Subsidy vs Cash Transfer

cash transfer line IC3 > IC2 >IC1

M/py F

Y” C IC3

IC2

y’ A

IC1 B.L facing the consumer with

subsidy

X’ M/px x” P B M/p’x x

Budget line facing the consumer when there was no subsidy

Fig (1)

x : is the commodity on which subsidy is given.

Subsidy :

We consider a situation where the government subsidizes good x (say food) .

Suppose the market price of x is given by px and that for y by py . Since
government subsidizes the price of food (good x) therefore the price consumers
face of good x is p’x , where p’x < px . The budget line facing the consumer with
income M is given by AB (Refer to fig 1). The equation of the budget line, AB is
given by

xp’x + ypy = M --------------------------------------------------------------(1)

The optimal consumption bundle (with subsidy) is given by (x” , y”). This is
indicated by point C in Fig (1).

When consumers consume x” units of good x at subsidized price p’x then the
expenditure made on good x is x”p’x . On the other hand had the consumers
purchased x” units of good x at price px (the market price) then the expenditure
made on good x is x”px . Thus the subsidy benefits the consumer by the amount
x”(px – p’x). Hence the cost to government is given by x”(px – p’x). Thus we
conclude that the amount of subsidy given by government is x”(px – p’x).

Cash Transfer:

Suppose instead of subsidy the government gives an equivalent amount of cash

transfer to the consumer. This means that the consumer’s income after cash
transfer is increased to M + x”(px – p’x) (amount of subsidy plus the initial income
M). The budget line (also known as the cash transfer line) facing the consumer is

xpx + ypy = M + x”(px – p’x)------------------------------------------------------------ (2) .

This is shown by the line DP in Fig (1).

We now claim that the budget line, DP passes through the point C = (x”, y”). i.e.
(x”, y”) is affordable in the new scheme (i.e. with cash tranfers). We need to show
that y”py + x”px = M + x”(px – p’x).

Since C= (x” , y”) lies on the budget line AB ( refer to equation 1)

Therefore, x”p’x + y”py = M------------------ -----------------------------------(3)

Adding x”(px – p’x) to both sides of equation 3 we obtain

x”p’x + y”py + x”(px – p’x) = M + x”(px – p’x). Upon simplification we obtain

y”py + x”px = M + x”(px – p’x) --------------------------------------------------------(4)

Thus (x”, y”) satisfies the cash transfer line i.e. equation 2. Thus the budget line,
DP (cash transfer line ) passes through point C.

The consumer’s optimal consumtion point in this case is given by point F .

Conclusion

Thus it is clear that the consumer prefers cash transfer compared to subsidy
since she enjoy’s a higher level of utility (IC3>IC2).