Question

Oranges cost $1/kg and apples cost $0.5/kg. Niki has $12 to spend on apples or oranges. He chooses to buy 10 kg of apples.

1. Draw (on a diagram measuring quantity of oranges on the horizontal axis) Niki’s budget line and show the optimal consumption point. Do not forget to draw the relevant indifference curve(s).

2. The government introduces a tax of 100% on apples (that is, apples now cost $1/kg). How does Niki’s budget line change? Show graphically (on the same diagram you used to answer question 3!) his optimal choice. Can you say whether he will buy more or less apples? Would Niki be better off, or worse off than in question 3?

3. In addition to the tax from question 4, the government has decided to give him a tax rebate (an amount of dollars) that would allow him to continue purchasing the basket from question 3. How large should this tax rebate be? Show (on the same diagram you drew for question 3!) the new budget line and the new optimal basket. Can you say whether he will buy more or less apples? Would Niki be better off, or worse off than in question 3?

Answer 1