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Econ1-Fall2010-PS5-sols

# Econ1-Fall2010-PS5-sols - Econ 1 PS#5 Solutions Fall 2010 1...

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Econ 1 PS #5 Solutions Fall 2010 1. a. Briefly explain to someone who has never taken an economics class what the following condition means. 2 2 1 1 = p MU p MU . This condition means that the additional happiness you get from the last dollar you spend on good 1 must equal to the additional happiness you get from the last dollar you spend on good 2. b. Give a brief intuitive explanation of how and why an individual should change his or her optimal consumption of good 1 and good 2 if 2 2 1 1 < p MU p MU . If the additional happiness that a person gets from the last dollar they spent on good 2 outweighs the additional happiness that a person gets from the last dollar they spent on good 1, then this individual should spend less money on good 1 and more money on good 2. People should spend their money on the goods that give them the greatest additional happiness per dollar (the biggest bang for their buck). 2. Suppose that Fiona’s marginal utility from drinking milk is 5 utils per ounce and her marginal utility from eating cereal is 10 utils per ounce. If the price of milk is 50 cents per ounce and the price of cereal is 80 cents per ounce, is Fiona maximizing her utility? If so, explain how you know. If not, explain how she should change her spending to increase her utility. The rational spending rule implies that at the optimal consumption bundle c c m m p MU p MU = Thus, since 5/50<10/80, we know that Fiona is not maximizing her utility. She should decrease her consumption of milk and increase her consumption of cereal, putting her money where she gets the biggest bang for her buck.

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3. Suppose that for Ellen, the marginal rate of substitution between t-shirts and shorts is 3. In other words, Ellen is willing to give up 3 t-shirts in order to get another pair of shorts.
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