problem-set-2-solutions

# Problem-set-2-soluti - Ecn 100 Intermediate Microeconomic Theory University of California Davis John Parman October 9 2010 Problem Set 2 Solutions

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Ecn 100 - Intermediate Microeconomic Theory University of California - Davis October 9, 2010 John Parman Problem Set 2 - Solutions This problem set will be graded and is due by 5pm on Monday, October 18th in my mailbox in the economics department. You may turn in problem sets early by putting them in my mailbox in the economics department or by dropping them oﬀ in lecture. No late problem sets will be accepted. You are welcome to work in groups. If working in a group, everyone in the group must still submit an individual problem set. 1. Rebating a Tax As a result of its budget crisis, the State of California decides to impose a new tax on gasoline. The tax adds an additional 5 cents to the price of every gallon of gas purchased. As a result of the tax, people decrease both their gas consumption and their consumption of other goods from ( g,o ) to ( g 0 ,o 0 ). The City of Davis has decided to help out it residents by oﬀering them a rebate to oﬀset the new gas tax. Three proposals are oﬀered: Proposal A will give people a check to raise their income enough to make their old bundle ( g,o ) just aﬀordable. Proposal B will give people a check to raise their income enough to make their old utility level just aﬀordable. Proposal C will position Davis city council members at all of the gas stations in town and have them directly refund the tax as people buy gas (each time an additional gallon is pumped, a city council member hands the driver a nickel which he can then give directly to the gas station to pay the tax). (a) Graph the budgets constraints, indiﬀerence curves and optimal bundles under each proposal. Can you rank the three proposals according to which the consumer prefers? The three proposals are graphed below. Notice that with proposal A, the consumer has the opportunity to move up and left from his original consumption bundle to get to a higher utility than he was initially at. Under proposal B, he will ultimately move to a new bundle but end up at the same utility as he originally had (this was how the rebate was constructed). Under proposal C, the after-tax, after-rebate budget line is identical to the original budget line (each gallon of gas has 5 cents in tax added to it and 5 cents in rebate subtracted from it), so his ﬁnal consumption bundle and utility will be identical to his original consumption bundle and utility. So the consumer will prefer proposal A to the other two. He is indiﬀerent between proposal B and proposal C.

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2 Problem Set 2 - Solutions (b) Can you rank the three proposals in terms of how much they will cost the City of Davis? Notice that the amount of money Davis has to spend for proposals A and B is given by however much they have to shift up the budget curve for the consumer. The budget line under proposal A is shifted up by more than the budget line in proposal B (we can see this graphically because the budget line under proposal A passes through the original bundle while the budget line in proposal B passes below the original bundle). So proposal
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## This note was uploaded on 09/11/2011 for the course ECON 100 taught by Professor Parman during the Winter '08 term at UC Davis.

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Problem-set-2-soluti - Ecn 100 Intermediate Microeconomic Theory University of California Davis John Parman October 9 2010 Problem Set 2 Solutions

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