=+10.12 Policy Application: Distortionary Taxes: Suppose that you have tastes for grits and “other goods”

(where the price of “other goods” is normalized to 1). Assume throughout (unless otherwise stated) that your tastes are quasilinear in grits.

A. The government decides to place a tax on grits, thus raising the price of grits from p to (p 1 t).

a. On a graph with grits on the horizontal axis and “other goods” on the vertical, illustrate the before- and after-tax budget.

b. Illustrate your optimal consumption bundle after the tax is imposed; then indicate how much tax revenue T the government collects from you.

c. Illustrate the most L you would be willing to pay to not have the tax.

d. Does your answer depend on the fact that you know your tastes are quasilinear in grits?

e. On a graph below the one you have drawn, derive the regular demand curve as well as the MWTP curve.

f. Illustrate T and L on your lower graph and indicate where in the graph you can locate the deadweight loss from the tax.

g. Suppose you only observed the demand curve in the lower graph, and you knew nothing else about tastes. If grits were actually a normal good (rather than a quasilinear good), would you under- or overestimate that deadweight loss by assuming grits are quasilinear?