Homer consumes only donuts and beer. When he consumes less than 10 beers, Homer would gladly drink one more. After drinking 10 beers, Homer is so drunk that he does not notice any additional bottle he drinks (that is, the benefit of an additional bottle of beer is zero). Drinking more than 17 beers is beyond the processing capability of Homer’s liver and any additional bottle makes him sick (beer is no longer a “good” for Homer). Homer’s preferences for donuts are similar. As long as he eats less than 15 donuts, an additional donut increases his utility. If he eats between 15 and 20 donuts, then additional donuts do not bring him any additional utility, and if he eats more than 20 donuts, then additional donuts make him worse off.
- Sketch Homer’s indifference curve passing through point (8 donuts, 8 beers).
- Sketch Homer’s indifference curve passing through point (16 donuts, 16 beers)
Hint: For each of the above questions, it is possible to (and you should!) sketch Homer’s entire indifference curves.
Suppose you expect to earn $10 this year and $10 next year. Each dollar you earn this year can be be either spent, or saved at an interest rate of 10%. If you want to spend more than $10 this year, you can borrow money at 10% interest and repay it next year. Next year, you plan to pay o your debts (if any), then spend all your earnings and all your savings (if any).
- Draw your budget line between “dollars spent this year” and “dollars spent next year”.
- Suppose the government imposes a 50% income tax on all your earnings this year and next year (not including your interest earnings). Draw your new budget line.
- Suppose the government imposes a 50% sales tax on everything you buy this year and next year. Draw your new budget line.
- Suppose the government imposes a 50% income tax on all your earnings this year and next year, including your interest earnings. Draw your new budget line.
- True or False: If interest earnings are not subject to income tax, then an income tax and a sales tax will lead you to spend exactly the same amount both this year and next year.
Suppose you allocate all your wealth to “housing” and “savings”. Housing costs $40 per square foot. You have $100,000 in wealth and have elected to build a 1000 square foot house.
- Draw your budget line between housing (on the horizontal axis) and savings (on the vertical). Draw the indifference curve you are on and illustrate your optimal consumption.
- Now suppose the price of housing falls to $30 per square foot. Draw your new budget line. (Hint: You can keep your existing house if you want to.)
- True or False: The fall in housing prices makes you happier.
- Assume that housing is an inferior good and illustrate the substitution and income effects from a fall in housing prices.
- True or False: If housing is an inferior good, then in this problem the substitution effect must be larger than the income effect.