Emily likes to drink wine and eat cheese. Her preferences are given by U(W,C) = min{5W,C}...

Emily likes to drink wine and eat cheese. Her preferences are given by U(W,C) = min{5W,C}

Emily has $150, wine costs $8 and cheese costs $2.

a. What is her optimal consumption bundle?

b. Suppose that the price of wine goes up to to $10.

c. Break down the effect of this change into income and substitution effects. Depict this in a graph.

d.What is the equivalent variation of this price change? Explain what it means

e. What is the compensating variation of this price change? Explain what it means

show all work

Solutions

Expert Solution

a) at eqm, 5W = C

From BC : 8W + 2C = 150

Put , C = 5W

So, 8W + 10W = 150

18W = 150

W*= 8.33

So, C*= 5*W*= 41.667

B) PW'= 10

so, from new BC : 10W + 2C = 150

Put C = 5W

So, 10W + 10W = 150

W"= 150/20= 7.5

C"= 37.5

c) as two goods are consumed in a fixed proportion, so Substitution effect is zero

entire Effect is income effect.

Graph

Rahul Sunny answered 1 year ago

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