Greg has a salary of $100. He spends his entire budget on milk and cookies. The cost of aquart of...

Question

Greg has a salary of $100. He spends his entire budget on milk and cookies. The cost of a
quart of milk is $2 and the cost of a box of cookies is $4.
(a) Construct Greg’s budget constraint (place milk on the y-axis). [3 marks]
(b) Suppose Greg’s salary rises by 10%. Also suppose that the price of milk and
cookies each rise by 10%. Construct Greg’s new budget constraint. What is the
difference between the new and old budget constraints? [3 marks]
(c) Suppose that the price of cookies fell from $4 per box to $2.50 per box. Show the
substitution and income effects as a result of this price change, assuming that
cookies are a normal good. Assume that Greg’s salary is $100. [10 marks]
(d) Suppose that cookies were a Giffen good. Describe what Greg would do if his
income effect were greater than his substitution effect. [4 marks]

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Robert · Accepted Answer

Greg has a salary of $100. He spends his entire budget on milk and cookies. The cost of a
quart of milk is $2 and the cost of a box of cookies is $4.
(a) Construct Greg’s budget constraint (place milk on the y-axis). [3 marks]
(b) Suppose Greg’s salary rises by 10%. Also suppose that the price of milk and
cookies each rise by 10%. Construct Greg’s new budget constraint. What is the
difference between the new and old budget constraints? [3 marks]
(c) Suppose that the price of cookies fell from $4 per box to $2.50 per box. Show the
substitution and income effects as a result of this price change, assuming that
cookies are a normal good. Assume that Greg’s salary is $100. [10 marks]
(d) Suppose that cookies were a Giffen good. Describe what Greg would do if his
income effect were greater than his substitution effect. [4 marks]
Ans) (a) Salary (Y) = $100, Price of Milk = PM = $2/quart and Price of cookies = PC = $4/box
Let the quantity of milk is given by M and the quantity of cookies be given as C. Therefore, the budget constraint is given by the following equation: 
Income = (Price of M*Quantity of M) + (Price of C*Quantity of C), or, Y = PMM + PCC.
Therefore, plugging in the given values, the equation of the budget constraint is100 = 2M + 4C.
If we plot a graph using the equation of the budget constraint we get the budget line. To draw the budget line we need to find the intercepts on the Y and X axes. We take Milk on the Y-axis and Cookies on the X-axis.
The intercept on the Y-axis is given by the quantity of the good on the Y-axis, or quantity of Milk (M). Income ÷ Price of a good = Quantity of the good, therefore M =$100 ÷ $2 = 50, which is the intercept on the Y-axis. Similarly,

Greg has a salary of $100. He spends his entire budget on milk and cookies. The cost of a quart of milk is $2 and the cost of a box of cookies is $4. (a) Construct Greg’s budget constraint (place milk...

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