P
Y
=6 and X = 8.
Total spending on good X = 2*8 = 16
Total spending on good Y = 6*6 = 36
Suppose now that the price of good X becomes $4 while the price of good Y does not change.
c)
Identify (on a diagram) the substitution effect and income effect associated with the increase in
the price of good X. (8 marks)
See class note or assignment 1 answer key. It is up to the student to draw the effects for a
normal or an inferior good. Key point is if the good is inferior good, then the 2 effects must
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be in opposite direction. If it is normal good then the 2 effects must be in the same
direction.
Suppose now that we are able to derive Tom’s demand for good X as: Px = 26 –
3X
T
(where X
T
is Tom’s
demand for good X). Also,
Peter (Tom’s brother) has identical utility function and budget like Tom.
d)
Prove that the market (consisting of 2 consumers: Tom and Peter) aggregate demand function
takes the following form:
3
26
2
X
AGG
P
X
. (6 marks)
Since Peter has identical utility and budget, he must have identical demand function for
good X. Thus the aggregate market demand for good X is:
52
2
2
3
3
AGG
T
P
T
X
X
X
X
X
P
Or
3
26
2
X
AGG
P
X
e)
What is the supply curve so that the market equilibrium quantity and price are 16 and 2
respectively? (4 marks)
An upward sloping supply curve normally takes the following form: P
X
= a + bX (linear).
Since it starts at the origin, a = 0. The supply curve is thus just Px = bX. With X = 16 and Px =
2, b = 1/8. Or the supply curve is Px = 1/8X.
Question 2 (30 marks)
Suppose the ORANGE COMP INC. has the following production function:
1/2
1/2
(
,
)
4
Q K L
K
L
.
It also
takes market wage (w) and rent (r)as given where w=2 and r = 4.
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 Fall '12
 Danvo
 Microeconomics, Supply And Demand, Tom

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