EC 100 Week 6
The Budget Set
- Feasible set defined by
- Given this income, maximise utility
Question 1
• Suppose there are two goods and the price of good 2 rises. If we draw a
budget line with good one on the horizontal axis and good 2 on the
vertical axis, how will the rise in the price of good 2 change the budget
line.
• Price of good on vertical axis becomes more expensive --- so if you were to
only purchase the good 2, then you could now purchase fewer units.
Question 2
Why?
Budget set does not change…
Bot left hand side (expenses on goods C1 and C2) goes up, but so do incomes.
Question 3
• 10 units of Coke makes you as happy as 10
units of Pepsi.
• You would thus be willing to give up 1 unit of
Coke in exchange for 1 unit Pepsi.
• No diminishing MRS
Question 4
Income Elasticity
Measures the responsiveness of your demand to a change in Income.
Imagine the budget set being shifted out – by how much does your
demand for Good 1 increase for a 1% increase in income?
Question 5
If you consider the example of there being two goods
(see graph) – what must happen to the demand for
good2 if good 1 is a luxury good?
It either increases (but with an income elasticity < 1)
or it decreases (in that case it is an inferior good)
Question 6
Question 7
Question 8
• Suppose a consumer buys more of a good when his/her
income rises. If the price of this good falls (keeping income
and other prices constant) which of the following
statements are true
• First statement: the good is a normal good with positive
income elasticity.
• Second statement: holding prices and income constant…a
lower price should induce consumers to demand more. The
question just asks for the Substitution Effect.
Question 9
• Increase tax: like a price increase
• Sub effect: reduce consumption
• Income effect: increase consumption (inferior
good)
• Net effect (sub + income effects) is ambiguous
Question 9
• So…
Remember: Every Giffen good is an inferior good.
However, not every inferior good is a Giffen good.
Question 11
Question 12
• Own Price Elasticity less than 1 means: a 1% increase in the price of the
good reduces demand by less than 1%.
• So if you increase the price by 1% you cut back quantity by less than 1%,
so total expenditure must rise.
Question 13
Discussion question
• Top tax rate rises from 40% to 50%
• What happens to hours worked and tax
revenue?
Without A Tax
Income
150 k
Total time
available
2000 hrs
Hours of work
Leisure
Tax on Income Above 150k?
Income
New
Budget
150 k
Leisure
2000 hrs
Hours of work
• Below 2000 hours a year: The Work-Leisure
choice is unaffected, as she is unaffected by
the tax change
• Above 2000 hours a year :
– Remember: leisure is a good to consume (labour is
its alternative)
– When wage falls:
– Substitution effect: more leisure (unambiguous)
– Income effect: income falls, so
• Consume less leisure if it is normal
• Consume more leisure if it is inferior
Somebody earning more than 150k
Income
150 k
Leisure
2000 hrs
Total time
available
Somebody earning more than 150k
Income
As drawn, leisure increases
(so hours worked falls)
150 k
Leisure
2000 hrs
Total time
available
How is the relationship between Tax
Rates and Tax Revenues?
• There is an “inverse U shaped” relationship
between tax rates and tax revenues.
• This is called the “Laffer Curve”
– Linked to the idea of backward-bending labour
supply curve
• Can people really substitute out of labour so
easily?