Question

9. Use the following information to work Problems (a) and (b). Show all your workings. Sara’s income is $12 a week. The price of popcorn rises from $3 to $6 a bag, and the price of smoothie is unchanged at $3.

1. How does the rise in the price of popcorn affect Sara’s real income in terms of smoothies and her real income in terms of popcorn?
2. How does the rise in the price of popcorn affect the relative price of a smoothie in terms of popcorn? What is the slope of Sara’s new budget line if it is drawn with smoothies on the X-axis?

Answer 1

(a)

Before price rise,

Real income in terms of smoothies = $12 / $3 = 4 smoothies

Real income in terms of popcorn = $12 / $3 = 4 popcorns

After price rise,

Real income in terms of smoothies = $12 / $3 = 4 smoothies (No change)

Real income in terms of popcorn = $12 / $6 = 2 popcorns (decrease by 2 popcorns)

(b)

Before price rise, Relative price of smoothie in terms of popcorn = $3 / $3 = 1 popcorn

After price rise, Relative price of smoothie in terms of popcorn = $3 / $6 = 0.5 popcorn (Decrease by 0.5 popcorn)

Slope of budget line = - Relative price of smoothie in terms of popcorn = - 0.5