Old State receives an open- ended matching grant from the federal government to finance Medicaid services to state residents. The federal grant covers 50 percent of state expenditures, and the state has selected a program that provides $5,000 of medical services per recipient per year, on average.

(a) Suppose that it is known that the (absolute value of the) price elasticity for Medicaid services in OS is .5. If the federal matching grant were eliminated so that OS had to pay $1.00 for each dollar of Medicaid expenditures, what would be expected to happen to the average level of Medicaid services selected in OS? Estimate the new expected average benefit amount.

(b) Now suppose the national government gives OS a lump-s um block grant to replace the previous matching grant. OS will receive lump- sum grant funds equal to $2,500 times the initial number of recipients: that is, the same amount of funds as was paid before. If the total lump- sum grant equals 5 percent of total income in Old State and the income elasticity of demand for Medicaid services is .6, estimate how much average Medicaid spending will now increase.

(c) After the grant substitution – replacing the matching grant with an equal-a mount lump- sum grant – is Medicaid spending in OS expected to be the same, greater, or less? Explain why.