01 May Question: Please answer the following question. Please show all your work/explanation. This question asks y…
Please answer the following question. Please show all your work/explanation.
This question asks you to recall what you know about how we study the choices of individual consumers. We will focus on an American tourist consumer in Tehran who must decide how many Persian Rugs (R) and how many ounces of Saffron (S) to purchase.
- Assume our consumer has complete, transitive preferences over Rugs and Saffron and prefers more to less. Explain in words the meaning of these assumptions. Draw a typical indifference map (set of indifference curves) with Rugs on the Y-axis and Saffron on the X-axis. Explain why the indifference map you drew satisfies the assumptions we have made about the household’s preferences.
- Define the marginal rate of substitution of Saffron for Rugs, which you may denote MRSS,R. How is the MRSS,R represented on your graph of the indifference curves?
- Suppose all transactions take place in cash, and our household has W units of cash (W stands for wealth). If the price of Rugs in terms of money is PR and the price of Saffron in terms of money is PS , write the household’s budget constraint (you may use R to denote the number of Rugs purchased and S to denote the ounces of Saffron purchased). Draw the consumer’s budget line on a graph (again, with Rugs on the Y-axis and Saffron on the X-axis).
- If the tourist maximizes her utility given the limited budget available to it, then the consumer’s optimal choice of Rugs and Saffron is the point on the budget line which yields the highest utility. Draw the consumer’s optimal choice. At the optimal choice of the tourist, what is true about the slope of the budget line and the slope of the indifference curve? What does this result tell you about the marginal rate of substitution of Saffron for Rugs and the prices of Saffron and Rugs?
- Now, suppose that the U.S. introduces a tax on all imports. How would your answer to the last part change? Graphically illustrate the outcome. Suppose that this tax is only on saffron. How does your answer change?
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