap x X + ap y Y = aI for any a > 0 if p x X + p y Y = I. Necessarily the relative prices will be unchanged. II.
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Econ 100A Ans to PS1 - Department of Economics University...

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