Question

1.Now state legislators want to make predictions about how changes in consumers’ budgets will impact their consumption behavior. If school supplies and salty snacks are both normal goods with school supplies on the x-axis of the graph and salty snacks on the y-axis, explain how a decrease in consumers’ budgets would impact the consumption of school supplies and salty snacks.

c)If the state legislature is considering giving people gift certificates for school supplies, what considerations about the impact of gift certificates on people’s utility should they understand in comparison to an equivalent cash gift?

Answer 1

As per given information both school supplies and salty snacks are normal goods , this implies if income falls, the demand for both the goods will fall. But how much demand will fall w.r.t income will be determined by their individual income elasticities.

In the figure below we see the initial budget constraint at BB and initial level of consumption at the point of intersection of BB line and indifference curve I1. Note the change in BB line. With fall in income the entire BB line shifts inwards thus reducing purchasing power of the person. In order to keep same proportion of goods in the budget, the consumer will consume less of both the goods in a way that indifference curve I2 has same slope as that of I1,( proportion of school supplies and salty snacks is maintained) but it gives lower utility than I1. So the consumer is worse off now.

c. Gift certificates for school supplies may send market signals to consumers to cut down spending on school supplies and increase consumption of salty snacks instead. This is because, gift certificates can be used to buy only one good. So it leaves the consumer better off with more purchasing power that can be used to buy either goods. If the substitution effect is larger, most of the additional savings in income due to receipt of gift certificates will go towards purchase of salty snacks. If income effect is stronger, it will lead to increase in consumption of both the goods. So some considerations to take notice before issuing gift certificates(GC) are -

• Does the issue if GC lead to increase in consumption of good that is unhealthy ? ( read: salty )
• Does it distort optimal utility of consumers and induce them to buy more of one good in current period? ( GCs cannot be exchanged or saved compared to cash grant that can be saved)
• Does it affect consumers preferences negatively?(as GCs have limited validity so consumers in order to 'use' the GC will change their preferences accordingly).
• What market signals does it give out as GCs are not part of taxable component of consumer?
• The burden on State exchequer of GC vis-a- vis cash grant.