Assignment Details:

Please read the article "Carbon price round two: let's get it right this time" as published on ABC Drum. The article proposes a simple carbon tax and a dividend scheme where all carbon emissions are taxed at a flat rate and the revenues earned are returned to the households as dividends.

Suppose that a household spends its entire income on two commodities x and z where producing a unit of x involves higher carbon emissions than a unit of z. Assume that the household has usual strictly convex indifference curves representing its preferences over alternative bundles of x and z.

(i) If only the carbon tax was imposed but no dividend provided, how might the household's consumption bundle change relative to its initial (pre-tax) choice? You need to consider the 2 alternative scenarios:

Scenario 1: Both x and z are normal

Scenario 2: x is a Giffen good while z is normal

Now consider the proposed carbon tax and dividend scheme. Suppose that the dividends are paid out to every household in a manner such that it is able to "just afford" the consumption bundle it purchased prior to the tax.

(ii) How might the combined carbon tax and dividend scheme change the household's consumption bundle and its wellbeing relative to the pre-tax situation?

(iii) Using your analysis from parts (i) and (ii), briefly compare the effects of a standalone carbon tax versus a carbon tax plus dividend scheme on emissions and wellbeing of households.

In answering the above questions, consider the following pointers:

(a) Think about how the imposition of the carbon tax will affect the prices of x and z.

(b) You will need to provide a separate diagram and explanation for each scenario in part (i) and provide a separate diagram and explanation for part (ii).

(c) For each scenario in part (i), you diagram should depict a logically plausible case consistent with the assumptions of that scenario.

(d) For part (iii), diagrams are not required.