Assignment 1 1.

(12 points) Assume the government has two policy options, a cash grant of $200 and
providing food stamps worth $200. (a) (3 points) Draw the budget constraint faced by the consumer in each of these two situations. (b) (3 points) Now, draw a set of indifference curves that corresponds to an individual who would be indifferent between these two policies. (c) (3 points) Next, draw a set of indifference curves corresponding to an individual who would prefer to have a cash grant rather than food stamps. (d) (3 points) Is there a consumer who strictly prefers food stamps to cash grants (i.e., is better off with food stamps rather than a cash grant?) Why does the government use food stamps?

2. Mary is starting a jewelry collection. She wants to own matched sets of three bracelets
and one necklace that can be worn together, and she doesn't want to own any bracelets or necklaces that are not in a matched set of this size. (a) Draw Mary's indi_erence curves and write her utility function. Put bracelets on the y axis and necklaces on the x axis. Assume she receives utility of 3 utils from each matched jewelry set she owns. (b) (5 points) Currently, Mary has 32 dollars to spend. The price of necklaces is pn =2 and the price of bracelets is pb =2. What is the optimal allocation of necklaces and bracelets for Mary? How much utility does she achieve from this allocation? (c) (4 points) Due to a shortage of gold, the price of necklaces increases to pn = 10. What is the new allocation of necklaces and bracelets at this price level, and what utility does Mary obtain? (d) (4 points) Luckily, Mary's parents value their daughter's utility, and are willing to give her enough income to ensure that she has the same utility she did prior to the price change. How much extra money do they have to give her? (e) (5 points) Mary has a sister Lily who doesn't like wearing matched sets of jewelry and has deferent preferences. Her utility function is nb2. If she started with the same jewelry budget as Mary of 32 dollars and then faced the same price shock, what would be the decrease in her utility when the price of necklaces increases from $2 to $4? (f) (3 points) Mary and Lily's parents are going to give a gift of equal monetary value to both sisters. They are trying to decide whether to give cash or give jewelry. Which sister is more likely to prefer cash? Please explain intuitively and/or graphically; there is no need for algebra in this section. 3. (29 points) Eric receives utility from days spent traveling on vacation domestically (D) and days

spent traveling in a foreign country (F) as given by the utility U(D, F) = DF. The price of a day spent traveling domestically is $160 and in a foreign country $200. Erics annual budget for traveling is $8,000. (a) (5 points) Find Erics utility maximizing choice of days traveling domestically and in a foreign country. Find also his utility level from consuming that bundle.

(b) (6 points) Suppose that the price of domestic traveling increases to $250 per day. Calling his budget for traveling x, (suppose by now that it is unknown) find the demand for D and F under the new prices as a function of x. (c) (4 points) Find the income necessary to make Eric reach the same utility level as before the price change. (d) (2 points) Compute the quantities demanded with the new prices and the income you found in section c. (e) (2 points) Compute the quantities demanded with the new prices and the original income. (f) (6 points) Using your previous answers tell us what is the total change in quantity of D due to the price increase in PD that the consumer experiences and what part of that change is due to income or substitution effects. Give definitions of what income and substitution effects mean. 4. S consumers utility function is given by U = X0.5 Y0.5
Price of X is Rs. 4 while price of Y is Rs. 2 the total income of the consumer is Rs. 24

(a) Find the optimal values of x and y. (b) What is total utility which the consumer shall have at equilibrium? (c) If a tax at Rs. 2 per unit of Y is imposed, how the optimal value of x and y and total utility of the consumer shall change. (d) If instead a lump-sum tax of equivalent amount imposed, how would equilibrium values of X and Y as well as total utility of the consumer shall change. (e) Suppose the utility function of consumer changes to
U=X0.25 Y0.75 Answer part (a) to (d)

5. Why we take first half of the hill of happiness, not other half in following diagram.