Question

GingerSnap Cookies sell for $40 per box, of which $10 consists of tax, and 600,000 boxes are sold every year. From previous research, you know that the price elasticity of demand for GingerSnap Cookies is –2.2 (that is 2.2 in absolute value terms). Choco cookies sell for $30 per box (which includes $l0 tax), and 800,000 boxes of Choco cookies are sold every year. The cross-price elasticity of demand for Choco cookies, with respect to a change in the price of GingerSnap Cookies, is 0.75. The income elasticity of demand is 1.25.
The government raises the tax on GingerSnap Cookies from $10 to $l2 per box, all of which is passed through to the consumer in the form of higher prices of GingerSnap Cookies. As the increased tax is imposed, real income drops by 0.5%. Using the appropriate elasticity measures (price elasticity of demand, income elasticity of demand, and cross price elasticity of demand), calculate the change in total government revenue from the government raising the tax (and hence raising the price).
a) Calculate government revenue before and after the tax change. Explain by showing how you calculated the new P’s and Q’s for GingerSnap and Choco cookies after the change in tax was levied.
b) Should the government raise the tax? Why or why not? Explain.
c) Characterize the elasticities by types of goods and tell how a different characterization would change your outcome.

Answer 1