Homework

1 Tax Incidence

Miguel Moreira Freire, 100361519

Exercise 1

a) Let " denote the price received by the monopolist and $ the price paid by consumers.
Without any taxes, " = $ . Hence, the Profit-Maximization Problem (PMP) is:

"
max

() s.t.
*
) ,,

which is equivalent to

1
max = 100 10 7
,
2

1
" = 100
2

= 10 + 7

and the solution is given by the First-Order Condition:

1
1
= 0 + 100 10 2 = 0 = 30 " = $ = 85

,9,
2
2

b) Now,

1
" + 15 = $ " = $ 15 " = 85
2

Hence, the PMP is:

1
max = 85 10 7
,
2

and the solution is given again by the First-Order Condition:

1
1
= 0 + 85 10 2 = 0 = 25
,9,
2
2

" = 72,5 $ = 87,5

c) It does not matter who pays the tax, since

" + 15 = $ " = $ 15

Therefore, changing the statutory incidence does not change the objective function of the PMP, and
thus the equilibrium (and consequently tax incidence) is still the same.

Exercise 2

Let " denote the wage received by workers and $ the wage paid by firms.

Step 1: Unrestricted Market Equilibrium

" = $ + 2 = 10 = 4 " = $ = 6

Since the minimum wage is set at 6, without any taxes this is a degenerate restriction.

Step 2: Introduction of the tax

" = $ 2 + 2 = 10 2 = 3

" = 5 $ = 7

Step 3: Introduction of the minimum wage

Regardless of who pays the tax, the mathematics of the problem do not change: the equilibrium
conditions are the same. However, the statutory incidence, on which minimum wage rules rely (the
firm has to pay at least the minimum wage of 6 to the workers), does. Therefore, if firms pay the
tax, they will deliver a wage of 5 per hour, which is illegal. In that case, the price floor is binding and

" = 6 $ = 8 $ = 2 " = 4 = 2

Here, the burden of taxation falls entirely onto firms, but involuntary unemployment has been
generated.
If, however, workers pay the tax, then firms deliver a wage of 7 per hour, which is above the minimum
wage. Therefore, in that case,

" = 5 $ = 7 $ = " = 3

which means the burden of taxation is evenly divided between workers and firms.

Exercise 3

Let $ denote the price paid by consumers and " denote the price received by firms. Then,

"
$
" = + " " =

$ = $ $ =

a)

$ = " = + =

+

+
$ = " =
=
=

+
+
+

b) If the tax is levied on producers, the equilibrium condition is

" = $

On the other hand, if the tax is levied on consumers, the equilibrium condition becomes

$ = " +

But
" = $ $ = " +

Therefore, since the equilibrium conditions are equivalent, they must generate the same equilibrium.
Accordingly, the statutory incidence does not affect the nature of the burden of taxation, Q.E.D. The
equilibrium will be



1 1
" = $
=

+
= +

+ +
+
=
=

+



1 +
+ + +
$ =
=
=


+
+
+


1 +
+
$ =
=
=

+
+