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Econ 5201 Lecture 4

Econ 5201 Lecture 4 - Consumers Problem IV Income...

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Consumer’s Problem IV Income, Substitution and Price Effects Consider the consumer’s problem: max U=U(x 1 , x 2 ) s.t. p 1 x 1 +p 2 x 2 =m We have seen that the optimal solution to the problem leads to the utility-maximizing bundle (x 1 *, x 2 *). Figure 1 x 2 C m/p 2 A x 2 ** R x 2 * P O x 1 * x 2 ** m/p B D x 1 Now suppose that p 1 and p 2 (Figure 1) remain unchanged but m is raised to m’. We know that the new budget line satisfying p 1 x 1 +p 2 x 2 =m’ represented by the line CD will be parallel to the old budget line AB. The point of tangency B of the new budget line with a higher indifference curve represents the new 1
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