Modern Microeconomics by A. Koutsoyiannis (auth.)

By A. Koutsoyiannis (auth.)

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Although this criterion is theoretically more correct than the usual approach based on the total change in the quantity of y as a result of a change in the price of x, in practice its application is impossible because it requires knowledge of the individual preference functions, which cannot be statistically estimated. On the other hand, the usual approach of the total price effect is feasible because it requires knowledge of the market demand functions which can be empirically estimated. Although the advantages of the indifference-curves approach are important, the theory has indeed its own severe limitations.

Such questions may be answered by using indifference-curves analysis. We will illustrate the way in which the above information may be obtained, assuming for simplicity that there is a single pensioner and two commodities, x (food) andy (money income). The initial equilibrium of the pensioner is at point e 1 , where his budget line, AB, is tangent to indifference curve I 1 : he consumes OX 1 , units of food, paying ZA of his income, and having OZ income left over to spend on other commodities. The goal of the government is to make it possible for the pensioner to move to the higher level of welfare (satisfaction) denoted by the indifference curve I 2 .

Following this measure the budget line of the pensioner shifts to AB', which is tangent to I 2 at point e 2 . At his new equilibrium position the pensioner buys OX 2 units of food, paying for this quantity AL of his income. If there were no food subsidy the pensioner would have to spend AK of his income to buy OX2 units of food. Since he pays only AL, the difference LK = (AK- AL) must be paid to the food producers by the government. Thus, if the government adopts the food subsidy policy we have the following effects: (a) The cost to the government (and to the taxpayer) is LK.

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