Question

Income and substitution effects in the analysis of a public policy.

A spike in the cost of electricity in Ontario has occurred (eg, one of the main power stations suffers a major accident, OR we could be considering a move to market pricing of electricity). The government is considering proposals to finance electricity costs for poorer families, to offset an expected sharp rise in the cost of electricity that is expected to occur next year. Briefly compare the following two proposals in terms of in terms of (i) the extent to which each program results in energy conservation and (ii) the likely size of public expenditure. Finally, (iii) predict which program recipients would prefer to see implemented.
a) The government pays the difference between a household’s electricity expenditure in the coming year (after the increase in price) and its expenditure in the prior year (before the price increase).
b) Each eligible household is given a voucher to be used only for paying for electricity. The value of the voucher is the expected cost increase for the same quantity(kilowatt hours) of electricity as the household consumed last year before the price increase took place.

Use indifference curve diagram(s) and explain your answers briefly. If you cannot reach a definite conclusion, briefly discuss the additional information that would be required to do so.

That's all the information provided for the question

Answer 1

In the graph, we can see the expenditure elections in a household between electricity (E) and other goods (O).

The income after the price increase without subsidies is I. In that situation the quantity of electricity consumed is A.

If the government chooses option A and give money for the difference between electricity expenditure before and after the price increase, the income will increase to I´ and the consumpion of electricity will be at B, we the higher indiference curve is reached.

But if the householders are given vouchers to the same quantity of electricity as the last year, they will consume the fixed quantity of C reaching a lower indiference curve than in B but higher than without any subside.

i) In B, as consumers are given a voucher that can only use in electricity, they are limited in their consumer decisions and will consum the same quantity.

In A, as we can see in the graph, consumers will decide how much electricity to consume based on their indiference curves. In this case, the consumer get a higher utility by using just a part of the subsidy in electricity and the other part in other goods so electricity consumption wil be lower. On the other hand, consumers could be motivated to waste electricity knowing it will be paid by the government.

ii) The size of expenditure will be the same for both options at least at the first period.

iii) Consumers will prefer option A so that they can adjust the money received to their indiference curves.