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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
Price paid by buyer: 100
Price received by seller: 100
Buyers Pay $10 Tax
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
price paid by buyers
Both Cases: Tax Incidence is the same:
Buyer pays $105 (not $100)
Seller receives $95 (not $100)
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Note
When tax levied on seller, buyer pays market price (and seller receives market price less the
tax)
When tax levied on buyer, buyer pays market price plus the tax (and seller receives market
price)
Demand Elasticities and the Incidence of a Tax:
Perfectly Inelastic Demand
● Market price increases exactly by the amount of the tax
● Buyer pays: P1 = P0 + 10 (full incidence)
● Seller receives: P1 – 10 = (P0 + 10) – 10 = P0 (no change)
● Intuition
o Buyers are completely unresponsive to changes in price
o Full burden (incidence) of tax is borne by buyers
Perfectly Elastic Demand
● Buyer pays: P1 = P0 (no change)
● Seller receives: P1 – 10 = P0 – 10 (full incidence)
● 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
Buyer pays
● No tax (infinitely elastic DD)
● All tax (infinitely inelastic DD)
● 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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