Exercise 3

I. Objectives

II. Data

Price of Coconuts (P1) Coconuts (X) Muffins (Y)

III. Questions

  1. Select a value for P1. Sketch the budget constraint. Sketch the indifference curve and indicate the optimal bundle on the graph. [Obtain the optimal values from the calculator above.]

  2. Increase P1 by 10%. The quantity demanded of coconuts will [ increase / decrease ] to ________. Sketch the new budget constraint and indifference curve. Indicate the new bundle on the graph. Has the consumer's utility increased? Explain.

    [Note a peculiar thing here: The quantity demanded of muffins has not changed. This result is unusual, and it is due to the choice of the utility function in the exercise. In a typical case, the quantity of muffins too would have changed as a result of the increase in the price of coconuts.]

  3. Consider the case where coconuts become cheaper. Since a decrease in P1 leads to [ more / less ] consumption of coconuts, we may conclude that the substitution effect is [ greater / less ] than the income effect. Explain.

  4. Consider the effect of a decrease in P1 on the quantity demanded of muffins. According to the substitution effect, the consumer will buy [ more / fewer ] muffins, while the income effect leads the consumer to buy [ more / fewer ] muffins. [Since the quantity of muffins has remained unchanged in this exercise (see table above), we may conclude that the two effects have exactly offset each other. As I said earlier, highly unusual.]

  5. Change P1 a few more times. Obtain the corresponding quantity of coconuts in each case. Sketch a demand curve for coconuts.