Two budget lines-without substitution and income effects

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Reference no: EM131001917

Hillary spends all her income on milk and cookies. Graph Hillary's budget line when income = $20, Pcookies = $1 & Pmilk = $2. Pick some point in the middle as her optimal choice and draw in the appropriate indifference curve. (PUT MILK on the Y-axis) a. The government decides to subsidize Hillary's consumption of cookies by giving her a subsidy of $.50 for every cookie she buys (that is, she now pays 50 cents for each cookie). Graph the change including her new optimal choices of cookies and milk and show the substitution and income effects for MILK.

b. Redraw the two budget lines, but without substitution and income effects.

c. Given her decision, how much does the government spend? Show this graphically also.

d. The government decides to change its policy. Instead of spending the dollar amount you reported in (c) as a subsidy, it will give her that amount as cash to spend as she chooses. (That is, it is not tied to her purchase of cookies. This is called a "cash equivalent.") Draw her new budget line.

e. Is she better or worse off with the cash equivalent?

Reference no: EM131001917

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