Question

Suppose you have a Pizza and Beer budget of $60. The initial price of Pizza is $15 and the initial price of Beer is $5.

1. (2 points) Draw a budget line showing the different combinations of Pizza and Beer that can be consumed within the initial budget. (Hint: put pizza on the horizontal axis)
2. (2 points) Now suppose that the price of pizza drops to $10. Draw the new budget line to show the new combinations of pizza and beer that could be consumed.
3. (2 points) Suppose your initial point of consumption is 2 pizzas and 6 beers. Using this information draw a new budget constraint that keeps your relative income constant while changing the relative pricing of Pizza and Beer.
4. (3 points) Show the substitution effect of the change in price of pizza.
5. (3 points) Finally show the income effect of the relative change in income due to the change in price of pizza.

For the last two items (4 & 5) you don’t need to use numbers. Just show the points on the graph.

Answer 1