ECO 226 Problems Chapter 11 Solution, Spring 2017

CHAPTER 11 Taxation, Prices, Efficiency, and the Distribution of Income ANSWERS TO TEXT PROBLEMS 1. The equilibrium price is $10 per gallon. The equilibrium quantity is 300,000 gallons per year. After a $1 per gallon tax is imposed on sellers, the supply curve is described by the equation Qs = $30,000(P – 1). Solving for the new equilibrium price by setting quantity demanded equal to quantity supplied gives P = $10.60. The net price received by sellers after paying the unit tax is therefore $9.60. The new equilibrium quantity is therefore $288,000. Assuming no income effects, the excess burden of the tax will be 0.5(12,000) = $6,000 per year. The incidence of the tax will be shared by buyers and sellers of liquor. 2. The additional tax on clothing will decrease the supply of clothing and cause resources to flow into food production. The price of food will fall, while the price of clothing will rise. Assuming that the tax revenue is returned, the incidence of the tax will depend entirely on the changes in the prices of food and clothing, which will depend both on the elasticities of supply and of demand for these items. 3. Because both the price elasticity of demand and of supply of wine is unity, the excess burden is 1/2(200/6)(1/2) = $8,333,333.33 per year If the tax rate goes up to two, the excess burden will quadruple to 1/2(4)(200/6)(1/2) = $33,333,333.33 If there are negative externalities associated with drinking wine, then the tax can actually improve resource use despite its high excess burden. 4. To minimize the excess burden, a second-best type tax system would vary tax rates according to elasticities of demand and supply of taxed items. The tax system could encourage work by levying high taxes on commodities that would be complementary with leisure. 5. The excess burden is 0.5(0.1)2150,000,000(–1) = –$750,000 per month. If the tax rate is doubled to 20 percent, the excess burden quadruples to a loss of $3 million per month. Because the supply is perfectly elastic, the incidence of the tax is borne fully by the buyers. For a 10-percent tax, the market equilibrium price per square foot of construction will rise to $165. For a 20-percent tax, the market equilibrium price will rise to $180. 88