Question

1. -shaped preferences.

1. Person A has an income of $M and spends all of her income on the only two goods in her world - good X with price p_x and good Y with p_Y which we will set equal to 1 (i.e. good y is the numeraire).   Draw a well-labelled diagram showing an individual’s budget constraint. This includes intercepts and slope.
2. Assume that Person A has Leontief preferences – that is, L-shaped indifference curves (such preferences are described by the equation U=min(x,y)). That is, this person only wants to consumer x and y in fixed proportions. In this case, this proportion is 1:1. Good x is useless without an equal amount of good y to go with it (think of French fries and ketchup). Show on the same graph you used in (a) how much of X and Y she chooses to consume using at least one indifference curve.
3. Now, the government introduces a tax on good X. This is an ad valorem tax, at rate t_x   Show how the budget constraint for Person A changes with the introduction of the tax.
4. What quantities of X and Y does person A now choose to consume (i.e. after the tax is introduced)? Label these new consumption values on your diagram. This will likely require you to draw in another indifference curve.
5. Label the amount of the tax collected. What is the equivalent variation (explain in words)? Label it on your diagram.
6. What is the excess burden of this tax? Explain your answer in detail.

Answer 1