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38583 HOME WORK #2 Chapter 4

Chapter 4
1. Consumers have limited income to be spent on a variety of goods and services.
Consumers, based on their preferences, maximize their satisfaction subject to their limited
a) Explain what is an inferior good and a Giffen good using graphs, and give an example
for each.
b) If there are two normal goods, X and Y, explain the two effects that exist when price
of good X increases, other things being equal. Show graphically the demand change
for good X.
2. James is an international student at FEB UI who always eats his lunch at the campus
canteen. He only eats gado-gado (X) and fried rice (Y) for lunch. His lunch budget is I per
month, and the price of gado-gado per portion (PX) is cheaper than fried rice (PY). This
month, however, the price of gado-gado is reduced to Pโ€™X (sellers say vegetables prices are
down during the rainy season,).
a) Explain graphically how James maximizes his utility from lunch, before and after the
reduction in the price of gado-gado (other things being equal), showing clearly the
substitution effect, income effect, and total effect. Graph also Jamesโ€™ derived
demand curve for gado-gado. Assume that gado-gado is a normal good.
b) If gado-gado is an inferior good for James, would his level of consumption after the
price decrease be different than in point (a) above? Explain the change graphically,
including the derived demand curve.
3. Petra is an economics student who uses all his income to buy instant coffee in sachets and
a) When he gets extra income, he would prefer to drink Starbucks coffee than instant
coffee. What type of good is instant coffee for Petra? Explain!
b) Based on your answer in point a) above, and Petra still consumes instant coffee and
food, explain graphically the two effects if the price of instant coffee is increased!
c) Petraโ€™s Utility function for instant coffee (X) and food consumption (Y) is
๐‘ˆ(๐‘‹, ๐‘Œ) = ๐‘‹ 0.2 ๐‘Œ 0.8
If Petraโ€™s income is $10 and the price of instant coffee is $1/unit and food $2/unit, what
is the optimal consumption bundle for instant coffee and food? How will this bundle change
when both goods prices double and income is held constant?