Question

a. Marsha has a salary of $500. He spends his entire budget on milk and cookies. The cost of a gallon of milk is $4 and the cost of a slice of cookies is $8. i. Construct Marsha’s budget constraint (place) cookies on the y-axis. ii. Suppose Marsha’s salary rises by 50%. Also suppose that the price of milk and cookies each rise by 50%. Construct Marsha’s new budget constraint. What is the difference between the new and old budget constraints? iii. Suppose that the price of cookies fell from $8 per cookie to $4. Construct Marsha’s new budget constraint. What is the difference between the new and old budget constraints. b. Explain the relationship between the budget constraint and indifference curve at consumer optimum.

Answer 1

Budget line equation:

Income= Cost of cookies*cookies+ cost of milk*milk

i) Budget line equation:

500=4m+8c

When m=0,c=62.5

When c=0,m=125

ii) New income= 500+50%*500=$750

New cost of cookie= $8+50%*$8= $12

New cost of milk= $4+50%*4= $6

New budget line equation:

750=6m+12c

There is no change in Budget constraint when there is rise in prices there is proportional rise in income.

When c=0,m=125

When m=0,c=62.5

iii. New budget line equation:

500=4m+4c

Old budget line pivots outwards. As the slope of budget line pm/pc has increased.

When m=0,c=125

When c=0,m=125

Red line=old budget line

Green line= new budget line

B. At the optimum consumption level, slope of budget line is equal to the slope of indifference curve.

Slope of budget line=-px/py

Slope of indifference curve=MRS=MUx/MUy

This optimum point shows that consumer derives maximum utility from the bundle he can afford given the Utility function, income and prices.