Econ 100A-Spring 2007 Page 1 Problem Set 3 Answers Department of Economics Spring 2007 University of California, Berkeley Prof. Woroch Economics 100APROBLEM SET 3 SUGGESTED ANSWERS TRUE or FALSE or UNCERTAIN and EXPLAIN: For each statement below, decide whether it is true or false or cannot be determined given the information, and explain the reasoning behind your answer in a few sentences. When appropriate, provide a diagram. 1.Worried that too many people are smoking in California, Gov. Schwarzenegger is correct in his welfare economic analysis by favoring a law that imposes an ad valoremtax on cigarette sales, rejecting a corporate income tax on tobacco companies. Solution: True. Recall the equation for profits with no corporate income tax: π=×−pqc q( ). The profit-maximizing level of output, q*, satisfies: ddqpc qπ=⇒−=00'()*(i.e., price = marginal cost) Now consider the equation for profit with a corporate income tax of τ: πττ=−×−()(( ))1pqc qThe profit-maximizing level of output with the corporate income tax, qτ*, satisfies: ddqpc qpc qqqπτττττ=⇒−−=⇒−⇒=010()('())'()****Therefore, the corporate income tax has no effect on market output. This means that there is no effect on the supply curve. Hence, there is no change in producer surplus. Since the corporate income tax does not affect the demand curve, social welfare is unchanged. Now consider the ad valorem tax. Let this be denoted by t. Suppose a given individual consumes 2 goods: cigarettes (C) and beer (B). An ad valorem tax on cigarettes causes the marginal rate of transformation to change from ppCBto ptpCB()1+. Assume cigarettes are a normal good. This would cause consumers to reduce their consumption of cigarettes. Hence, market demand would fall reducing the equilibrium number of cigarettes sold in the market. This is shown in the diagram below. As can be seen, the shift in demand causes the market equilibrium to change, thus creating deadweight loss.
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