Question

. (15 marks) Rajan spends all his money on only two goods, bananas and scones. Bananas cost $0.60/kg, and scones $0.50 each (assume he can purchase partial scones).

1. (1) Sketch Rajan's budget constraint if he has an income of $20/day. (Put bananas on the horizontal axis.)

Rajan has well-behaved preferences[1], and his optimal bundle contains 20 scones.

            b) (2) Illustrate his optimal bundle in your diagram for (a); label it A.  Why is this choice optimal?  What conditions does it satisfy?

2. (2) How many kg of bananas does he buy?  (Show how you derived this number.)  
3. (2) Suppose the price of bananas doubles; income and the price of scones are both unchanged. In your diagram for (a), identify the total effect of this price increase on Rajan's optimal choice.  (Label his new optimal bundle G.)

4. (3) Briefly explain the meaning of the following terms:

1. the substitution effect of the price change on both goods;

                        ii)  the income effect of the price change on bananas.

5. (2) Identify the effects in ( on your diagram.

7. (3) If Rajan's income increased so he could just purchase his initial optimal bundle at the new prices, would he choose to do so?  Explain why or why not (with reference to the diagram if you wish).

[1] ”Well-behaved preferences” means that his indifference curves are all strictly convex and negatively sloped – they satisfy all our usual assumptions.

Answer 1