Assignment:
A. Your income is $100 a week. The grocery store where you shop sells eggs for $10 apiece and wine for $20 a bottle. But, starting in June, your Aunt Agnes offers to pay for half your egg purchases, so eggs only cost you $5 a week.
With Aunt Agnes's offer in place, you buy 12 eggs and 2 bottles of wine each week.
1. Draw a diagram that illustrates your budget lines in May and June.
2. In June, how much is Aunt Agnes spending on you per week? (Your answer should be a number of dollars.)
In July, Aunt Agnes stops subsidizing your egg purchases and instead gives you a weekly cash gift equal to the amount you calculated in question 2 .
3. Add your July budget line to the picture.
4. True or False: You are exactly as happy in July as in June. Use your diagram to justify your answer.
B. The Pullman Company has a lot of pull in the town of Pullman, Illinois. Everybody in town is identical, and they all work for the company, which pays them each $10 a day. Their favorite food is apples, which they get from a mail order catalogue for $1 apiece.
5. Draw the typical resident's budget line between "apples" and "all other goods" (measured in dollars). Draw in the optimum point.
Pullman plans to lower the wage rate to $8 a day.
6. Draw the new budget line.
Pullman has discovered that if residents are less happy than they were at $10 a day, they will all leave town. To prevent this, Pullman has offered to subsidize everyone's apple purchases: From now on, if you are a Pullmanite who buys an apple, you will pay only a fraction of the cost and the company will pay the rest. Pullman plans to choose a fraction which is just large enough to keep people from leaving town.
7. Draw the new budget line. Indicate the new budget point. Label the corresponding quantity of apples A.
8. d) Use your graph to illustrate the amount that Pullman spends on the apple subsidy. (Hint: How much of your $8 income do you have left over after buying A apples? How much of your $8 income would you have left over if you bought A apples at the unsubsidized price of $1 apiece? Where is the difference coming from?
9. True or False: Pullman could end up spending just as much on the apple subsidy as it saves by lowering wages.
C. Suppose you allocate all your wealth to "housing" and "savings". Housing costs $40 per square foot. You have $100,000 in wealth and have elected to build a 1000 square foot house.
10. Draw your budget line between housing (on the horizontal axis) and savings (on the vertical). Draw the indifference curve you are on.
11. Now suppose the price of housing falls to $30 per square foot. Draw your new budget line. (Hint: You can keep your existing house if you want to.)
12. True or False: The fall in housing prices makes you happier.
13. Assume that housing is an inferior good and illustrate the substitution and income effects from a fall in housing prices.
14. True or False: If housing is an inferior good, then in this problem the substitution effect must be larger than the income effect.