Quiz 2 Ec21 W2014 Solutions.pdf

# Quiz 2 Ec21 W2014 Solutions.pdf - Economics 21 Winter 2014...

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Page 1 of 6 Economics 21 Winter 2014 Quiz 2 Solutions 1. Short Answer Questions (17 points) a. (3 points) Give the definition of the “compensating variation” of a policy. An individual’s Compensating Variation of a policy is the amount of income that needs to be taken away under that policy so that the individual is as well off as (=has the same utility as) under the previous policy. Thus, the CV is a measure of the welfare effect of the new policy relative to the old policy, and is positive whenever the new policy makes the person better off. b. (3 points) Draw an Engel curve for a luxury good. Give values to two points on the curve: specify a number on the X-axis and the on the Y-axis for two points on the Engel curve. Be sure to label the axes (as always). You need to draw an upward sloping curve with income on the Y-axis and quantity of the good in question on the X-axis. Because the good is a luxury, the percentage change in the quantities of the two points you drew needs to be larger than the percentage change in incomes of the two points you drew. c. (3 points) True/False/Uncertain. “If an individual consumes four goods including one inferior good and one necessity, then at least one of the other two goods must be a luxury good.” Explain why . True. The weighted average of income elasticities (weighted by expenditure shares) of all goods consumed must equal one because as income increases by a given percentage (say 10%) total expenditure must also increase by that percentage (10% in our example). The income elasticity of an inferior good is negative, and the income elasticity of a necessity lies between 0 and 1. Suppose (for the sake of argument) that neither of the other two goods is a luxury, then the other two goods also would have income elasticities of one or less. Thus under our supposition, all four goods have elasticities less or equal to one (with at least two less than one), and then the weighted average of elasticities cannot be equal to 1. Hence, the supposition is false, and at least one of the other two goods must be a luxury. d. (3 points) Suppose there is a currently a 3% tax on meals eaten at restaurants. A study has estimated that the DWL of this tax is \$30 million per year. The government decides to increase the meals tax by 12 percentage points (so that the new meals tax is 15%). How much additional DWL is created by the tax increase? Explain in words how you arrived at your answer . DWL rises with the square of the distortion. The distortion becomes 5 times as large (15% / 3% = 5), so the DWL becomes 25 times as large. So the new DWL is 25*30 million =750 million. The additional DWL = 750 million - 30 million =\$720 million.

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Page 2 of 6 e. (5 points) Suppose Hajna consumes two goods, video games (V) and food (F). Her income is 600/month, the price of a video game is 2 and the price of a unit of food is 4. Her compensated demand elasticity for video games is -2, and her compensated demand elasticity for food is -0.6. The supply of both goods is perfectly elastic.
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