Question

Suppose you allocate all your wealth to “housing” and “savings”. Housing costs $40 per square foot. You have $100,000 in wealth and have elected to build a 1000 square foot house. Draw your budget line between housing (on the horizontal axis) and savings (on the vertical). Draw the indifference curve you are on. Now suppose the price of housing falls to $30 per square foot. (Do not forget that you already bought a 1000 square foot house!) Draw your new budget line. (Hint: You can keep your existing house -- the one shown in your answer to question 8 -- if you want to.) True or False: The fall in housing prices makes you happier. Assume that housing is an inferior good and illustrate the substitution and income effects from a fall in housing prices.. True or False: If housing is an inferior good, then in this problem the substitution effect must be larger than the income effect.

Answer 1

Solution

A person either spend money on housing o do saving.

The cost of housing is $40.

The income or wealth of the person is $100,000

He wants to build a 1000 square foot house

so, the cost of building house= 40*1000=$40,000

Therefore, savings= $100,000-$40,000= $60,000

So, the budget line and indifference curve will be

Now, the price of housing falls to $30 per square foot. As the price falls the slope of the budget line also falls and it becomes flatter.

So, housing cost= 30*1000=$30,000

Savings= $70,000

The new budget line will be

True, the fall in house prices will make the person happy because it will increase the purchasing power. NOw person can build the same level of the house at a lower cost and save more.

Assume that housing is inferior good. In that case, both substitution and income effect is negative. Fall in price will lead to an increase in the spending on housing and income effect will decrease the spending on housing.

True, If housing is an inferior good then the substitution effect must be larger than the income effect as shown in the above diagram.

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