EC 100 Week 6

The Budget Set Feasible set defined by Given this income, maximise utility

Question 1 Suppose there are two goods and the price of good 2 rises. If we draw a budget line with good one on the horizontal axis and good 2 on the vertical axis, how will the rise in the price of good 2 change the budget line. Price of good on vertical axis becomes more expensive --- so if you were to only purchase the good 2, then you could now purchase fewer units.

Question 2 Why? Budget set does not change… Bot left hand side (expenses on goods C1 and C2) goes up, but so do incomes.

Question 3 10 units of Coke makes you as happy as 10 units of Pepsi. You would thus be willing to give up 1 unit of Coke in exchange for 1 unit Pepsi. No diminishing MRS

Question 4

Income Elasticity Measures the responsiveness of your demand to a change in Income. Imagine the budget set being shifted out – by how much does your demand for Good 1 increase for a 1% increase in income?

Question 5 If you consider the example of there being two goods (see graph) – what must happen to the demand for good2 if good 1 is a luxury good? It either increases (but with an income elasticity < 1) or it decreases (in that case it is an inferior good)

Question 6

Question 7

Question 8 Suppose a consumer buys more of a good when his/her income rises. If the price of this good falls (keeping income and other prices constant) which of the following statements are true First statement: the good is a normal good with positive income elasticity. Second statement: holding prices and income constant…a lower price should induce consumers to demand more. The question just asks for the Substitution Effect.

Question 9 Increase tax: like a price increase Sub effect: reduce consumption Income effect: increase consumption (inferior good) Net effect (sub + income effects) is ambiguous

Question 9 So… Remember: Every Giffen good is an inferior good. However, not every inferior good is a Giffen good.

Question 11

Question 12 Own Price Elasticity less than 1 means: a 1% increase in the price of the good reduces demand by less than 1%. So if you increase the price by 1% you cut back quantity by less than 1%, so total expenditure must rise.

Question 13

Discussion question Top tax rate rises from 40% to 50% What happens to hours worked and tax revenue?

Without A Tax Income Leisure 150 k Total time available 2000 hrs Hours of work Without A Tax 150 k 2000 hrs

Tax on Income Above 150k? Income Leisure New Budget 150 k 2000 hrs Hours of work Tax on Income Above 150k? New Budget 150 k 2000 hrs

Below 2000 hours a year: The Work-Leisure choice is unaffected, as she is unaffected by the tax change Above 2000 hours a year : Remember: leisure is a good to consume (labour is its alternative) When wage falls: Substitution effect: more leisure (unambiguous) Income effect: income falls, so Consume less leisure if it is normal Consume more leisure if it is inferior

Somebody earning more than 150k Income Leisure Total time available Somebody earning more than 150k 150 k 2000 hrs

Somebody earning more than 150k Income Leisure Total time available Somebody earning more than 150k As drawn, leisure increases (so hours worked falls) 150 k 2000 hrs

How is the relationship between Tax Rates and Tax Revenues? There is an “inverse U shaped” relationship between tax rates and tax revenues. This is called the “Laffer Curve” Linked to the idea of backward-bending labour supply curve Can people really substitute out of labour so easily?