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Problem - Consider Garfield's utility function given as
U(x_{1}, x_{2}) = x_{1}x_{2},
where x1 is lasagna and x2 is "everything else". Suppose his allowance from Jon is
m = $8 and p1= $1 and p2= $1
(i) Find Garfield's optimal choice of lasagna and everything else and illustrate your answer graphically. Show your work.
(ii) Find an expression of Garfield's marginal rate of substitution between lasagna and all other goods and explain its meaning at the initial choice that you found in (i).
(iii) If the price of lasagna doubled, i.e., p1 increased from p1= $1 to p0= $2, what would be Garfield's new optimal bundle? Show the bundle on your graph.
(iv) Under the assumption that Garfield's demand for lasagna is linear, derive the demand equation from his two optimal bundles computed in (i) and (iii). Illustrate your answer graphically by drawing two graphs: one representing Garfield's optimal choice and the other representing his demand curve for lasagna driven from the two optimal bundles.
(v) Compute Garfield's price elasticity of demand for lasagna between the two prices p= $1and p0= $2 and explain its meaning.
(vi) Compute Garfield's price elasticity of demand at p1= $3:
(vii) If Garfield always consumes lasagna with garlic bread. Show the effect of an increase in the price of wheat on (a) the wheat market, (b) the bread market, and (c) the market for lasagna. Draw three graphs to illustrate your answer (one graph for each market). No calculations are necessary.
Summary:
This problem in price theory of economics deals with deriving maximum marginal utility, marginal rate of substitution and price elasticity of demand.