Question

1. Continuing with the budget constraints you drew in Homework 2, Question 3. There are three budget constraints, one where an individual has an income of $1000 per month with which they buy the composite good with a price of $1 and food with a price of $2/unit of food, a second in which they receive $100 in food stamps from the government, and a third in which they receive $100 in cash from the government.

   (a) (20 Points) Would the consumer prefer to get $100 in food stamps or $100 in cash? You need to justify your answer thinking through the possible optimal consumption bundles for the consumer.

Answer 1

When the income is 1000

Price of composite good = $1

Price of food = $2

Maximum food to purchase = 1000/2=500

Maximum composite good to purchase = 1000/1=1000

The following graph shows the budget line A1-A1

When the government offers $100 in food stamps then the consumption of composite goods remains same but consumption of food will increase to 1100/2=550 which will result in the shift in budget line of food but not for the composite good to A1-A2-A2

When the government offers $100 in cash then the consumer can spend it to buy either on food or on composite good in which case his budget constraint would increase to

Maximum food to purchase = 1100/2=550

Maximum composite good to purchase = 1100/1=1100

So,in this case,his budget line would be E-A2-A2

So, the consumer would prefer to take $100 in cash as it will help him to increase his consumption of composite good too rather than $100 food stamps which limits his consumption to spending it on food items only. Therefore the cash payment helps the person to increase his budget line and so he will prefer to take it.