Question

Every month you spend $1, 500 on education and the rest of your income is used for the consumption of other goods. On the unforeseen circumstance of COVID-19, the government ensures no change in your income through a cash transfer to your nominated bank account. At the same time, the university provides you a $1000 voucher to use for your education expense only. If your preference pattern satisfies all textbook assumptions, in a diagram, show the effect of the voucher on your optimal consumption. If, instead of a voucher, the university provides you a cash transfer of the same amount to your bank account, will you be better off? How will your answer be different if your education expense is $900 instead of $1,500? Explain in the diagram.

Answer 1

SOLUTION:-

* The diagram below assumes total income equals 3000, though the conclusion will be same for any level of income.

* Consider that the initial optimal bundle is at point A where 1500 was spend on education and rest 1500 was spent on other consumption before COVID-19.

* When govt. ensures no change in income during COVID, the buget line LL' will not change. However, when the university provides a voucher of $1000 which can only obe used for education, the budget line shifts to LCL'', with a kink at education = 1000 and the horizontal intercept becomes 3000 + 1000 = 4000.

* Since, the expenditure on education is $1500, the consumption will shift to point B where, the voucher of $1000 + an additional amount of $500 will be spent on education and rest 4000 - 1500 = 2500 will be spent on other consumption.

* However, if the education expenditure equals to $900, the voucher will be sufficient to cover education expenditure and a value of $100 will be left, but it cannot be used anywhere else.

* Hence, the entire income will be spent on other consumption and the point of equilibrium will be the kink point C, because any point on the horizontal section of the budget line will yield a lower level of utility and hence, the consumer will be at point C only.

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