Please answer the following questions:

III. Consumer Choice Theory

1. Medicaid is an in-kind transfer program that provides health services to low-income families. Suppose that the government provides a low-income family with $100 worth of Medicaid benefits per month that can only be spent on health services. Furthermore, assume that the family has $500 dollars of income per month that can be spent on health services, H , or all other goods, X . The price of X is $1 and the price of H $20.

1a) Create a diagram that illustrates the familys budget constraint without Medicaid and the familys budget constraint with Medicaid. Label the intercepts and add indifference curves to indicate the optimal level of health services with and without and Medicaid.

1b) Now consider two types of families. One family is very healthy and therefore has little preference for health care but cares a lot about consuming other goods. The other family is very sick and therefore cares a lot about health care and other goods. If the Medicaid program was replaced with an unrestricted cash grant of $100 per month, how would the welfare of each family be affected? Illustrate your answer using two diagrams, one for the healthy family and one for the sick family.

2. Norm spends all of his income each month on beer at Cheers, a local tavern, and on a composite commodity, x . He has an income of $1,200 per month. The price of beer is $4 and the price of x is $1.

2a) Illustrate Norms budget constraint, indifference curve, and his optimal bundle of beer and all other goods. Label your diagram carefully and label Norm's optimal bundle point A.

2b) Now suppose the government is worried about Norm's beer consumption and hence impose a tax on beer. Specifically suppose the tax on beer raises the price of beer to $6.00. Provide a detailed diagram of the old and new budget constraints. You are now comparing Norm's situation to that before the tax. Label Norm's new optimal bundle point B. Does Norm consume more or less beer? Is he better or worse of than before? Explain.

2c) Now suppose the manager of Cheers gives Norm a cash grant for being such a great patron of Cheers. Specifically suppose the manager gives Norm just enough money each month to make his original optimal bundle (point A) affordable. In a new diagram, illustrate Norm's budget constraint, indifference curve and optimal bundle when: (1) the price of beer is $4, (2) the price of beer is $6 due to the tax, and (3) the price of beer is $6 due to the tax but Norm gets a cash grant from the manager. Is Norm better off or worse off then he was originally (when he was consuming bundle A)? Does Norm drink more or less beer than he did originally?

2d) Finally, explain carefully whether the manager of Cheers should give Norm more, less or the same amount of money as he did in part 1c if he wishes to make Norm no worse off then he was originally. Illustrate your answer using a diagram similar to the one you created in part 1c.

3. Most states in the U.S. justify their lotteries (i.e. legal state sponsored gambling) by telling voters that all of the money raised through the lottery will be devoted to education spending and nothing else. Now consider a state where residents have preferences defined over education spending, S and all other goods, X . For simplicity, further assume that the price of both education spending and all 5 other goods is $1 and that all residents have M dollars of income. Finally, suppose that prior to implementing the lottery the state was spending $A on education and that the lottery raises $B in revenue.

3a) If the state is true to its word and requires that every dollar raised through the lottery be spent on education, what would you predict would happen to spending on education? Use budget constraints and indifference curves to support your answer. Specifically, use budget constraints and indifference curves to illustrate the level of spending prior to the lottery and after the lottery.

3b) Now suppose that the state requires education spending to equal $(A+B) after the lottery is implemented. What effect does this have on the welfare of residents? Use budget constraints and indifference curves to support you answer.