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 TaxIncome

LeisureTotal time available

Hours of work

2000 hrs

150 k

Tax on Income Above 150k?Income

Leisure

Hours of work

2000 hrs

150 k

New Budget

• 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 150kIncome

LeisureTotal time available

2000 hrs

150 k

Somebody earning more than 150kIncome

LeisureTotal time available

2000 hrs

150 k

As drawn, leisure increases (so hours worked falls)

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?