1. The government of Freeland is considering introducing a carbon tax to tackle global warming. They have asked for your help in analyzing the impact. They give you the following information. The average person in Freedland earns 30 a week. She spends it on a carbon good and on all other goods. Her preferences satisfy the usual assumptions of consumer choice theory. The carbon good currently costs 2 a unit and the average person buys 5 units of a carbon good per week. The government is considering putting a tax of 1 on carbon and giving a transfer of 5 to the average person to compensate her for the price increase.

Analyse the effect of this proposal on the utility of the average consumer using a large clearly drawn diagram. Put units of carbon on the horizontal axis and all other goods on the vertical axis.

Will this proposal make the average consumer better off, worse off or the same as they were before the proposal? Explain clearly.

Will this proposal lead to any change in the amount of the carbon good bought by the average consumer? Explain clearly.

Interpret this proposal in regard to income and substitution effects.