Question

The budget equation 2X + 3Y = 12 suggests that price per unit of Good X = $2, price per unit of Good Y = $3 and total income, I = $12.

a) Use your mathematical calculation to determine the end-points of the budget equation. and illustrate the budget line in a clearly labeled diagram.

b) Suppose that consumer maximizes her consumption by consuming 3 units of Good X and 2 units of Good Y. Illustrate where the indifference curve intersects the budget line in your diagram above.

c) A tax on Good X is imposed. Under this scenario, the consumer consumes 4 units of Good X when she consumes zero units of Good Y. Similarly, as above, the consumer consumes 4 units of Good Y when she consumes zero units of Good X. Illustrate your new budget line in a clearly labelled diagram.

d) Suppose that after the tax takes effect, the consumer maximizes her preferences by choosing 2 units of Good X and 2 units of Good Y. Illustrate where the indifference curve intersects the budget line in your diagram above.

e) Suppose that the government decides to rebate the proceeds of the tax to the consumer. Under this scenario, her income moves up from $12 to $13.5. Use your mathematical calculation to determine the end-points of the updated budget equation, and illustrate the updated line in a clearly labeled diagram. Note that your updated budget line in this case is 3X + 2Y = 13.5.

f) Suppose that after proceeds of the tax are rebated to the consumer, the consumer now maximizes her preferences by choosing 2.5 units of Good X and 2 units of Good Y. Illustrate where the indifference curve intersects the budget line in your diagram.

g) Is the consumer better off with the help of the rebate program? Explain.

h) Does income effect dominate substitution effect? Explain.

Answer 1