ECO206: Assignment 1, Spring 2024

20 marks

Question 1:
The diagram below shows part of Lisa’s indifference map over coconuts and carrots. Initially, Lisa
is on budget line B0, where the price of coconuts is $8 and the price of carrots is $2. As illustrated
on budget line B1, the price of coconuts drops to $4, while the price of carrots remains at $2. Also
shown is budget line B’ -- Lisa’s hypothetical budget constraint.

a. What is Lisa’s income? (1)

b. (1)What is the total effect corresponding to the price decrease of coconuts? (1)
c. What is the income effect corresponding to the price decrease of coconuts? (2)
d. What is the substitution effect corresponding to the price decrease of coconuts? (2)
e. Are coconuts an inferior or a normal good for Lisa? Be clear about which budget constraints
you compared. (2)
f. Draw Lisa’s Marshallian Demand curve for coconuts. (1)
Question 2:
Let an individual’s utility function be given as:
U(x1, x2) = 2√x1 x2
a. Compute the Marginal Rate of Substitution for the given function. (1)
b. Initially, the individual consumes bundle (x1 = 100, x2 = 12.5). Then, the individual’s
consumption of the first good is cut to x1′ = 50. What is the new level of consumption of good
2, x2′, which the individual needs to consume in order to reach the same utility level as before?
(2)
c. Given the above mentioned utility function and prices of the two goods p1 = 1 and p2 = 2 and
a budget of m = 100, perform a utility maximization exercise and identify the Marshallian
demands? Please note that it’s a case of constraint optimization. (2+2)
d. If the price for the first good rises to 𝑃1′ = 50, how much less of good 2 will the individual
consume? (1)
1𝑚
e. Assuming the demand function for good 1 is x1(p1) = 2 𝑃 , mathematically show that the good
1
is not inferior. (2)