Suppose Peggy consumes only two goods, gasoline and cigarettes. Her income is $120, the price of cigarettes per pack is $4 and the price of gasoline per gallon is $2. Currently, she consumes 40 gallons of gas at the optimal level.

a) Sketch the following budget lines. Be sure to show how you calculated the slopes and

endpoints. (Put gas on the X-axis.).

b) What is the optimal level of consumption of cigarettes for Peggy? Use an arbitrary convex indifference curve, indicating the current consumption combination is optimal.

c) If the government imposes a sales tax of $1 per unit on gasoline, Peggy will consume 28 gallons of gas. Draw the new budget constraint and the new optimal basket. Be sure to show how you calculated the slopes and endpoints. (Put gas on the X-axis.).

d) What is the optimal level of consumption of cigarettes for Peggy? Use an arbitrary convex indifference curve, indicating the current consumption combination is optimal.

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