Question 3

(a) Consider a two-commodity world, where an individual's money income is determined by the value of his endowment. Suppose this individual's initial endowments of goods 1 and 2 are (4, 8) units respectively, and his consumption of the same two goods is (7, 5) units respectively. Let the price of good 1 initially be 2.5, and suppose that it then becomes 3.5. Analyse the implications of this price change in the context of the individual's optimal choices. (10 marks)

(b) If the utility function for two commodities is of a Cobb-Douglas form, then what is the nature of the p1-price offer curve? (6 marks)

(c) Explain, and show diagrammatically, the substitution and income effects of a price change when preferences are quasi-linear. (7 marks)

(d) What is the effect on equilibrium price and quantity, and on consumers/producers, of (i) an excise tax levied on each unit of output sold, and (ii) a quantity tax in a market with a perfectly inelastic supply curve? (10 marks)