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INCOME AND SUBSTITUTION EFFECTS : APPLICATIONS. AN INCREASE in INCOME v . A SUBSIDY on ONE PRODUCT ONLY. Involves equal cost to the government Example : food stamps used in the US for welfare recipients (Ireland: television licence, electricity, transport, … ) .

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an increase in income v a subsidy on one product only
AN INCREASE in INCOME v. A SUBSIDY on ONE PRODUCT ONLY
  • Involves equal cost to the government
  • Example: food stamps used in the US for welfare recipients (Ireland: television licence, electricity, transport, … )
an increase in income v a subsidy on one product only1
AN INCREASE in INCOME v. A SUBSIDY on ONE PRODUCT ONLY

Budget constraint is given by

The government can

(1) give a subsidy on food (x1)

Note: Equal cost to the government

(2) give a increase in income

an increase in income v a subsidy on one product only2
AN INCREASE in INCOME v A SUBSIDY on ONE PRODUCT ONLY

But which makes the consumer better off ?

X2

A

U0

X1

an increase in income v a subsidy on one product only3
AN INCREASE in INCOME v A SUBSIDY on ONE PRODUCT ONLY

But which makes the consumer better off ?

X2

The subsidy on food leaves the consumer at B (better off than at A)

B

A

U1

U0

X1

an increase in income v a subsidy on one product only4
AN INCREASE in INCOME v A SUBSIDY on ONE PRODUCT ONLY

But which makes the consumer better off ?

X2

The subsidy on food leaves the consumer at B (better off than at A)

B

A

U1

U0

X1

an increase in income v a subsidy on one product only5
AN INCREASE in INCOME v A SUBSIDY on ONE PRODUCT ONLY

To illustrate the equal cost nature of the the subsidy v. the income increase, you draw a line parallel to the original budget constraint which passes through the point B (as B must be affordable after the income increase).

an increase in income v a subsidy on one product only6
AN INCREASE in INCOME v A SUBSIDY on ONE PRODUCT ONLY

But which makes the consumer better off ?

X2

U2

The increase in income leaves the consumer at C (better off than at B)

C

B

A

U1

U0

X1

an increase in income v a subsidy on one product only7
AN INCREASE in INCOME v A SUBSIDY on ONE PRODUCT ONLY

But which makes the consumer better off ?

X2

U2

The increase in income leaves the consumer at C (better off than at B)

C

B

A

U1

U0

X1

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