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Consider a demand equation of the form T= 0 - SPI Ty. where p is price and y is income. Suppose we have estimated the
Consider a demand equation of the form T= 0 - SPI Ty. where p is price and y is income. Suppose we have estimated the parameters of this equation using market data on prices and quantities, so that a = 2, 8 =0.65, and y =0.0002. Assume that the initial market price is USD10, and that we are interested in examining the welfare effects for a person with income of USD50000. 1. Compute the baseline demand, price clasticity, and income elasticity for this person. Is the income effect large or small according to your intuitive understanding? 2. Consider a price increase to USD20. Compute the compensating and equivalent variation for this change. Hint: Example 14.1 in PR shows that a" =V(py) = exp( 7)yo-Ap
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