Iggy only consumes two goods: coffee and cigarettes. Three cigarettes can be tra
ID: 1169385 • Letter: I
Question
Iggy only consumes two goods: coffee and cigarettes. Three cigarettes can be traded for one cup of coffee in a free market, or one cup coffee can be traded for three cigarettes. Iggy initially has 12 cigarettes and 5 cups of coffees.
1. Find an equation that gives every bundle of cigarettes and coffee that Iggy could trade for.
2. Iggy has a MRS = -5 when he is holding his initial bundles (cigs, coffee)=(12,5). Given the rate of exchange, would Iggy trade cigarettes for coffee, or coffee for cigarettes?
Explanation / Answer
1.
Lets cup of coffee is represented by y and cigarettes by x.
Initial endowment of (x,y) is (12,5)
Equation of trade
Let suppose Iggy trade t cup of coffee
Endowment level is (x,y) = (12-3t, 5+t) where t can lie between -5 to 4.
2.
Marginal rate of substitution is the rate at which a consumer is ready to give up one good in exchange for another good while maintaining the same level of utility. Since MRS is -5, so Iggy is ready to exchange 5 cigarettes for one cup of coffee which is more than trading cost so she should buy more coffee buy exchanging cigarettes.