Question

Alice has income of $300, which she spends on cheese and red wine (both are divisible). The price of cheese is $5 per unit, and the price of red wine is $10 per glass.

a. Draw Alice budget constraint with cheese is on the horizontal axis. (1 mark)

b. Now assume that the shop has a special offer: if you buy more than 10 units of cheese, then the price is $2 each for any subsequent amount more than 10 units of cheese. Draw Alice new budget constraint on the same diagram as in part a. Explain briefly how you get to the budget line

c. Is Alice better off or not after the change? Can she be indifferent? Draw indifference curves on the diagram to explain your answers.

Answer 1

Given the income and prices of two goods the budget line can easily be drawn in part (a). But in part (b) there was a catch that after initial consumption of 10 units of cheese, the price of cheese fell down from $5 to $2, which results in an increase in the consumption of cheese, and the slope of the budget line became much flatter than the original one as the slope of the budget line was decreased from 1/2 to 1/5. In part (c) Alice can be indifferent when the Indifference curve is tangent at the common area of the original and the new budget line slope and can be better off when the indifference curve is tangent to the new budget line slope and the old one also. From that the utilities will differ and we can clearly identify the utility will be higher when price changes.