Question

Use budget constraints and indifference curves to answer the following:
Suppose that the average household consumes 500 gallons of gasoline per year. A 10-cent per gallon tax is introduced coupled with a $50 annual tax rebate per household.

How will the consumption of gasoline be affected? Will the household be better or worse off after the new program is introduced?

Answer 1

Answer :

Here the annual consumption of gasoline of each household is 500 gallons. Let in the above picture's diagram the initial budget line is BB and indifference curve is IC. Now after imposing tax by 10% per gallon, the annual tax payment is (500 * 10%) = $50. As a result, the budget level decrease and the budget line shifts to leftward and becomes B₁B₁ where indifference curve becomes IC₁. But every households get annual tax rebate or refund of $50. As here tax payment = tax rebate = $50 hence the annual budget remains same as before. Hence after getting tax refund the budget line shifts back and becomes BB where the indifference curve becomes IC. As after introduction of new program the budget line and indifference curve remains same as before hence the consumption level of gasoline is not affected here.

Higher indifference curve means higher utility and lower indifference curve means lower utility. Hence if the consumer reach at higher indifference curve then consumer become better off. If the consumer reach at lower indifference curve then the consumer become worse off. As here the budget line and indifference curve remains unchanged after introducing the new program hence households becomes neither better off nor worse off.