Suppose Mike’s utility consists of consuming two ordinary goods: Hotdogs (normal good) and beer (inferior good). Quantity and price for hotdogs and beer are Xh, Xb, Ph and Pb and his income is I. Drawing a clean and clear graph, answer the following questions. Show the answer to all the parts on one graph. Note: Put beer on the horizontal axes and hotdogs on the vertical axes.
a. Draw Mike’s indifference curve, budget line and show the optimal point on the graph.
b. Suppose government decreases excise tax on beer. Draw the new budget line and show the new optimal point. (Hint: pay attention to the type of the two goods.)
c. Show the income effect, substitution effect and total effect.
d. Refer to your graph, are these two goods substitutes, complements or unrelated?