Rihanna likes to work. She currently works 70 hours per week for 50 weeks a year

Question

Rihanna likes to work. She currently works 70 hours per week for 50 weeks a year (she takes a two-week vacation), at an hourly wage of $2,000/hour, and lives in Barbados, which has no tax on income of any type. She gets $4 million per year in unearned income. Next year, to close its budget deficit, Barbados is imposing a 40% tax, which applies just to earned income. Rihanna will choose between two alternatives, to which she is indifferent: 1) she will work 80 hours per week for 50 weeks, at a pre-tax hourly wage of $2,000/hour; or 2) she will move to the Cayman Islands, which has no income tax, where she will work 100 hours per week for 50 weeks a year, at an hourly wage of $2,000/hour, but for which she will pay $4 million in relocation costs.

A. Graphically illustrate Rihanna’s consumption and leisure choice this year, as well as her choices next year under the two options. Clearly label all points, lines, axes, etc.

B. How much revenue would Barbados make from taxing Rihanna?

C. What is Rihanna’s equivalent variation?

D. What is the deadweight loss from Barbados taxing Rihanna’s earned income?

E. Which effect dominates for Rihanna, the substitution effect or the income effect? Explain your reasoning.

F. What would the deadweight loss be if instead of a 40% tax on earned income, Barbados taxed Rihanna at a 40% rate on her unearned income? Explain your reasoning.

Please answer questions A-F.

Explanation / Answer

Marginal analysis involves a cost-versus-benefits comparison of various business activities. In marginal analysis, the cost of an activity is measured against incremental changes in volume to determine how the overall change in cost will affect the bottom line of a business. Marginal analysis can show the cost of additional production by a business all the way up to the break-even point. This is generally the maximum cost that a business can sustain without losing money.

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