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2. Consider the Constant Elasticity of Substitution (CES) utility function: u( C1, 2) = (0c] + (1 -0)c3)1/ where 1 > 0 > 0 is
2. Consider the Constant Elasticity of Substitution (CES) utility function: u( C1, 2) = (0c] + (1 -0)c3)1/ where 1 > 0 > 0 is an exogenous parameter that determines the relative preference for ci, and I = 1/(1 - y) is the elasticity of substitution between c and c2, which is the percent change in the ratio of those two variables with respect to a one percent change in the Marginal Rate of Substitution. (a) Compute the Marginal Rate of Substitution (MRS) of c for c2 in terms of A and y. (b) Use your answer from part (a) to express the consumer's optimality condition. (c) Use your answer from part (b) to explain what the size of the elasticity of substitution implies for the size of the change in the optimal ratio c * /c2* when the relative price Pi/ P2 increases
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