Granny lives in the Woods and consumes only bread and fruits and has $60 dollars to spend of food each week. One week she falls ill and has to ask her niece, Red, to buy her weekly food (Granny will reimburse Red for the $60 she spends on food, of course). Red lives in the City, where the price of fruit is $2 per kilogram and the price of bread is also $2 per loaf. Red decided to buy 20 loaves of bread for Granny.
1. How much fruit did Red buy for Granny?
2. In a diagram measuring the quantity of bread on the horizontal axis draw: i. Red’s budget line, ii. the point (label it C) showing the basket Red purchased in the city, and iii. the Indifference curve passing through point C.
3. What is the slope of the budget line, and its economic meaning?
Heading to Granny’s house in the Woods with the food from question 1 in her basket, Red unexpectedly meets the infamous trader B. B. Wolf, which offers to buy or sell food at a price of $6 per kilogram of fruits, and $3$ per loaf of bread.
4. In the diagram you used to answer question 2, and add Red’s budget line after meeting Wolf. Should Red trade with Wolf? Note: Red can always afford point C (if she desires so), by simply not trading with Wolf. This means her new budget line must pass through point C! And since you know the prices at which she can trade with Wolf, you should easily be able to calculate the slope. If you know a point and the clone of a line passing through it, it should be easy to draw that line.
5. Draw, in the diagram you used to answer question 2 and 4: i. the point (label it W) showing Red’s basket after trading (or not trading) with Wolf, and ii. the indifference curve passing through it.
6. Draw, in the same diagram you used to answer questions 2, 4, and 5, the compensated budget line of Red’s meeting with Wolf.
7. Show, in the same diagram you used to answer questions 2, 4, 5, and 6, the income effect and the substitution effect on Granny’s consumption of bread due to Red’s meeting Wolf.
Note: I expect only ONE diagram to answer all above questions. That diagram must be very well labelled, so I do not have to guess what the various lines and curves are.
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