Problem Set 3 Solutions

# 1m 03px01 now xnew x 0301 so you consume 003

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Unformatted text preview: Xnew = 1 + 0.1m - 0.3(px+0.1) + ε. Now Xnew – X = -0.3*0.1, so you consume 0.03 less apples. The intuition is that for each dollar increase in the price of apples, you consume 0.3 less apples, but since the price only rose by ten cents instead of a dollar, you consume 0.03 less apples. Hence demand for apples is not perfectly elastic. You can also see this by differentiating X wrt Px and multiplying the result by 0.1. c) We know that when the price of apples increases by 10 cents, demand for apples falls by 0.3*.1 = .03 apples. But the important thing to note is that this 0.03 decrease is the combined income and substitution effects. The Slutsky equation is that the substitution effect S = ∂X/∂px + (∂X/∂m)*X, where the term S is the substitution effect, ∂X/∂px is the total effect, and (∂X/∂m)*X is the income effect. When the price increase by 1, we have S = -0.3+0.1*2 = -0.1, where -0.3 is t...
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## This note was uploaded on 02/09/2014 for the course ECON 1130 taught by Professor Baum-snow during the Spring '11 term at Brown.

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