Income and substitution effects applications
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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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INCOME AND SUBSTITUTION EFFECTS : APPLICATIONS

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Income and substitution effects applications

INCOME AND SUBSTITUTION EFFECTS:APPLICATIONS


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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