Application and Limitations of Rational Choice and Demand Theories Flashcards
Sin Tax
Tax levied on goods/ activities deemed harmful to society:
- cigarettes
- alcohol
Statutory/ Legal Incidence
Who’s responsible for paying the tax
- ignores the idea that tax changes purchasing behavior
Economic Incidence
Who bears the burden of the tax - measures share of tax borne by buyers and sellers through tax impact on price
Specific or Unit Tax
Levied as a fixed amount sold per unit
Ad Valorem Tax
Levied as a % of the sales price
Tax Paid by Producers
Burden of tax falls on producers, they receive a lower price and consumers therefore pay a higher price
- Tax Wedge: Difference between price consumers pay and receive
(learn the graph!)
Tax Paid by Consumers
The side of the market which tax is levied is irrelevant to who bears the economic burden of the tax
- Producers still bear some of this burden
(learn the graph!)
Burden of Tax
Whichever side of the market is less responsive/ sensitive to change in price will bear an increase in burden of tax (dependent on elasticities of supply and demand)
- Perfect Inelastic Demand: Entire burden falls on the consumer. (graph)
- Perfect Elastic Demand: Entire burden falls on the producer. (graph)
An increase in elasticity of demand = decrease in burden of tax borne by consumers.
Effectiveness of a Tax
PED determines the effectiveness of a tax:
- If demand is more elastic: Tax helps raise revenue for government but has little impact on discouraging consumption
- If demand is more inelastic: Tax raises less revenue but is more effective in discouraging consumption
Consumer Surplus
Increases as price decreases and decreases as price increases
(graph)
Rational Choice and Budget Constraint
RC model assumes:
- Consumers face budget constraints
- Consumers have well defined preferences
- Consumers made choices which maximise utility
Bounded Rationality
Individual Rationality is limited by information availability: Decision making isnt costless
- Herbert Simon: Individuals rarely optimise, instead they satisfy.
Two-System Model
System 1: Happens with little effort
System 2: Happens slower with more logic.
- Information is costly, individuals rely on heuristics
Availability Bias
Estimates the frequency of event based on how easy we can recall examples
Representativeness Bias
Mental shortcuts used to estimate probability
