Suppose a consumer has $120/week to spend on two consumer goods, good x and good y.
(a) Illustrate the weekly budget lines (with x on the horizontal and y on the vertical axis) under two price scenarios. In scenario 1 the price of x is $1 and the price of y is $2. In scenario 2 the price of x is $2 and the price of y is $1. Under each scenario, what is the relative price of a unit of x? [4]
(b) Suppose under scenario 1 the consumer would choose 80 units of x, while under scenario 2 the consumer would choose 20 units of x. How much y is consumed in each scenario? Assuming that the consumer is indifferent between the two, illustrate the choices with an indifference curve. [4]
(c) Assume that the consumer was originally faced with price scenario 1. Now suppose that the price of x rises to $4 and the consumer chooses 15 units of x. How many units of y would be chosen? What is the new relative price of x? Illustrate this new choice with an indifference curve. Can you tell from previous results how the consumer thinks of the two goods in terms of normal/inferior? [Hint: Think about and explain the substitution and income effects.] [6]
(d) Following from part (c), suppose that income now increases to 360. Given what you know about the consumer’s preferences, can you predict a possible equilibrium on the new budget line? [4]