A consumer considers gasoline an imperfect substitute to other things (curvy indifference curves). With a budget of 100 Euros, when gasoline costs 1 Euro per liter the consumer buys 30 liters of gasoline. After a tax raises the cost of gasoline to 2 Euros per liter, the consumer still buys 30 liters of gasoline. a) In an indifference curve diagram, illustrate this fact. b) Define the concept of substitution and income effect. d) Now, in your diagram disentangle the substitution and income effect of the (tax induced) price increase and show that this consumer considers gasoline an inferior good.

ENGR.ECONOMIC ANALYSIS
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Chapter1: Making Economics Decisions
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A consumer considers gasoline an imperfect substitute to other things (curvy indifference curves). With a budget of 100 Euros, when gasoline costs 1 Euro per liter the consumer buys 30 liters of gasoline. After a tax raises the cost of gasoline to 2 Euros per liter, the consumer still buys 30 liters of gasoline. a) In an indifference curve diagram, illustrate this fact. b) Define the concept of substitution and income effect. d) Now, in your diagram disentangle the substitution and income effect of the (tax induced) price increase and show that this consumer considers gasoline an inferior good.
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Economics homework question answer, step 1, image 1

As shown in the diagram the initial budget line is AB and the original consumption bundle is determined by the tangency of the budget line on the indifference curve (e1) at that point quantity demanded is x1. When the price of gasoline rises due to tax the budget line rotates to AC and optimal choices changes from e1 to e3 but quantity demanded of gasoline is unchanged because consumer consumes 30 liter of gasoline after tax.

 

 

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