Question

Consider a household that buys two things: clothing and everything else.

a) Draw the household’s budget constraint, with clothing on the vertical axis and everything else on the horizontal axis. In terms of the household’s income and the prices of clothing and everything else, what are the vertical intercept, the horizontal intercept, and the slope of the budget constraint?

b) What is the condition for the household to be allocating its income in the way that maximizes utility? Explain in words the intuition behind the condition.

c) Suppose droughts cause the price of cotton and other raw materials used in clothing to rise, and so cause the price of clothing to rise. How will the household need to modify its consumption of clothing and everything else to continue maximizing its utility? (Be sure to discuss both the substitution effect and the income effect of the price change.)

d) Suppose the household starts socializing with more stylish friends and now feels awkward in its original wardrobe. How will the household need to modify its consumption of clothing and everything else to continue maximizing its utility? What will be the effect on its demand curve for clothing?

Answer #1

a. Consider a household living for two periods. The
intertemporal budget constraint is given by:
?1 + /?2/1+r =
?1 + /y2/1+r ,
where ? is consumption, ? is income and ? is the interest rate.
The household’s preferences are characterised by the utility
function.
?(?1, ?2 ) = ln ?1 + ? ln
?2,
where ? < 1 is the discount factor. Derive the Euler
equation.
b. Consider the bathtub model of unemployment. Let ? denote the
constant labour...

1. A firm production function is given by q(l,k) =
l0.5·k0.5, where q is number of units of
output produced, l the number of units of labor input used and k
the number of units of capital input used. This firm profit
function is π = p·q(l,k) – w·l – v·k, where p is the price of
output, w the wage rate of labor and v the rental rate of capital.
In the short-run, k = 100. This firm hires...

Question 1
The line that connects the combinations of goods that leave you
indifferent is called:
Select one:
a. the indifference curve.
b. the budget constraint.
c. the indifference constraint.
d. the indifference line.
Question 2
An increase in income will cause:
Select one:
a. the budget constraint to become flatter, so that it includes
more combinations.
b. the budget constraint to become steeper, so that it includes
more combinations.
c. a parallel shift inward of the budget constraint.
d....

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