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UtilityMax Problem #3 ( points)
(1)Open the UtilityMax module. Record the “Initial Conditions” for future reference. Enter the following preference parameters: a = 0.24 and b = 0.73. Find the utility maximizing quantity of beer and CD’s. What is the relationship between the marginal rate of substitution and the price ratio at this point? Explain this relationship. Draw a graph showing the budget line, several indifference curves and the utility maximizing point. Label all axes, lines and important points.
(2)What impact does increasing the consumer’s income has on the utility maximizing combination of beer and CD’s? What impact does decreasing the consumer’s income have on the utility maximizing combination of beer and CD’s. Is beer a normal good, an inferior good or a neutral good? Are CD’s normal, inferior or neutral? Give reasons for your answers.
(3)Increase the price of beer by $5. What impact does increasing the price of beer have on the utility maximizing quantity of CD’s purchased? What impact does decreasing the price of beer have on the utility maximizing quantity of CD’s purchased? What is the relationship between beer and CD’s? Are they substitutes or complements? Give reasons for your answer.
(4)Increase the price of CD’s to $15. Determine, using the UtilityMax module, the income and substitution effects from this price change. Explain and define the terms income effect and substitution effect. Draw a graph of this price change that includes the budget line, several indifference curves, the utility maximizing point and a diagrammatic representation of the income and substitution effects
(5)Now restart the UtilityMax module. This time, enter the following preference parameters: a = 0.74 and b = 0.73. Determine the utility maximizing quantity using these new parameters. What impact did increasing preference parameter “a” have on the utility maximizing quantity of beer and CD’s? What does preference parameter “a” measure?