QUESTION

# F is a small society that produces and consumes just two goods: tequila and medicine.

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.