09HWS1 - Economics 104A Solution for Problem Set#1 Winter...

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Economics 104A Solution for Problem Set #1 Winter 2009 1. When the price of a good, say good 1 is $5 per unit, Jim consumes 1,000 units. The price rises to $5.50, and to offset the harm to Jim, the government gives him a cash transfer of $500. Use IC’s and budget lines to determine whether Jim is better off or worse off after the price rise plus the cash transfer. Label your diagram completely. Answer: With the new price of good 1, the additional cost of the bundle the consumer bought before the increase in the price of good is $500. Thus with a cash transfer of $500, the consumer can still buy the old bundle. Since the price ratios before and after the price increase are different, the new optimal bundle is going to be different from the old bundle (see Figure 1). Hence, the new optimal bundle is revealed preferred to the old one, which implies that the Jim is better off. Notice that to buy 1,000 units of good 1 at price $5, the consumer must have at least $5,000 before price increase. The horizontal intercept of the budget line with the cash
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