Question

Grandma lives in the forest and relies on her favorite niece, Red, to do her weekly grocery shopping. Grandma consumes only two goods, bread and wine, and each week she spends $60 on them.
In week 1, price of bread is $4 per loaf and price of wine is $2 per bottle. Knowing perfectly well Grandma's preferences, and willing to make her grandma as well off as possible, Red buys 10 loafs of bread.
1. Draw Grandma's budget line. Make sure that in your diagram the quantity of bread is measured on the horizontal axis.
2. What is the slope of the budget line? What it the economic interpretation of the numerical value you obtained?
3. How much wine does Grandma drink in week 1? Point Grandma's optimal consumption point on the diagram you used to answer question 1, and label it "1". How does your diagram show that pint 1 is optimal?

In week 2 the price of wine increases to $4 per bottle.
4. In the same diagram you used to answer question 1, draw Grandma's new budget line, along with her new optimal point. Label it "2". Make sure your diagram shows point 2 is optimal.
5. Is Grandma better off or worse off than in week 1? How does your diagram show that? Can you say whether she consumes more bread or less bread?
6. In the same diagram you used so far, draw Grandma's compensated budget line.
7. In the same diagram, show the income and substitution effect on consumption of wine. Make sure you also show the direction of each effect.
8. In your diagram, is wine a normal or an inferior good? How does your diagram show that?

In week 3, the price of wine returns to the value week 1, and therefore Red once again buys 10 loafs of bread. On her way to Grandma's house in the forest, Red unexpectedly meets the infamous trader B. B. Wolf, who offers to buy or sell bread and wine at a price of $10 per loaf of bread and $10 per bottle of wine.
9. In a new diagram draw Grandma's budget line from week 1 and her budget line after Red meets Wolf. (hint: Red can always choose not to trade with Wolf). Make sure your diagram measures quantity of bread on the horizontal axis.
10. Should Red trade with Wolf? If yes, what should she sell and what should she buy? How does your diagram show that?

Answer 1

slope of budget line = - Pb/Pw