Question

The government wants to tax the price of apples (X1) by a per-unit tax. If it wants to study the substitution effect of this tax, it should compensate for the utility change by a. Increasing the price of oranges (X2 ) b. Decreasing the price of oranges c. Imposing a Lump-sum tax d. Providing a Lump-sum subsidy

Answer 1

D) Providing a Lump-sum subsidy is the correct option.

Step-by-step explanation:

Solution:

D) Providing a Lump-sum subsidy is the correct option.

Because:

This is done so as to compensate the consumer for the loss in welfare occurred by an increase in price per unit tax on apples.

And due to this compensating variation provided to the consumer, the consumer is now at the same real income level as before the rise of price.

And hence it helps us to capture the substitution effect. The remaining effect would be the income effect.

Hence, the option d. providing a lump-sum subsidy is the correct option.