Question

Question 7 (20 points) 7.1 (15 points) Suppose a person has a fixed income which is spent on two commodities, barley and corn. Draw a graph showing how a consumption tax on barley affects the optimal bundle chosen by a utility maximizing consumer. Give definitions of the equivalent variation and excess burden of a consumption tax and show how they can be computed on the same graph. 7.2 (5 points) Does income tax generate an excess burden? Explain your answer.

Answer 1

Co, \Uо — Во Barely

initially ,budget line was C0 B0 with IC0 IC curve equilibrium at point a

with increase in taxes in barely , price of barely increases . Budget line will rotate leftward to C0 to B1 because with fixed income consumer will buy less of barely .

new equilibrium will be at point b , buying less of barely and same quantity of corn .

there will be no excess burden of income tax . Rather , consumer will buy less of barely