# Problem on Marginal utility

Question:

Max has a utility function U =√ x1x2 where x1 is litres of ice-cream and x2 is boxes of strawberries. The marginal utility of a litre if ice-cream is MU1 =0.5 x2/ x1 and the marginal utility of a box of strawberries is MU2 =0.5 x1 /x2. The prices of x1 and x2 are both \$2 and Max has a budget of \$80.

(a) How much of each good will Max demand?

(b) A fat-tax of \$2 per litre is placed on ice-cream so that it now costs Max \$4 per litre. Everything else remains the same. How much of each good does Max now consume? How much tax does he pay?

(c) Now suppose that, instead of imposing a \$2 tax on ice-cream, the government imposes a \$20 income tax, reducing Max’s budget to \$60. Would Max prefer the \$2 tax on ice-cream or the \$20 reduction is his budget?

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