exercise 3

Exercise 3. (10 points) The excess burden of a specific tax is the difference between the tax equivalent variation and the tax revenue. Consider a consumer with a budget I to spend on good x and y. The price of x and the price of y are Px = Py = 1. At these prices, the consumer spends one third of his budget on x and two thirds on y. a) In an indifference curve diagram, illustrate the consumer's optimal choice. Suppose a tax increases the price of x to P'x = 2 and that the price increase does not affect the quantity of good x the consumer purchases. b) Illustrate this fact in your diagram. Last show that even if the consumer's Marshallian demand has not changed, the tax imposes a deadweight loss. c) In your diagram, highlight the revenue of the tax (the vertical segment between the two budget constraints at x*) and show that it is smaller than the tax EV