Question

When the price of gasoline is $2.00 per gallon, Harry consumes 1,000 gallons per year. The price rises to $2.50 and to offset the harm to Harry, the government gives him a cash transfer of $500 a year [enough to enable him to buy as much as before].

A. Will Harry be better or worse off after the price rise plus transfer than he was before?   

B. What will happen to his gasoline consumption? [Hint: this is a variation of the excise tax/transfer problem, draw a graph]

Answer 1

a)

Harry is initially at equilibrium at Point E, where he is consuming 1000 gallons of gasoline. The budget line is AB.

When the price of gasoline rises the budget line rotates inward to AC.

Now when the government gives hum cash transfer of 500, his budget line shifts parallel to AC to DF such that the new budget line passes through old consumption of E.

As can be seen from the diagram with the new budget line of DF he will not be at point E. Instead he will move to a higher satisfaction point of S with a higher indifference curve tangent to the new budget line. Hence Harry will be better off.

b)

Since Harry is now at equilibrium at point S, he will consume less gasoline than before.