Question

The senate has proposed raising all tolls as they are cheap right now. The people have convinced the government to give all in state residents a tax break equivalent to the amount they would be facing in raised tolls. Evaluate the gains and losses for both the resident and non-resident use indifference curves to help explain.

Answer 1

Let us assume that there only two commodities.

X:- Consumption Toll Tax Y:- Other Goods

Budget equation for both residents and non- residents:- PXQX+PYQY=M where:- Px:- Price of toll consumption Py:- Price on consumption of other goods

The optimal solution will be as follows:-

So, initially one is at U1 Level of utility and is consuming Qx amount of toll

Now, the government has increased the toll rate by t%. So, the price of toll consumption will increase by t%The new bugdet equation will be:-

(1+t)PXQX+PYQY=M

As a result, one will consume less of toll and the budget line will shift left towards the origin on X-axis.

The optimum bundle will shift to a lower indifference curve U2. One will consume lower quantities of toll QX'. So, after the toll rate is increased, one iwll be worse off and shifts below to an indifference curve with lower utility.

Now, the government is also providing its resident a tax break of the same amount. So, the disposable income of a resident will increase by a lumpsum ampount of PXt. So the new budget constraints for the residents will be:-

PXQX+PYQY=M+PXt

So, the budget line will shift upwards parallely. The new optimum solution will be:-

So, the residents will move to a higher indifference curve U3 after the tax break but it is still lower than the initial curve U1. They will consume QX'' units of toll.

Thus, initially both residents and non resident starts with QX units of toll at U1 indifference curve. But at the final equilibrium level, non residents shift to a lower indifference curve U2 and consume QX' units of toll. The residents shift to an indifference curve U3 which is higher than U2 but at a lower level than U1 consumes QX'' quantity of toll. Both residents and non residents are worse off after the toll rate is increased and it decreases the toll consumption for both residents and non residents.