Question

Billy has a​ $20 budget to spend on yogurt and cereal. Yogurt cost​ $2 each and cereal costs​ $4 each. Suppose that the quantity of yogurt is on the vertical axis and the quantity of cereal is on the horizontal axis. If the price of yogurt​ increases, which of the following is​ true?
​i) The budget line rotates outward.

​ii) Yogurt's marginal utility per dollar decreases.

​iii) The relative price of yogurt increases.

Answer 1

Answer:

The answer is option "iii) The relative price of yogurt increased"

Explanation:

The budget line is a function of a consumer's budget constraint. With the quantity of one good on the y axis and the quantity of the other good on the x axis, the budget line shows how much of each good the consumer can buy from a defined, limited budget.

In our example, the customer's budget is $20 which mean the customer can buy any combination of goods between the two extreme. One extreme is 10 of Yogurt ($20 budget/$2 Price) while the other extreme is 5 of cereal ($20 budget/$4 price). So the budget line is a downward sloping line from point 10 on the y axis to point 5 on the axis.

Option i) is incorrect since the increase in the price of yogurt would mean that the consumer can buy ONLY less of yogurt. It does not impact the quantity of cereal that he can buy. So the line will rotate downward along the y axis. The x axis will remain unchanged since the maximum amount of cereal Billy can buy remains unchanged. An outward rotation would occur only if the price of cereal decreased. This does not happen in this case therefore the line would not rotate outward.

Option ii) is incorrect because the marginal utility. The law of marginal utility states that the utility, or the pleasure, one gets from consuming a good decreases as more and more of the same good is being consumed. This does not happen in this case.

Option iii) is correct. This is called the slope effect. Since the Billy can consume less yogurt (since the price of yogurt increased), the relative price of yogurt increases while the relative price of cereal decreases. Think of relative price of yogurt as the number of units of cereal that Billy would have to forgo to consumer 1 unit of yogurt. Since yogurt has gotten expensive, Billy would have to give up more units of cereal to consumer 1 unit of yogurt.