Week 5 - Taxation and utility Flashcards
What is a Specific tax
An indirect tax placed on a good or service when the tax levied is a specific/fixed amount of money per unit
What is Ad valorem tax
An indirect tax placed on a good or service that is proportional to expenditure on the good/service
What is Tax incidence
Measured as the proportion of the total tax revenue paid by consumers and producers
What determines the Tax incidence
The relative elasticities of supply and demand
How do you calculate the incidence of Specific tax on consumers
Consumer’s pay = (PD - P) x Q1
How do you calculate the incidence of Specific tax on producers
Producer’s pay = (P-PS) x Q1
How do you calculate the Specific tax amount from a supply and demand diagram
Specific tax = (PD - P) + (P - PS) = t
Describe the relationship between the Incidence of tax on consumers and producers and the relative Elasticities of supply and demand (x3)
If demand is more inelastic than supply, then consumers will pay more of the tax than producers
If supply is more inelastic than demand, then producers will pay more of the tax than consumers
Holding one curve constant, the larger the difference in elasticity between the two curves, the larger the difference in tax incidence
Describe the relationship between Dead Weight Loss (DWL) and the Elasticity of demand
As demand becomes more elastic the deadweight loss increases
As demand becomes more inelastic the deadweight loss decreases
What do we consider as the 3 components to Individual decision making
- Utility (a numerical representation of tastes or preferences)
- Income
- Prices
and…assumption of rationality (maximise utility)
What is Utility
A numerical indicator of the value that an individual places on an outcome, based on the individual’s preferences
What is a Rational individual
An individual who will always choose outcomes that provide higher utility to outcomes that provide lower utility when both are feasible
What is Cardinal utility
When an individual can attach a specific number of utils to every outcome
What is Ordinal utility
When an individual can rank different outcomes by preference, but not attach a measurable number of utils to every outcome
Why is the Utility curve concave in shape
The law of diminishing marginal utility
What are the 3 key elements to model consumer decision making when utility is Ordinal
- Preferences
- assume completeness, transitivity, and non-satiation
- consumers are indifferent between 2 bundles if they provide the same utility - Budget constraint
- income
- prices - Choice
- need to define the consumer’s objectives
- assume consumers are rational (maximise utility)
What are the 3 key assumptions made about consumer preferences
- Completeness - for any 2 bundles of goods, a consumer can always say whether they prefer one bundle to the other, or are indifferent between them
- Transitivity - if a consumer prefers bundle A to bundle B, and bundle B to bundle C, they must also prefer bundle A to bundle C
- Non-satiation - a consumer will always prefer a bundle containing more of a good compared to a bundle containing less of that good, holding all other goods constant
What is an Indifference curve
A graphical reprsentation of all combinations of 2 goods that deliver a fixed level of utility
What are the 3 properties of Indifference curves
- Infinite curves covering all possible bundles, each curve represents a different utility level (completeness)
- Downward sloping (if the quantity of one good changes, the quantity of the other good must exactly offset this change for the consumer to remain equally happy)
- Indifference curves never cross (transitivity)
What is Marginal Rate of Substitution (MRS)
The rate at which a consumer is willing to trade one good for another while holding utility constant
How do you calculate MRS of good Y for good X
MRSy,x = - change in Y / change in X
What is Diminishing MRS
Holding utility constant, as a consumer acquires more of one good, they are willing to give up less of another good in exchange
How do you calculate the slope of an Indifference curve at a given point
MUx / MUy
Describe the relationship between MRS and Indifference curves (x3)
- MRS changes along the indifference curve (unless X and Y are perfect substitutes)
- At each point, the MRS is equal to the slope of the indifference curve
- As X increases, MRS decreases (reflecting diminishing marginal utility)
What is a Cobb-Douglas utility function
A preference representation of the following form:
U = X^alpha Y^beta
(where alpha and beta are positive parameters with a value less than 1)
What are 2 features of Cobb-Douglas utility indifference curves
- Indifference curves are smooth and curved
- MRS is different at every point on the indifference curve
What is a Perfect substitute utility function
A linear function that represents a situation where two goods can be completely substituted for each other at a constant rate
What are 2 features of perfect substitute indifference curves
- Indifference curves are straight lines
- MRS is the same at every point on the indifference curve (constant)
What are 2 features of perfect complement indifference curves
- Indifference curves right angled
- MRS = 0
What is a Perfect complement utility function
2 goods must be consumed in fixed proportion to each other
U(x, y) = min(ax, by)
(a and b being constants representing the required ratio)
