exercise 2

Exercise 2. (20 points) Stella's preferences over power bars (x) and other goods (y) are represented by the utility function U(x,y) = 4vx + y. Assume that the price of other goods is normalized to Py = $1 and that Stella has a budget of $10. a) What is Stella's optimal basket when the price of power bars is Px = $2? Label it basket A. b) What is Stella's' optimal basket when the price of power bars drops to P'x = $1? Label it basket B. c) In a diagram, illustrate Stella's initial and new budget constraints and optimal baskets. Now, decompose the total effect of the price decline into the substitution and the income effect using the Hicksian method. d) What is Stella's Hicksian compensated bundle? e) What is Stella's compensating variation of the price decline? Find it numerically and then illustrate Stella's CV in your diagram. f) What is Stella's equivalent variation of the price decline? Find it numerically and then illustrate Stella's EV in your diagram g) Find the expression of Stella's Marshallian demand for product x. h) Using Stella's Marshallian demand compute her change in consumer surplus when the price of x drops from Px = 2 to P'x = 1