Question

During the energy crisis of the mid-1970s a proposal was made to increase the tax on gasoline by 50¢ per gallon. The government would give poor consumers an amount of cash large enough that they could buy their original bundle (of gasoline and other goods).
1. Show how a typical poor person’s budget line changes as a result of the tax and the subsidy.
2. Use a graph to show how the tax and subsidy could affect this person’s optimal bundle.
3. Is this individual better or worse off or stay on the same bundle as a result of the tax and the subsidy? Explain your answer using your graph and show the possible scenarios.

Answer 1

1) Tax makes the budget line steeper, because gasoline is now expensive. However, a rebate means that total income remains the same, so consumpton of other goods increases. Since rebate is such that original bundle is affordable, the two BLs (Budget Lines) passes through the original bundl X.

In the diagram, gasoline is on X axis and other consumption on Y axis.

2) Applying the principle of Revealed preference, we see that consumer is now better off if he consumes on the part of new budget line that is left to the X:

In diagram, new optimal bundle X* provides higher level of utility.

3) The consumer is better off because he is on a higher IC (Indifference curve)