Week 5 - Taxation and utility

Question 1

What is a Specific tax

Answer 1

An indirect tax placed on a good or service when the tax levied is a specific/fixed amount of money per unit

Question 2

What is Ad valorem tax

Answer 2

An indirect tax placed on a good or service that is proportional to expenditure on the good/service

Question 3

What is Tax incidence

Answer 3

Measured as the proportion of the total tax revenue paid by consumers and producers

Question 4

What determines the Tax incidence

Answer 4

The relative elasticities of supply and demand

Question 5

How do you calculate the incidence of Specific tax on consumers

Answer 5

Consumer’s pay = (PD - P) x Q1

Question 6

How do you calculate the incidence of Specific tax on producers

Answer 6

Producer’s pay = (P-PS) x Q1

Question 7

How do you calculate the Specific tax amount from a supply and demand diagram

Answer 7

Specific tax = (PD - P) + (P - PS) = t

Question 8

Describe the relationship between the Incidence of tax on consumers and producers and the relative Elasticities of supply and demand (x3)

Answer 8

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

Question 9

Describe the relationship between Dead Weight Loss (DWL) and the Elasticity of demand

Answer 9

As demand becomes more elastic the deadweight loss increases
As demand becomes more inelastic the deadweight loss decreases

Question 10

What do we consider as the 3 components to Individual decision making

Answer 10

1. Utility (a numerical representation of tastes or preferences)
2. Income
3. Prices
   and…assumption of rationality (maximise utility)

Question 11

What is Utility

Answer 11

A numerical indicator of the value that an individual places on an outcome, based on the individual’s preferences

Question 12

What is a Rational individual

Answer 12

An individual who will always choose outcomes that provide higher utility to outcomes that provide lower utility when both are feasible

Question 13

What is Cardinal utility

Answer 13

When an individual can attach a specific number of utils to every outcome

Question 14

What is Ordinal utility

Answer 14

When an individual can rank different outcomes by preference, but not attach a measurable number of utils to every outcome

Question 15

Why is the Utility curve concave in shape

Answer 15

The law of diminishing marginal utility

Question 16

What are the 3 key elements to model consumer decision making when utility is Ordinal

Answer 16

1. Preferences
   - assume completeness, transitivity, and non-satiation
   - consumers are indifferent between 2 bundles if they provide the same utility
2. Budget constraint
   - income
   - prices
3. Choice
   - need to define the consumer’s objectives
   - assume consumers are rational (maximise utility)

Question 17

What are the 3 key assumptions made about consumer preferences

Answer 17

1. 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
2. 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
3. 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

Question 18

What is an Indifference curve

Answer 18

A graphical reprsentation of all combinations of 2 goods that deliver a fixed level of utility

Question 19

What are the 3 properties of Indifference curves

Answer 19

1. Infinite curves covering all possible bundles, each curve represents a different utility level (completeness)
2. 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)
3. Indifference curves never cross (transitivity)

Question 20

What is Marginal Rate of Substitution (MRS)

Answer 20

The rate at which a consumer is willing to trade one good for another while holding utility constant

Question 21

How do you calculate MRS of good Y for good X

Answer 21

MRSy,x = - change in Y / change in X

Question 22

What is Diminishing MRS

Answer 22

Holding utility constant, as a consumer acquires more of one good, they are willing to give up less of another good in exchange

Question 23

How do you calculate the slope of an Indifference curve at a given point

Answer 23

MUx / MUy

Question 24

Describe the relationship between MRS and Indifference curves (x3)

Answer 24

1. MRS changes along the indifference curve (unless X and Y are perfect substitutes)
2. At each point, the MRS is equal to the slope of the indifference curve
3. As X increases, MRS decreases (reflecting diminishing marginal utility)

Question 25

What is a Cobb-Douglas utility function

Answer 25

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)

Question 26

What are 2 features of Cobb-Douglas utility indifference curves

Answer 26

1. Indifference curves are smooth and curved
2. MRS is different at every point on the indifference curve

Question 27

What is a Perfect substitute utility function

Answer 27

A linear function that represents a situation where two goods can be completely substituted for each other at a constant rate

Question 28

What are 2 features of perfect substitute indifference curves

Answer 28

1. Indifference curves are straight lines
2. MRS is the same at every point on the indifference curve (constant)

Question 29

What are 2 features of perfect complement indifference curves

Answer 29

1. Indifference curves right angled
2. MRS = 0

Question 30

What is a Perfect complement utility function

Answer 30

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)