1. Suppose the price of a pack of cigarettes is $30 and the cigarette consumption is 100,000 packs a day. The government now introduces a consumption tax of $10 on cigarettes. Cigarette consumption decreases to 80,000 packs a day. Assume that the demand for cigarettes is not perfectly inelastic. Draw on a single graph the original demand and supply curves and the new demand curve facing the producers, the price paid by the consumers and the price received by the producers. Label your graph accordingly. Will the price paid by the consumers be above, below, or equal to $40? Explain.
2. a) John always spends 10% of his income on buying CDs. What is his income elasticity of demand for CDs? Explain your answer.
b) Suppose John’s preference (taste) changes and he decides to always spend 20% of his income on buying CDs. What will happen to John’s demand curve for CDs? What will happen to his income elasticity of demand for CDs? Explain your answer.