Behavior of consumers in the market for water - The residents of Norway consume water (W ) and spend the rest of their

2. Behavior of consumers in the market for water (15 %)

(a) The residents of Norway consume water (W ) and spend the rest of their income on other goods (O). The price of water is PW , while the price of other goods is PO. The income of a typical Norwegian is I. Write down the budget constraint for this typical 1 Norwegian and explain what each of the components mean and why this represents a budget constraint.

(b) Draw a diagram with an initial budget line, putting water on the horizontal axis. Use a standard indifference curve with a smoothly declining marginal rate of substitution to illustrate an initial optimal consumption choice for a typical Norwegian. Label this initial consumption point as “a,” and explain why it represents the optimal consumption choice.

(c) In the year 2040, Belgium is plagued by severe droughts and Norway starts exporting water to Belgium. Illustrate in your diagram the impact of the resulting increase in the price of water for your Norwegian consumer, noting that water is a normal good. Label your new consumption point as “b.” Explain how and why the Norwegian consumer changes their consumption.

(d) As a result of its water exports, the Norwegian government’s revenue from water sales have increased, while Norwegian consumers are hurt by the price increase of water. That is why the Norwegian government decides to increase each Norwegian con- sumer’s income with an identical, lump-sum refund, such that the typical consumer is exactly equally well-off as before the water exports. Show the new consumption point after the consumer receives this refund in a diagram, and label it “c.” Briefly discuss how the situation in “c” compares to “a” and “b”.

(e) Use the water consumption at points “a,” “b” and “c” to describe the income and substitution effect going from “a” to “b” for our Norwegian consumer, and explain why.