Question

Consider a household that buys two things: clothing and everything else.

a) Draw the household’s budget constraint, with clothing on the vertical axis and everything else on the horizontal axis. In terms of the household’s income and the prices of clothing and everything else, what are the vertical intercept, the horizontal intercept, and the slope of the budget constraint?

b) What is the condition for the household to be allocating its income in the way that maximizes utility? Explain in words the intuition behind the condition.

c) Suppose droughts cause the price of cotton and other raw materials used in clothing to rise, and so cause the price of clothing to rise. How will the household need to modify its consumption of clothing and everything else to continue maximizing its utility? (Be sure to discuss both the substitution effect and the income effect of the price change.)

d) Suppose the household starts socializing with more stylish friends and now feels awkward in its original wardrobe. How will the household need to modify its consumption of clothing and everything else to continue maximizing its utility? What will be the effect on its demand curve for clothing?

Answer 1