Chapter 7 Homework 1 . Substitution and Income Effects a Mr. T's preferences are represented in the graph below. So too are three of his budget lines. Assume that Mr. T's income is $120 and unchanging and the price of one unit of good Y is $1 i. One of the solid budget lines represents Mr. T's original budget line when the price of good I was "low" and the other solid budget line represents Mr. T's new budget line after the price of good X has increased and is now "high". What was the numerical value of the original "low" price and what is the numerical value of the new, "high" price? ii. What is the utility-maximizing quantity of good X with the "low" price and what is the utility- maximizing quantity of good X with the "high" price? As a result of the increase in price, did Mr. T choose to increase or decrease his consumption of good X, according to the graph? What is the numerical value of the "net effect" of this price increase?" iii. As a result of the increase in price, does the "substitution effect" of the price increase lead Mr. T to consume more units of X or fewer units of X? What is the numerical value of the "substitution effect" of this price increase? Describe how you found your answer iv. As a result of the increase in price, does the "income effect" of the price increase lead Mr. Tconsume more units of X or fewer units of X? What is the numerical value of the "income effect" of this price increase? Describe how you found your answer. v. For Mr. T, is good X a normal good or an inferior good? How do you know? vi. For Mr. T, is good X a Giffen good? How do you know? Do- 20 30 50 60 *b. Mr. W's preferences are represented in the graph below. So too are three of his budget lines. Assume that Mr. W's income is $120 and unchanging and the price of one unit of good Y is $1. i. One of the solid budget lines represents Mr. W's original budget line when the price of good X was "low" and the other solid budget line represents Mr. W's new budget line after the price of good X has increased and is now "high". What was the numerical value of the original "low" price and what is the numerical value of the new, "high" price? ii. What is the utility-maximizing quantity of good X with the "low price and what is the utility- maximizing quantity of good X with the "high" price? As a result of the increase in price, did Mr. W choose to increase or decrease his consumption of good X, according to the graph? What is the numerical value of the "net effect" of this price increase?" iii. As a result of the increase in price, does the "substitution effect" of the price increase lead Mr. W consume more units of X or fewer units of X? What is the numerical value of the "substitution effect" of this price increase? Describe how you found your answer. iv. As a result of the increase in price, does the "income effect" of the price increase lead Mr. W consume more units of X or fewer units of X? What is the numerical value of the "income effect" of this price increase? Describe how you found your answer. v. For Mr. W, is good X a normal good or an inferior good? How do you know? vi. For Mr. W, is good X a Giffen good? How do you know? 30 50