Exercise 2:Suppose Valentine's utility function is U(x, y)=√x+2√y and her income is $90. Theprice of y is always $1, but the price of x drops from $1 to 50 cents. Label her optimalchoice of consumption before the price change as (x,y) and the optimal choice ofconsumption after the price change as (x,yc). As shown below, the bundle (x,y) willkeep her utility unchanged (Hicksian method) from point A but be consistent with thenew price.• Substitution effect = x - x₁Income effect Xc-XBTotal effect XC-X₁.90●●The goal of this exercise is calculating the exact amount of xxxc0BCXA XB XCNew budgetconstraint90XA to Xa: substitution effectXB to XC: income effectXA to Xc: total effect180old budgetconstrainta) calculate (x,y)This is the old choice before the price of x changes. The problem can be written as:max U(x, y)=√x+2+√ysubject to:px+p, y=x+y=90b) calculate (x+Yc)This is the new choice after the price of x changes. The problem can be written as:max U(x, y)=√x +2√subject to:px+p, y=0.5x+y=90c) calculate (x,ya)This is the choice that the individual would make if she stays on the sameindifference curve as (x,y) but faces the new price of x.

The income and substitution effects are two concepts in economics that help explain the change in…

Answered: The goal of this exercise is…

Business

Economics

The goal of this exercise is calculating the exact amount of x₁, x, XC

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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