EC 100 Week 6

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EC 100 Week 6. The Budget Set. Feasible set defined by Given this income, maximise utility. Question 1.

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### 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
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 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 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.
Discussion question
• Top tax rate rises from 40% to 50%
• What happens to hours worked and tax revenue?
Without A Tax

Income

150 k

Leisure

Total time available

2000 hrs

Hours of work

Tax on Income Above 150k?

Income

New Budget

150 k

Leisure

2000 hrs

Hours of work

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

150 k

Leisure

2000 hrs

Total time available

Somebody earning more than 150k

Income

As drawn, leisure increases (so hours worked falls)

150 k

Leisure

2000 hrs

Total time available

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?