F is a small society that produces and consumes just two goods: tequila and medicine. The price of tequila and medicine are both $1 per unit, but the marginal utility of medicine is less than the marginal utility of tequila. All consumers have identical Cobb-Douglass preferences.
Q.1 Explain how equilibrium is achieved. Provide a graph with your explanation. Place medicine on the horizontal axis and tequila on the vertical axis. Clearly label the budget line and the indifference curves before and in equilibrium.
Q2. F has decided to place a per unit tax on Medicine. You are provided with following information:
- All consumers have the same incomes and preferences.
- Utility for a typical consumer is given by: U(tequila, Medicine) = 1(tequila) + 1(medicine).
- Income for a typical consumer is $200
- Before the tax the price of both goods is $1 per unit.
- Per unit tax on medicine is $1
- After the tax, the price of tequila remains $1, but the price of medicine rises to $2.
- Currently, a typical consumer purchases both goods.
- You are quick to observe that tequila and medicine are perfect substitutes for each other.
How much tax revenue will F collect from a typical consumer? Use a graph with medicine on the horizontal axis and tequila on the vertical axis to explain. Clearly label budget lines and indifference curves. Provide both a written and graphical analysis.
