Reference no: EM132264210

There are two goods in this economy, Cigarettes and "all other goods," sold at a per unit price of pc and po = $1. Consider a representative consumer with CobbDouglas preferences u(xc, xo) = x 1/3 c x 2/3 o , where xc is the quantity of cigarettes and xo is the quantity of "all other goods" (assume both amounts can be any positive real number). This consumer has a $9 income. Suppose congress enacts a $0.75 quantity tax on cigarettes (a quantity tax is a per unit tax). Show the original and new budget constraint for a representative consumer. (1) Compute the pre- and post-tax optimal bundle. Then decompose the change in cigarette consumption into Slutsky income and substitution effects.