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# Optimal Consumption, Market Demand, and Income Effect

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At the optimal consumption bundle
a. the marginal utility of all goods consumed is equal
b. the marginal utility per dollar spent is equal for all goods consumed
c. the price of all goods consumed is equal
d. none of the above are true

Well consumption bundle, the goods and services that are consumed so it is D

The market demand curve
a. is the horizontal summation of the individual demand curve of all consumers
b. is the vertical summation of the individual demand curve of all consumers
c. cannot be derived from the individual demand curve of all consumers
d. has no relation to individual demand

It is A (individual consumer's quantity demanded depends on price. Individual demand curves are summed orizontally to yield the market demand curve.)

The income effect of a price change is the effect on the consumption of a good
a. due to a change in income when all prices change in the same proportion
b. due to a change in purchasing power caused by a change in the price of the good
c. due to a change in income caused by a change in the price of labor
D. due to a change in income sufficient to offset the effect of a price change

https://brainmass.com/economics/utility-demand/optimal-consumption-market-demand-and-income-effect-157559

#### Solution Preview

1) b - check the graph at the end of page 6 ...

\$2.19

## Microeconomics problem

1) a. Lee has an income of \$15,000 (after taxes). When the price of gasoline is \$1.25 per gallon, Leebuys 4,000 gallons. Putting gasoline on the horizontal axis and "other goods" on the vertical axis,and assuming a unit of "other goods" costs \$1, draw Lee's budget constraint and show the
equilibrium.

a. The price of gasoline falls to \$1.00, while Lee's income remains at \$15,000. Draw the new
constraint and show a possible new equilibrium choice. For the choice you have drawn, illustrate
the income and substitution effects of the price change. As you have drawn it, is the income
effect positive or negative?

2) The state of California offers health insurance to its employees. It pays for 90 percent of each
employee's health care expenditures. To ease pressure on the budget, the State proposes to lower that share to 80 percent. (Assume there is no "deductible" provision in either plan; the State pays 80 or 90 percent of every dollar spent.) According to its consultant, employees' elasticity of demand for health care is 0.2. By what percentage will the State's outlays on employee health care decrease?

3) What would Consumer Surplus equal if market demand is perfectly price inelastic? What would Consumer Surplus equal if market demand is perfectly price elastic?

4) In a simple endowment economy, Jack and Jill are the only two consumers. Suppose that only two goods are consumed in this economy: apples and pails of water. Initially, Jack has an endowment of 5 apples and 10 pails of water. At this endowment, his marginal rate of substitution of water for apples is -1. Jill's endowment consists of 15 apples and 20 pails of water, and her marginal rate of substitution of water for apples is -3. Is the endowment Pareto efficient? If so, explain why. If not, describe a way to reallocate resources in order to make both agents better off. Draw an Edgeworth box diagram to illustrate your answer.

5. Suppose that there are only five consumers of a software game program. The demand curve for each of the consumers is identical. Will the market demand curve that is obtained by horizontally summing across the five individual consumers' demand curves be less or more price elastic at any price than the demand curve for any of the individual consumers?

6. For a person who saves in year 1, a higher interest rate will increase consumption in year 2 but may either increase or reduce the amount saved in year 1. Explain this statement, using the concepts of income and substitution effects.

7. Even though they enter graduate school at roughly the same age, law students typically own nicer cars than do Ph.D. students. Assuming that there is no difference across the two groups in terms of preferences and current incomes, explain this phenomenon. Rely on the intertemporal for your explanation.

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