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Lecture 5

# ECO101H1 Lecture Notes - Lecture 5: Budget Constraint, Utility, Market Price

Department
Economics
Course Code
ECO101H1
Professor
Jack Carr
Lecture
5

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Case #2 Sales Tax Levied on Buyers
No Tax
P QD QS
120 1 9
115 2 8
110 3 7
105 4 6
100 5 5
95 6 4
90 7 3
P = 100
Q = 5
P QD QS
120 9
115 8
110 1 7
105 2 6
100 3 5
95 4 4
90 5 3
P = 95
Q = 4
Price paid by buyer: 105 (P + 10)
Price paid by seller: 95
DD shifts vertically downward by \$10 if there is a \$10 tax is levied on buyers
At the new equilibrium that is the price received by the seller. Go up to old DD to determine the
Both Cases: Tax Incidence is the same:
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Note
When tax levied on seller, buyer pays market price (and seller receives market price less the
tax)
price)
Demand Elasticities and the Incidence of a Tax:
Perfectly Inelastic Demand
ā Market price increases exactly by the amount of the tax
ā Buyer pays: P1 = P0 + 10 (full incidence)
ā Seller receives: P1 ā 10 = (P0 + 10) ā 10 = P0 (no change)
ā Intuition
o Buyers are completely unresponsive to changes in price
o Full burden (incidence) of tax is borne by buyers
Perfectly Elastic Demand
ā Buyer pays: P1 = P0 (no change)
ā Seller receives: P1 ā 10 = P0 ā 10 (full incidence)
ā Intuition
o Buyers very responsive to change in price (quantity demanded falls to zero for any
increase in price)
o Full burden (incidence) of tax is borne by sellers
Incidence of 10% Sales Tax
ā No tax (infinitely elastic DD)
ā All tax (infinitely inelastic DD)
ā Some of tax (usual case)
Student Exercise
What is incidence (burden) of sales tax if:
1. SS is perfectly inelastic
2. SS is perfectly elastic
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Theory of Consumer Choice (used to derive law of downward-sloping demand)
Year 2: Indifference Curve
Year 1: Utility Theory
Mankiw, 5th edition, page 468 has a brief discussion of utility theory
Principle of Diminishing Marginal Utility:
Total utility = total satisfaction to a person from consumption of product
Marginal utility = additional satisfaction (change in total utility) from consumption of one more
unit of product
Principle of Diminishing Marginal Utility: As a person consumes more of a good, the marginal
utility of the good declines
Numerical Example:
Movies Per Month Total Utility (TU) Marginal Utility (MU)
0 0 -
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