Question

(8 Points) California decides to introduce a tax on the sale of marijuana. Assume the elasticity of demand is -0.5, and that supply is perfectly elastic. a) If the tax increases the price of marijuana by 100%, what will happen to the amount that is sold? b) Suppose marijuana is addictive, and that consumers who choose to buy it are rational addicts. Explain what the theory of rational addition predicts will happen to the quantity sold today if the tax increase begins next year. (Note: the theory of rational addiction says nothing about stockpiling goods to avoid paying taxes, so that is not the answer I am looking for.) c) (Extra Credit Question) Suppose there is a legal market with perfectly elastic supply that pays the tax, and a secondary black market that evades the tax. The elasticity of supply in the black market is 1 (the number doesn't matter, just assume that it's neither perfectly elastic nor perfectly inelastic), and assume that after the tax it's cheaper to buy from the black market at low market quantities. Draw an example of what the market supply curve would look like. (Hint: the market supply curve represents the lowest price at which you could buy a given quantity of a good.) Now suppose the state is short on money so they raise the tax rate. Show using a supply- demand diagram what will happen to total tax revenue.

Answer 1