Question

Frank spends a total of $2500 per month on rent for his apartment: he spends $1250 of his own money and . receive a cash reimbursement of $1250 from his employer. The employer is in the process of adopting a new policy that would provide him a lump sum transfer of $1250, which can be used for housing or other goods. Using a graph, demonstrate whether Frank would prefer the current program, the proposed program, or would be indifferent between the two.

Answer 1

When Frank receives 1250 reimbursement , his personal income is only 1250, so if he chooses not to pay rent he can only spend 1250 on other goods . This is shown by the diagram of his budget constraint on the left.

When Frank receives 1250 as lump sum transfer, his income is now 2500 and he can spend that all on rent or on other goods as shown by diagram on the right.

Frank should be indifferent between two programmes as in both the cases he spends all his income on rent .

If the rent had been lower like $2000 then he would have been better off with lump sum transfer as in that scenario he can but some other goods with leftover income. But he can't do the same in reimbursement case as heonly gets the reimbursement of the value he spends over his income on rent ( so if rent is $2000 he pays 1250 of his own and gets 750 reimbursement)