Question 3: Gas Prices Straining Budgets With gas prices rising, many people say

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Question 3: Gas Prices Straining Budgets With gas prices rising, many people say they are staying in and scaling back spending to try to keep within their budget. They are driving as little as possible, cutting back on shopping and eating out, and reducing other discretionary spending Source: CNN, February 29, 2008 Sketch a budget line for a household that spends its income on only two goods: gasoline and restaurant meals. Identify the combinations of gasoline and restaurant meals that are affordable and those that are unaffordable. a. b. Sketch a second budget line on the same graph to show how a rise in the price of gasoline changes the affordable and unaffordable combinations of gasoline and restaurant meals. Describe how the household's consumption possibilities change. How does a rise in the price of gasoline change the relative price of a restaurant meal? How does a rise in the price of gasoline change real income in terms of restaurant meals? c.

Explanation / Answer

a. Budget Line: It shows the combination of two goods, that a consumer can buy, give the prices of the goods and income of the consumer.

Assuming that gasoline cost $20 Per Unit and Restaurant meals cot $40 per meal, and consumer's income is $240; then he will spend his income in the the following combination on two goods:

In the above graph; combination A is unattainable and combination B is attainable.

b. The rise in price of gasoline will shift the bugety line inside on x-axis. suppose the price increase from $20 to $40, the new combination would be as follows:

With rise in price of gasoline, point B also becomes unaffordabe for the consumer. Now with 4 restaurent meals, consumer woule be able to buy only two units of gasoline.

c. The rise in price of gasoline, would make relative price of restaurent meals to fall. The real income of the consumer falls with rise in price of gasoline as the consumer is able to buy less quantity of gasoline and restraunt meals.

Gasoline Restaurant meals 12 0 10 1 8 2 6 3 4 4 2 5 0 6

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