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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. 

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