Per Unit Subsidy vs Lump-Sum Transfer

In: Business and Management

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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 quantity of Q1= 17 units. This can be seen on Figure 1 at point X. The expenditure on all other goods is the remaining of A= £57.5.

Figure 1
Applying a per unit subsidy of 50% will the budget line will pivot outwards from B1 to B2 as the new price of the heating fuel drops to £1.25. This will increase consumption, in our case the new optimum consumption point is Y where Q2= 38 units of heating fuel will be used. The consumer is better off hence moving on a superior indifference curve, I2.
Both the income and the substitution effect are responsible for this change, to differentiate between them the budget line B1S, which is parallel to B2 but tangential to the initial indifference curve, is drawn. This shows the optimum point of Xs where Q1s= 31 units of heating fuel are used. Hence the substitution effect accounts for the Q1 to Q1s movement and the income effect for the Q1s to Q2.
The subsidy being S= £1.25 for every unit of heating fuel hence the government will be liable to a payment of Q2*S= £47.5. The government liability is also represented as the vertical difference between the budget lines at the point of consumption chosen by the pensioner. If the consumer didn’t…...

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