Question

Ben allocates his lunch budget between two goods, pizza, and burritos.

a. Illustrate Ben’s optimal bundle on a graph with pizza on the horizontal axis.

b. Suppose now that pizza is taxed, causing the price to increase by 20 percent. Illustrate Ben’s new optimal bundle.

c. Suppose instead that pizza is rationed at a quantity less than Ben’s desired quantity. Illustrate Ben’s new optimal bundle.

Short answer

a.

b.

c.

Step-by-step solution

Ben’s optimal consumption bundle for lunch

Ben consumes pizza and burritos for lunch. His optimal consumption bundle (P₁, B₁) is shown in the following diagram.

The optimal consumption bundle is the point of tangency of the indifference curve with the budget line.

Effect of tax on Ben’s budget line

Pizza becomes costly when government taxes are imposed. Ben’s budget line will shift due to the price rise after taxes.

Ben’s optimal consumption bundle shifts to a lower indifference curve shown in the above figure. The new consumption bundle will be (P₂,B₂).

Consumer’s indifference curve during rationing

Rationing is the government’s action for controlled product distribution rather than allowing prices to increase to competitive levels.

Pizza is rationed at quantity less than the desired (Ben’s optimal consumption bundle) quantity; the indifference curve shifts downward.

The above figure shows the indifference curve, which is below Ben’s budget line. His rationed consumption bundle (P₃, B₃) will lie on the indifference curve below the initial indifference curve (shown in dotted lines).