Question

Explain the economic value of the following equation, $\frac{M{U}_X}{P_X}=M{U}_M$ when X happens to be a domestic fuel (LPG) and $P_X$ is lowered by way of subsidy by the government.

Answer 1

Taking MUM as constant, a fall in PX (by way of subsidy) would mean that MUXPX>MUM. The consumer's equilibrium is disturbed. But the change is good for the consumer. Induced by lower PX, the consumer increase the consumption of LPG. A rise in the consumption of LPG leads to a fall in MUX. The equilibrium (MUXPX=MUM) is now established at a higher level of consumption of LPG.

The subsidy plays its role by increasing the consumption of LPG, as desired by the government Consumer's equilibrium is shifted to a higher level of satisfaction, even when his income remains constant.