Homework 4

Intro Micro--

1. Suppose 1,000,000 bunches of bananas and 1,000,000 packs of cigarettes are sold each month at a price of $2.00. (You do not have to carry out numerical calculations for this question.)

   1. In which market do you expect demand to be more elastic? Why? In which market do you expect supply to be more elastic? Why? Answer to 1(a)

   2. Graph each market making whatever assumptions you think are reasonable regarding the relative steepness of the supply and demand curves. Show on each graph the original equilibrium price P_E, the price paid by consumers after the tax, P_t, and the price received by the producers after the tax P_s. Answer to 1(b)

   3. Imagine the government places an excise tax of 50 cents on each bunch of bananas and pack of cigarettes sold. Show the effect in each market. Answer to 1(c)

   4. Shade the area representing the amount of revenue collected by the government. In which market is it likely to be larger? In which market did consumers pay more? In which market did producers pay more? Briefly explain your answers. Answer to 1(d)

2. Suppose Bill has $300 a month to spend on books and movies. Suppose books cost $25 each and movies cost $10 each.

   1. Draw Bill's budget constraint with books on the horizontal axis and movies on the vertical axis. Be sure and label the endpoints accurately. If Bill buys 8 books a month how many movies can he see? Indicate this point on the budget constraint. Answer to 2(a)

   2. Suppose the price of books falls to $20 each. Draw a new budget constraint for Bill, label the endpoints. Pick a likely consumption bundle on his new budget constraint and along the horizontal axis label the number of books purchased after the price change B_N. Label the original number of books purchased B_O. Answer to 2(b)

   3. Show graphically how we could compensate Bill for the change in the price of books so that we would remove the income effect brought about by the price change. (You may want to draw a new graph.) Pick a likely consumption bundle for Bill after compensation for the income effect. Label the number of books consumed in this case B_s. Answer to 2(c)

   4. Indicate on your last graph how much of the change in book purchases was due to the income effect and how much was due to the substitution effect. Considering how you drew your graphs, are books a normal or inferior good for Bill? (Either can be correct). Answer to 2(d)

   5. Draw another graph similar to the one you drew in part (d) except that books are now normal if they were inferior or inferior if they were normal. On this new graph show the total change in demand, the part due to the income effect, and the part due to the substitution effect. Answer to 2(e)