Question

. What is the relationship between the size of the Substitution Effect and the size of the Income Effect for a Giffen Good? (2 points) o 2 cho 1alb Sond tegbue a. 4. Suppose you're a manager at a plant producing Aston Martin cars. You estimate thatol4 your production function is q = 0.1L2K3 where q is the quantity produced, L is labor, and K is capital. Suppose in the short-run, capital is fixed at 3 units. a. What is the short-run production function? (2 points) In the long-run, does this production function have constant returns to scale, increasing returns to scale, or decreasing returns to scale? (2 points) b. aloo You take a part time job as a florist. Using your knowledge of economics, you estimate 5. noln that the demand for flowers is elastic. If you decide you want to increase your total revenue, should you lower the price of the flowers or increase the price of the flowers? (2 points)

Answer 1

3. a. In case of Giffen goods, the size of substitution effect is lesser than the size of income effect. This is why the quantity demanded of Giffen goods move in the same direction as its price (as giffen goods are highly inferior goods and have their quantity demanded is negatively related with the change in income, i.e., Income rises, the demand for giffen goods fall).

4. a. Short run production function: q= $0.1L^{^{2}}3^{3}$ = 2.7$L^{^{2}}$.

b. The given production function will have increasing returns to scale in the long run. This can be shown by the simple analysis:

let us increase our inputs K and L by z, then our production function becomes: q=0.1$(zL)^{^{2}}(zK)^{3}$ = 0.1 $(z)^{2+3} L^{^{2}}K^{3}$

This clearly states that the output will rise more than proportionately than the rise in inputs. Hence increasing returns to scale.

5. Since demand for our flowers is elastic, we will lower the price of our product to increase our revenue. This is because if our prices will decrease, then our demand will rise more than proportionately than the fall in our prices and will lead to rise in total revenue.