Suppose the income elasticity of demand for food is 0.5 and the price elasticity of demand is -1.0. Suppose also that Felicia spends $10,000 a year on food, the price of food is $2, and that her income is $25,000.
a) If a sales tax on food caused the price of food to increase to $2.50, what would happen to her consumption of food? (Hint: Because a large price change is involved, you should assume that the price elasticity measures an arc elasticity, rather than a point elasticity.)
b) Suppose that Felicia gets a tax rebate of $2500 to ease the effect of the sales tax. What would her consumption of food be now?
c) Is she better or worse off when given a rebate equal to the sales tax payments? Draw a graph and explain.