Problem 2 solutions:

a) The formula for the budget constraint with two goods is 𝑝1 𝑥1 + 𝑝2 𝑥2 ≤ 𝑚. For this problem,
𝑝1 = 2 (assume French Fries are 𝑥1 ), the price of Beef Jerky is 𝑝2 = 5 per pack. With income
m = $100, Murphy's budget constraint is:
2𝑥1 + 5𝑥2 ≤ 100
Notice that the budget constraint represents all the affordable (𝑥1 , 𝑥2 ) combinations (anything
less than or equal to $100). The budget line represents the (𝑥1 , 𝑥2 ) combinations that cost
exactly $100, so the equation representing the budget line is:
2𝑥1 + 5𝑥2 = 100
b) The real income in terms of French Fries (portion of French Fries Murphy could consume if
he spent all his income on French Fries) is:

𝑚 100
= = 50
𝑝1 2

c) The real income in terms of Beef Jerky (which is the packs of Beef Jerky Murphy could
consume if he were to consume only Beef Jerky) is

𝑚 100
= = 20
𝑝2 5
d) The red budget line (2𝑥1 + 5𝑥2 = 100) and the pink budget set area (all (𝑥1 , 𝑥2 ) that are
affordable under 2𝑥1 + 5𝑥2 ≤ 100) are shown below. Notice that solutions to (b) and (c) are
the 𝑥1 and 𝑥2 intercepts.

e) Slope of the budget line is:

𝑝1 2
− = −
𝑝2 5

This can also be calculated from the 𝑥1 (0, 50) and 𝑥2 (20, 0) intercepts’ coordinates:

∆𝑦 (𝑣𝑒𝑟𝑡𝑖𝑐𝑎𝑙) 𝑦1 − 𝑦2 20 − 0 2
𝑠𝑙𝑜𝑝𝑒 = = = = −
∆𝑥 (ℎ𝑜𝑟𝑖𝑧𝑜𝑛𝑡𝑎𝑙) 𝑥1 − 𝑥2 0 − 50 5

f) The new budget line at the new price of beef jerky:

2𝑥1 + 10𝑥2 ≤ 100

The corresponding 𝑥1 and 𝑥2 intercepts are:

𝑚 100
𝑥1 intercept: = = 50
𝑝1 2

𝑚 100
𝑥2 intercept: = = 10
𝑝2 10

Therefore, the new red budget line is (2𝑥1 + 10𝑥2 = 100):

 This shift is not parallel, it is pivotal.

The new relative price is:

𝑝1 1
=
𝑝2 5
(Fries are relatively cheaper compared to Beef Jerky than they were before. )

g) The “Jerky" Bill prohibits Murphy from consuming any combination (𝑥1 , 𝑥2 ) of French
Fries and Beef Jerky with 𝑥2 > 5. So the area of this budget constraint set that overlaps
with the part of the graph where 𝑥2 > 5 is off limits. Notice that this does not change the
slope of the budget line exactly. It forces Murphy to choose among the affordable bundles
for which 𝑥2 ≤ 5.
Problem 3 solutions:
a) The relative price of a CD in terms of milk is:
𝑝1 20
= = 20
𝑝2 1

To purchase one more CD, Amy must forego 20 bottles of milk.

Note: The slope of the budget line is negative (-20), however price is not expressed
negatively.

b) Amy’s budget set:

c) An ad valorem tax on CDs is equivalent to a change in the price of CDs to:

𝑝1𝑇 = (1 + 𝑡𝑎𝑥). 𝑝1 = (1 + 1). 20 = 40

Therefore, Amy’s new budget set becomes:

𝑝1𝑇 𝑥1 + 𝑝2 𝑥2 ≤ 𝑚

40𝑥1 + 1𝑥2 ≤ $2000

The new relative price of a CD in terms of bottles of milk is therefore:

𝑝1𝑇 40
= = 40
𝑝2 1

Graphically, the new budget line and set are:

d) If Amy receives 5 CDs then her new budget set includes the budget set shown in c plus 5
CDs at any point, shifting the budget line to the right by 5 units. The maximum units of
CDs she can consume has increased by 5 everywhere, including the 𝑥2 intercept and is
now:
𝑚 2000
+5= + 5 = 55
𝑝1 40

The 𝑥1 intercept is unchanged:

𝑚 2000
= = 2000
𝑝2 1
This means her budget line will have a kink at (5, 2000) as shown below.