Question

A consumer purchases housing (H) and spends the remainder of income on a composite good (OG). Her preferences over housing and the composite good are monotonic, complete, transitive and convex. The government is considering one of two policies. Policy A subsidizes housing, reducing its price by $50 per unit. With the subsidy in place, the consumer purchases 10 units of housing and Y units of the composite good. Policy B instead provides a lump-sum cash payment $500. Which of the following statements is accurate? a. The consumer prefers Policy A to Policy B, and will consume more housing under Policy A than Policy B. b. The consumer prefers Policy A to Policy B, and will consume more housing under Policy B than Policy A. c. The consumer prefers Policy B to Policy A, and will consume more housing under Policy A than Policy B. d. The consumer prefers Policy B to Policy A, and will consume more housing under Policy B than Policy A. e. The consumer is indifferent between Policy A and Policy B, and will consume the same amount of housing under both policies.

Answer 1

• c. The consumer prefers Policy B to Policy A, and will consume more housing under Policy A than Policy B.

Explanation:

If the government providesthe consumer, a lump-sum cash grant which is equivalent to the price subsidy of housing, this will result in increasing the money income of the consumer by the amount of cash grant. With this extra cash transfer, consumer's budget line shift outwards and he can attain higher indifference curves (measure the welfare of consumer) that were earlier unattainable. At these higher indifference curves, less quantity of housing is consumed and more of other goods are demanded. This can be shown through a diagram as in the following image:

In the diagram, AB is original budget line. AB' is budget line corresponding to price subsidy. CD is budget line corresponding to lump-sum cash payment. At CD consumer attains a higher Indifference curve IC₂.

Hence, in a case of lump-sum cash subsidy the consumer is better-off and consume less housing relative to what he would have consumed in case of a price subsidy.

It happens mainly because under lump-sum cash payment policy, the individual is free to buy different goods according to his/her own tastes and preferences which increases consumer welfare than under a price subsidy case which imposes a certain pattern of consumption in favor of housing. So basically more autonomy in making choices is what increases consumer's welfare in  lump-sum cash payment .