Illustrate the budget line faced by Ian, with “other goods” on the vertical axis and lattes on the horizontal axis. If he chooses to consume 15 lattes a month, how much does he spend on other goods? Using an indifference curve, illustrate the choice.
Ian is a Queen’s student who has $120 to spend every month on two goods, lattes and a composite good representing “all other goods”. Assume initially that the price of a latte is $4 and the price of “other goods” is normalized to $1.
- (a) Illustrate the budget line faced by Ian, with “other goods” on the vertical axis and lattes on the horizontal axis. If he chooses to consume 15 lattes a month, how much does he spend on other goods? Using an indifference curve, illustrate the choice.
- (b) Suppose the price of lattes increases to $6. Illustrate the new budget line. Suppose Ian’s new choice is to consume 12 lattes. How much does he spend now on other goods? Illustrate this new point with an indifference curve. Is he better off or worse off after the price change?
- (c) Can you tell whether Ian thinks of “other goods” as normal or inferior? What about lattes? [Hint: explain the income and substitution effects of the price change]
- (d) Using the information concerning the price change from parts (a) and (b) illustrate Ian’s demand curve for lattes, assuming that it is linear. Calculate and illustrate the change in consumer surplus as a result of the price increase.
- (e) SupposeIan’sparentsfeelbadforhimandoffertopay$30/monthfora“lattemembership”cardthat would allow him to purchase lattes at the original price. Explain why he would prefer it if his parents just sent him $30/month.
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