Question

Consider an individual making choices over two goods, x and y with prices px = 3 and py = 4, and who has income I = 120 and her preferences can be represented by the utility function U(x,y) = x2y2. Suppose the government imposes a sales tax of $1 per unit on good x:

(a) Calculate the substitution effect and Income effect (on good x) after the price change. Also Illustrate on a graph.

(b) Find the government tax revenues (T), the equivalent lump sum tax (L), and the dead weight loss (DWL). (Hint: Expenditure minimization at the final level of utility.)

(c) Is good x a normal good? Does law of demand hold for good x? Are good x and good y substitutes or complements?

Answer 1