1. Observe the diagram below and answer the questions based on the given information.
Good x is on the horizontal axis. Good y is on the vertical axis. The dashed curves
represent indifference curves, and the lines represent budget constraints. Points A, B, C,
etc., represent the optimal bundle on the respective budget line. For example, on the
green budget line, point D is optimal because the green dashed indifference curve is
tangent to the green budget line at this point (assuming interior solution throughout).
a. Suppose the initial budget line is given by the red line. Prices change and the new
budget line is the blue one.
i. Which price has changed and in which direction (increase/decrease)?
Assume the other price and income remain constant.
ii. Identify the initial optimal and the final optimal bundles.
iii. Calculate the total change in consumption for the good whose price has
changed.
iv. Identify the budget line which has the same slope as the final budget line
and passes through the original optimum.
v. Identify the optimal bundle on the budget line in part (iv).
vi. Calculate the Slutsky substitution effect and the income effect for the good
whose price has changed.
vii. Verify that the sum of the substitution effect and income effect is equal to
the total change in consumption.
viii. Is the good whose price has changed, normal, inferior (but not Giffen) or
Giffen?
b. Suppose now that the initial budget line is given by the blue line, and the new one is
the red line.
i. Repeat all the steps as in part (a) above.
Graded bonus question 4 (3 points)
Refer to the same diagram as above. All the indifference curves have been generated by using
the utility function 𝑢(𝑥, 𝑦) = 𝑥𝑦.
Find the equations of all the budget lines shown in the diagram. (Hint: choose one of the goods
to be numeraire—choose carefully!)
Note:
If any students are found to have submitted identical/near identical explanations, all such students
will receive a zero and be debarred from availing bonus scores.
Clearly write your name and student ID on the answer sheet. Please scan your answer sheet with
good ambient light without blurry/dark sections in the final PDF.
Show all your work in the answer. Partial credit will be given for the correct approach.
The handwritten answer should be scanned and submitted (in a PDF file) using this form
https://forms.gle/r3RcYVNuDrwT1Hb77 using your SNU email ID. The submissions are due by
Sunday, March 17th, 5 pm. Please do not email your answers.
Rules regarding availing the bonus score are mentioned in the course outline.
