When the price of gasoline is 200 per gallon Joe consumes 10

When the price of gasoline is $2.00 per gallon, Joe consumes 1,000 gallons per year. The price increases to $2.50, and to offset the harm to Joe, the government gives him a cash transfer of $500 per year. Will Joe be better off or worse off after the price increase and cash transfer than he was before? What will happen to his gasoline consumption? (Assume that Joe’s marginal rate of substitution of gasoline for other goods is diminishing.)

Solution

At price of $ 2, Joe consume 1000 gallons i.e. Income of Joe = P X Q = 2 x 1000 = $ 2000

When price increases to $ 2.50 and government gives cash transfer of 500 then Total income = 2000 + 500 = 2500

So, quantity that Joe can purchase from this amount = 2500/2.5 = 25000/25 = 1000 gallons

Joe will be indifferent after the price increase and cash transfer than he was before. Gasoline consumption will be same.