6.g.

A Subsidy Versus a Cash Gift

Many goods receive government subsidies: education, health care, and rail transit, to name a few. An
important question for any consumer to ask is Would I rather have the subsidy? Or would I rather have my
share of the money the government spent on the subsidy? For example, if the governments subsidy to
your education were $20,000 per year, you might reasonably prefer to have the government give you the
$20,000, which you could then use to buy an education on the private market, or to buy some other good
that you might value more than education.

We can use figure 6.g.1 to show that a rational consumer will always prefer a cash gift to an equal-valued
subsidy to some good. A consumers initial optimum is at point A, consuming a combination of education x
and other goods y. A subsidy to education would make education cheaper, causing the budget constraint to
rotate outward as shown. The consumers new optimum would be at point B, along the budget line labeled
as $100 subsidy.

At the optimum point B, the consumer is buying XB units of x and YB units of y. We can judge the
governments spending on the subsidy by comparing points B and D. Point D shows us that if the
consumer had tried to buy XB units of x without the subsidy, he could have afforded only YD units of y. But
with the subsidy, he can afford YB units of y while still buying XB units of x. Thus the value of the subsidy is
equal to (YB -YD) units of y. We will assume that this amounts to 100 units of y. If y is a numeraire good, so
that Py=$1, then this means that the government is spending $100 on the subsidy.

Now suppose that instead of spending $100 on the subsidy, the government gave $100 in cash to the
consumer. Starting from the original optimum at point A, this $100 cash gift would shift the budget line up
by $100, to the new budget line labeled as $100 Cash gift. Note that the $100 cash gift budget line
passes through point B, since we already know that point B is $100 above point D. Because the $100 cash
gift line cuts through the indifference curve at point B, a higher indifference curve is now reachable at
point C. In other words, the $100 cash gift allows the consumer to reach point C, while the $100 subsidy
only allows the consumer to reach point B. Since C is on a higher indifference curve than B, the $100 cash
gift is preferred to the $100 subsidy.