1. EC 100 Week 6

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

3. 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.

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

5. 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

6. Question 4

7. 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?

8. 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)

9. Question 6

10. Question 7

11. 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.

12. 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

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

14. Question 11

15. 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.

16. Question 13

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

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

19. 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

20. 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

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

22. 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

23. 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?