Question

Many large corporations in Hong Kong provide insurance subsidies for their staffs. The staffs are restricted to use the subsidies to buy insurance from any insurance company. Assume there are only two types of goods in the consumption bundle: insurance and other goods. Suppose the salary of a representative staff is I and the insurance subsidy is S in addition to the salary.

a. Draw and explain the budget constraint line of the above representative staff. Let insurance be on the horizontal axis and other goods on the vertical axis.

b. Suppose that the insurance policy is changed so that the insurance subsidy S is changed into an equal-amount cash allowance. Under what circumstance will the optimal consumption bundle change? Will the staff be better off? Use a diagram to explain your answers in details.

Answer 1

The solid line represents actual budget line.

As, clear from above, if the employees were consuming on the flat part of budget constraint, a change of subsidy to cash allowance would shift them to a higher indifference curve, and the staff will be better off. However, if they were consuming on the downward sloping part, then there wouldn't be any change in the consumption as that part of the budget line remains intact in part (b).