In an isolated mountain village, the only crop is corn. Good harvests alternate with bad harvests. This year the harvest will be 1,000 bushels. Next year it will be 150 bushels. There is no trade with the outside world. Corn can be stored from one year to the next, but rats will eat 25% of what is stored in a year. The villagers have Cobb-Douglas utility functions, U (c1, c2) = c1c2 where c1 is consumption this year, and c2 is consumption next year.
(a) Use red ink to draw a “budget line,” showing consumption possibilities for the village, with this year’s consumption on the horizontal axis and next year’s consumption on the vertical axis. Put numbers on your graph to show where the budget line hits the axes.
(b) How much corn will the villagers consume this year? _________. How much will the rats eat? _________. How much corn will the villagers consume next year? _________.
(c) Suppose that a road is built to the village so that now the village is able to trade with the rest of the world. Now the villagers are able to buy and sell corn at the world price, which is $1 per bushel. They are also able to borrow and lend money at an interest rate of 10%. On your graph, use blue ink to draw the new budget line for the villagers. Solve for the amount they would now consume in the first period _________ and the second period ________.
(d) Suppose that all is as in the last part of the question except that there is a transportation cost of $.10 per bushel for every bushel of grain hauled into or out of the village. On your graph, use black ink or pencil to draw the budget line for the village under these circumstances.