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Consider a household with income I and two goods to choose from - square feet of housing (x1) and dollars of other consumption (x2). Assume that price of other consumption is normalized to 1, and the annual price per square foot of housing is p, and the households tastes can be described by the utility function u(x1, x2) = (x1^0.25)(x2^0.75) (a) How much housing and other goods will the household demand as a function of p and I? (b) Suppose income is $100,000 and the price of housing is $10 per square foot. Then the government introduces a subsidy that lowers the housing price to $5 per square foot. In the attached graph, let the solid lines denote the budget lines of the household before and after the subsidy. What are the values of the intercept terms a, b and c in the graph? (c) How much of each good does the household consume at bundle A -i.e. what are the consumption levels of x1 and x2 at the utility maximizing bundle before the subsidy. How much would the household consume of each good after the subsidy (bundle B)? (d) Answer this part in terms of letters on the vertical axis of the graph. What is the most this household would be willing to pay in cash to get this price subsidy? If a household already had the subsidy (without having paid any cash to get it), what is the least that we would have to pay the household in cash for the household to be willing to give up the subsidy? (e) The expenditure function for this household is approximately E(p,U) = 1.755p0.25U. Calculate dollar values for the first question in part (d). (f) What is the dollar value for the second question in part (d)? (g) Explain intuitively why there is a deadweight (welfare) loss of implementing the subsidy using EV (equivalent variation), and then calculate the dollar value of the deadweight loss.
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