Budget constraint

Question

Mrs. Griffiths earns $5000 a week and spends her entire income on dresses and handbags since these are the only two items that provide her utility. Furthermore, Mrs. Griffiths insists that for every dress she buys, she must also buy a handbag.

i. What is the algebraic equation for Mrs. Griffiths budget constraint if dresses cost $25 each and handbags cost $14 each? How many of each good will she buy, and represent this on a budget line with handbags on the horizontal axis. [5 marks]

ii. Draw an indifference curve showing the optimum choice. Label the optimum as point A. What would be the marginal rate of substitution at the point that corresponds to the optimal consumption choice? Interpret the marginal rate of substitution. [5 marks]

iii. Suppose the price of a dress increases to $200 and income decreases to $4200. What is the new algebraic equation for Mrs. Griffiths budget constraint? Show the impact of the new budget line relative to the original budget line. [4 marks]

iv. What would be the new marginal rate of substitution that corresponds to the optimal consumption choice? Interpret the marginal rate of substitution. [3 marks]

v. Assume for this question only that when the price of dresses decreases, less of that good is demanded. Illustrate the income and substitution effect of this price decrease. [5 marks]

Solution:

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