Question

Question 1 (1 point) Suppose the consumer's utility function is given by U(X1,x2) xx ,where a-4.0, and b-3.0. Suppose further, the price of good 1 is 1.2, price of good 2 is 4.3 and income is 120 Finally suppose the price of good 1 has decreased to 0.2 What is the substitution effect for good 1 Round your answer to two decimal places Your Answer: Answer

Please show your work and explain the steps involved.

Answer 1

Q = u(x,x) = x, x2 a-4, 6-3 Price of good 7 = 1.2 , Prim of good 2= 4.3 Income = 120 Budget line - 1.2x + 4.3x2 = 120 As it is well behaved intility function - So x = a M x a+bP, x= 4 x 4+3 100 1.2 [x, = $7.12 Now if frices are decreased to 0.2 = h' then money or income will also change AM = Ahz x M'M = (hi - R.) xi M'- 120=(0.2-1. 2) 57.12

M-120= -57.12 M = 62.88 New Inome. New budget line 7 0.2 x, + 4-3x2= 62.88 Now x ² = a M atb R 4 62.88 7 0.2 x3 = 179.65 Subst = 2,2-2, 3 179.65-57.12 - 122-53