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Chapter 4 Practice A - Answers 1. Suppose Jane has an income of \$40, the price of good X is \$4, and the price of good Y is \$4. She consumes a bundle that consists of 5 units of X and 5 units of Y each month. a. Now the price of X falls to \$2. Jane decides to consume 7 units of X and 6.5 units of Y. Does Jane feel richer? Why do you think so? (4 points) Yes. Her purchasing power increases (caused by the decrease in P X ). b. Can you tell whether good X is non-Giffen or Giffen for Jane? (4 points) Yes. Good X is non-Giffen because she consumes more (by total effect) of good X when P X falls. c. To support your answer in part (b), construct Jane’s demand curve for X. Is the slope of the demand curve consistent with your answer in part (b)? (4 points) Yes – this demand curve is for a non-Giffen good because it is negatively (downward) sloped. (A Giffen good has a positive, or upward-sloping, demand curve.)

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d. Can you tell whether good X is normal or inferior for Jane? (4 points) No. You would need to see the compensated budget constraint, so that the income effect could be separated from the substitution effect. e. Now Jane finds that the fall in the price of X has increased her purchasing power, so she decides to share it with her brother by sending him \$12 each month for the rest of her life. Can she afford bundle A (what she had been consuming before the price and income changes)? (4 points) No. To afford Bundle A, she would need \$30 (\$2×5 + \$4×5 = \$30). After sending \$12 to her brother, she only has \$28. f. To maintain her utility level at U 1 after the price and income change, she decides to consume 8 units of X and 3 units of Y. Draw a compensated budget constraint and label the new optimal point as C. (4 points) Income left after she gives money to her brother = (\$2)(8) + (\$4)(3) = \$28 g. Now can you tell whether good X is normal or inferior for Jane? Explain. (4 points) X is an inferior good because she buys less X (by the income effect, from point C to point B)) when her purchasing power goes up (caused by a fall in P X ). h. To support your answer in part (g), construct Jane’s Engel curve for good X. Is the slope of the Engel curve consistent with your answer in part (g)? (4 points) \$28 is her “compensated” income and \$40 is her actual income.
2. Suppose that the only 2 goods you purchase are X and Y. One day, the price of X goes down. a. Illustrate your old and new budget lines.

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