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The government considers different calculations to help senior citizens with their increasing heating bills. One proposal on the table is to pay 20% of senior citizens' heating bills out of public funds. Another part is to pay a fixed amount of money to each senior household. Using indifference curve analysis, show the different effects of the two calculations! Under which option could the draw on public funds be greater, if the government plans aim at guaranteeing a minimum welfare level for the poorest senior household? Which calculate would you consider environmentally more friendly?
Answer: A subsidization of the heating bill could result in a price reduction of heating oil relative to the price of the composite good Y. With a direct income transfer, the household increase from the old optimum E to the new optimum A. The income transfer MN essential to reach the guaranteed indifference curve i* is smaller than the subsidy essiential to reach the subsidy LK necessary to reach this indifference curve. In addition to the income effect x0 x1 there is the substitution effect x1 x2 as heating oil becomes relatively cheaper. Due to the substitution effect, the environmental effect of the subsidy could be detrimental as well.
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