M HUSSNAIN RAZA GILL
23i-4528
A&F-3A
October 09,2024
Assignment # 2
Micro Economics
Question#1: Abdullah has income of $2,000. Wheat costs $3 and Milk cost $6
I. Draw the consumer’s budget constraint.
Ans:
• W = Quantity of Wheat
• M= Quantity of Milk
• Pw=3(Price of wheat per unit)
• Pm=6 (Price of milk per unit)
• Income = $2,000
The budget constraint formula is:
3W+6M=2000
We need to make a table to draw the Budget Line
Wheat(W) Milk(M) Spending on Spending on Total Spending
wheat $ Milk $ $
666.67 0 2000 0 2000
500 83.33 1500 500 2000
400 133.33 1200 800 2000
300 183.33 900 1100 2000
200 233.33 600 1400 2000
100 283.33 300 1700 2000
0 333.33 0 2000 2000
II. What is the slope of this budget constraint?
Ans: The slope of the budget constraint is determined by the ratio of the prices of wheat and milk.
The slope tells us the rate at which Abdullah can trade wheat for milk while staying within his budget.
Slope = -Pw/Pm = -3/6 = -0.5
So, the slope of the budget constraint is −0.5 meaning that for each additional unit of milk Abdullah
buys, he must give up 0.5 units of wheat.
III. Draw a consumer’s indifference curve for wheat and milk?
Ans: An indifference curve represents different combinations of two goods (in this case, wheat and
milk) that provide the same level of utility or satisfaction to the consumer. To plot an indifference
curve, you need to follow a few key steps:
Question#2: Compare the following two pairs of goods:
• Lux and Dove
• CD and CD Player
1. In which case will the consumer respond more to a change in the relative price of two goods?
Ans: Lux and Dove:
• Lux and Dove are close substitutes, both being brands of soap. If the price of one increase
while the other stays the same, consumers are likely to switch to the cheaper brand since both
goods serve a very similar purpose. Therefore, the consumer is likely to respond more
strongly to a change in the relative price between Lux and Dove.
CD and CD Player:
• CDs and CD players are complementary goods, meaning that they are consumed together. If
the price of one change (e.g., CDs get more expensive), it might not significantly change
consumer behaviour unless the price change is extreme. Consumers will still need both to
enjoy music, and if one becomes more expensive, the other loses its usefulness. Therefore, the
consumer's response to a change in the relative price between CDs and CD players is likely to
be weaker compared to Lux and Dove.
2. In which case do you expect the indifference curves to be fairly straight?
In which cases do you expect the indifference curves to be very bowed?
Ans: Fairly Straight Indifference Curves:
• Lux and Dove: Because Lux and Dove are close substitutes, the consumer is willing to
substitute one almost entirely for the other. This means that the marginal rate of substitution
(MRS) between them is nearly constant. The indifference curves for close substitutes are
usually fairly straight, as the consumer doesn’t mind switching between the two brands.
Very Bowed Indifference Curves:
• CD and CD Player: These are complementary goods, meaning the consumer needs both in
fixed proportions to derive satisfaction. The consumer won’t trade off CDs for a CD player in
a flexible manner. As a result, the indifference curves for complementary goods are usually
very bowed, reflecting a low willingness to substitute one good for the other.
3. Consider your decision about how many hours to work
Draw your budget constraint assuming that you pay no taxes on your income. On the same
diagram, draw another budget constraint assuming that you pay 15% tax.
Ans: let total income of $1,000, and you're deciding between spending it on two goods: Wheat and
Milk and the Assuming
• The price of Wheat is Pw
• The Price of Milk is Pm
So when there is no tax the total income $ 1000 The Budget Constraint is Simply
PwQw+ PmQm= $1000
The without tax budget line will start at:
• If you spend all your money on Wheat: Qw=1000/Pw intercept on the Wheat axis.
• If you spend all your money on Milk: Qm=1000/Pm intercept on the Milk axis.
As shown In Graph below in Line point A and B
Further With a 15% tax: Your available income after tax is 85% of $1,000, which is:850
PwQw+ PmQm= $850
With tax the Budget line will start at:
• If you spend all your money on Wheat: Qw=850/Pw intercept on the Wheat axis.
• If you spend all your money on Milk: Qm=850/Pm intercept on the Milk axis.
Both lines will have the same slope (since prices Pw and Pm are constant), but the "with tax" line will
be closer to the origin because of the reduced income. As Shown In Graph below
(b) Show how the tax might lead to more hours of work, fewer hours, or the same number of
hours. Explain
Ans: Number of hours worked can be influence by Tax So, analyse the income effect and
substitution effect in detail..
Effects of Tax on Work Hours
1. Income Effect:
o The income effect occurs when a change in income (due to taxation in this case)
affects the amount of goods and services one can purchase.
o With a tax, disposable income decreases. In this scenario, consumer go from having
$1,000 to $850 after a 15% tax.
o If want to maintain the same standard of living or consumption level (i.e., the same
amount of Wheat and Milk), he might feel compelled to work more hours to make up
for the lost income.
o Example: If a person was working 40 hours to earn $1,000, they might now decide to
work 46 or 48 hours to earn enough to buy the same amount of Wheat and Milk they
were purchasing before.
2. Substitution Effect:
o The substitution effect occurs when a change in the relative price of leisure (time not
working) versus consumption (income from working) affects the amount of work a
person is willing to do.
o After a tax is imposed, the effective wage (after tax) decreases, which reduces the
incentive to work additional hours.
o With a lower effective wage, the opportunity cost of leisure time becomes lower;
people may choose to work fewer hours because they feel the reward for working is
no longer worth it compared to enjoying their free time.
o Example: If a worker decides that the tax has made working less rewarding, they
might cut back their hours from 40 to 35 hours a week, choosing to enjoy more
leisure time instead.
Possible Outcomes
1. More Hours of Work:
o If the income effect is stronger, the worker might feel the need to work more hours to
compensate for the reduced disposable income. For instance, if a person needs to
maintain a certain consumption level, they may work longer hours despite the tax.
o Graphical Representation: This would be reflected in a scenario where the
individual’s budget constraint shifts inward due to the tax, but they move along the
new constraint to a point that requires more hours worked.
2. Fewer Hours of Work:
o If the substitution effect is stronger, the worker may find that the reduced effective
wage makes leisure time more attractive, leading to a reduction in the number of
hours worked.
o Graphical Representation: This would be shown by the individual moving down the
new budget line to a point that involves fewer hours worked.
3. Same Number of Hours of Work:
o If the income and substitution effects balance each other out, the worker may choose
to keep the same number of hours worked. They may find a new equilibrium where
the tax has no effect on their work hours.
o Graphical Representation: The individual may still operate at the same point on the
budget line even after it shifts inward, indicating that their decision regarding work
hours remains unchanged.
