Per Unit Subsidy Vs Lump Sum Transfer

998 words - 4 pages

This essay intends to compare a per unit subsidy to heating fuel to a lump-sum transfer, in the case of pensioners. Starting with an indifference curve analysis of the subsidy, moving on to the lump-sum transfer and finishing with a combined analysis the essay will provide general guidelines for the government to take in consideration when deciding which option to implement. In each of the analysis 100 units of income will be allocated, which will be translated to £100 for simplicity, therefor every unit of income will be equal to 1 Pound. Finally a recommendation on the advisable policy will be issued.

With a price of £2.5 for a heating fuel unit the pensioners choose to buy the ...view middle of the document...

The alternative for the government is to give a £47.5 cash grant, known as lump-sum transfer (Browning & Zupan, 2001), totalling the sum of A”= £147.5. By doing that the budget line B1 will shift rightwards to the new parallel budget line B3. The new optimum consumption point is where the indifference curve I3 is tangential to B3, point Z where Q3= 31 units.

Figure 2
Because the price remained constant, there is no substitution effect, hence all the transition Q1 to Q3 is due to the income effect.

Figure 3 is plotted by combining Figure 1 and Figure 2 in the same diagram. Because the government cost is the equal in both cases, the budget line emerging from the lump-sum transfer, B3, will intersect the budget line of the subsidy, B2, at the point Y. Therefor in the former approach the consumer has the choice of purchasing at point Y at the same cost as under the latter approach. This indicates that the optimum consumption point lies upper left of point Y, namely point Z of the budget line B3.

Figure 3
A higher consumption of heating fuel is achieved by using a per unit subsidy because of the substitution effect, the consumer pays £1.25 for a good of £2.5 market value, as the government pays for the rest £1.25, that causes to purchase the good until the marginal value of substitution between the heating fuel and the other goods equals to £1.25. Subsequently, after a point, the consumer would be better off by getting £2.5 worth of all other goods however he continues to buy heating fuel units as its price lowered to £1.25. Thus the pensioner can be better off by an increase in income rather than a...

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