Question

2. Suppose that Jesse earns $1,000 per month which she allocates between food and other goods. Assume that the average price of a unit of food is $5 and the price of other goods as $1. Currently, she maximizes her utility by purchasing 25 units of food each month. [5] a. With other goods on the y-axis and food on the x-axis, illustrate Jesse's budget constraint and an indifference curve at her optimal bundle. Label all relevant values. b. In an effort to fight poverty, the government is considering providing 50 units of food via a food stamp program. Illustrate the impact of this program on Jesse's budget constraint and assume that this leads Jesse to consume 50 units of food (include an indifference curve at this point). c. Alternatively, the government could give individuals $250 in cash rather than food stamps. Illustrate this proposal on the same diagram and assume that Jesse now purchases 40 units of food (include a new indifference curve at this point), d. Which program would Jesse prefer? How would your answer change if Jesse had been consuming 75 units of food? e. Give three reasons why governments use in-kind transfers such as the food stamp program in this example.

Answer 1

a) The price of food is $5 and other goods is $1. Optimal bundle for Jesse has 25 units of food. Her total income is $1000. From her budget constraint, 5*25 + 1*O = 1000, we have
=> O = 1000-125
or O = 875. Therefore, optimal bundle is (25.875) which is on the budget line as shown in the figure below and is tangent to the indifference curve IC1.

1200 IC1 875 Other Goods 100 150 200 250 Food

b) When food stamps worth 50 units of food is given by the government, Jesse consumes 50 units of food and her income remains constant at $1000. Her new budget line is shown in Orange color. The indifference curve IC2 is tangent at the new budget line at optimal point (50,1000).

ICE 875 IC Other Goods 0 50 100 150 200 250 Food


c) When government transfers $250, instead of food stamps, Jesse income rises to $1250. Her budget line shifts to the right (new budget constraint is in Green). From her new budget constraint, we calculate the optimal level of other goods' consumption,  5*40 + 1*O = 1000, we have
=> O = 1000-200
or O = 1050. Therefore, optimal bundle is (40.1050) which is on the budget line as shown in the figure below and is tangent to the indifference curve IC3.

1400 1050 Other Goods 50 100 200 250 150 Food

d) Jesse would prefer the cash transfer rather than the food subsidy because her optimal requirement of food is only 40 units, while the government wants her to have 50 units of food. With the cash transfer, she not only can have enough food but also spend to consume more of the other good (it rises from 875 to 1050). In this way, her utility rises more with the cash transfer program rather than the food stamp program.