Question

At a price of $3 each, Dave (a typical New Yorker) drinks 200 44-ounce sodas each year. Concerned about burgeoning obesity, the Mayor of New York proposes a $0.50 tax on such drinks. He then proposes compensating consumers for the price increase by mailing each consumer a $100 check each year. (a) What will happen to Dave’s consumption of soda? Show using an indifference curve diagram with soda on the horizontal axis and a composite good (price = $1) on the vertical axis. (b) Will Dave be better off, worse off, or indifferent to the change? Explain using your diagram. (c) In terms of revenue, will the government be better off, worse off, or indifferent to the proposal? Explain assuming Dave's income is at least $600

Answer 1

(a) The implication of the optimal bundle is that Dave’s income is at least $600. In addition, assuming well-behaved indifference curves implies that Dave’s income is greater than $600. As a result of the tax and the rebate, the intercepts in the two axes change. The intercept of the horizontal axis, after the tax and the rebate, lies to the left of y/3. The intercept of the vertical axis, after the tax and therebate, lies above y. The graph is indicated below. As shown, Dave’s consumption of soda will decrease and his consumption of the composite good will increase.

b. Dave will be better off as his optimal bundle lies on a higher indifference curve than before.

c.Since Dave cuts back on soda, the government raises less than $100 in revenue. At the same time, the government spends $100 subsidizing Dave. The government is therefore worse off.