In: Economics
During droughts, cities often impose water use restrictions on consumers. Suppose a representative consumer has preferences for Water (W) and other goods (X) given by the utility function: U(W,X) = WX. Suppose the price of other goods is $1 and the price of water is initially 50¢. The consumer has a budget of $100/week. a. How much water will the consumer purchase each week? b. Suppose the government imposes a quota on water use of 50 units/week. Show that the quota reduces the representative consumerʹs utility. c. By how much does the quota harm the representative consumer? Specifically, compute the equivalent variation of the quota.
a)
U(W,X)=WX
Marginal Utility from water=MUw=dU/dW=X
Marginal Utility from other goods=MUx=dU/dX=W
Px=$1, Pw=$0.50
In utility maximization,
MUx/MUw=Px/Pw
W/X=(1/0.50)
W=2X
We know that
XPx+WPw=$100 or
X+0.5W=100
Put W=2X in budget constraint
X+0.5*(2X)=100
2X=100
X=50
W=2X=2*50=100
Consumer will purchase 100 units of water and 50 units of other goods to maximize utility.
Utility=WX=100*50=5000 utils
b)
Given W=50
We have derived in part a that
X+0.5W=100
X+0.5*50=100
X=75
So, new consumption level is W=50 and X=75
Utility=WX=50*75=$3750
We have calculate the utility at earlier consumption level in part (a)
Earlier utility=5000
We can see that utility has decreased due to quota.
c)
Let us calculate the X for which consumer gets the total utility equal to earlier utility i.e. 50000
U(X,W)=WX
5000=50*X
X=100
So, total budget required to meet this condition.
Required budget=WPw+XPx=50*0.50+100*1 =$125
Equivalent variation=New budget required-Earlier consumption=125-100=$25