Question 1

Alfred's income is $100 per week. The price of a CD is $10 and the price of a book is $20.

(a)Draw a graph of Alfred's budget line with CDs on the x-axis (i.e. horizontal axis).

(b)What is the opportunity cost of Alfred buying a CD?

(c)Draw a set of indifference curves, showing the point at which he will maximise his utility.

Explain why these indifference curves have they shape that they do.

(d)Explain the relationship between price and marginal utility for CDs and books at this utilitymaximising point.

Now suppose the price of a CD rises to $20, and the price of a book and Alfred's income remain the same.

(e)Draw a new diagram finding the substitution and income effects of the price change.

*Hint: Draw three separate diagrams, for parts (a), (c) and (e).

Question 2

Adam buys smoothies and sushi. The price of a smoothie is $5 and the price of sushi is $1 per piece. Adam has an income of $20.

(a)Draw a graph of Adam's budget line with smoothies on the x-axis (i.e. horizontal axis).

(b)What is the opportunity cost of Adam buying a smoothie?

(c)Draw a set of indifference curves, showing the point at which Adam will maximise his utility.

Explain why these indifference curves have they shape that they do.

(d)Explain the relationship between the marginal utility of smoothies and the marginal utility of sushi at this point.

Now suppose Adam's income increases to $40, with the price of smoothies and sushi remaining unchanged.

(e)Draw a new diagram showing the effects of this situation. If Adam continues to buy the same quantity of smoothies as when his income was $20, how many pieces of sushi will he buy when his income increases to $40?

*Hint: Draw three separate diagrams, for parts (a), (c) and (e).