Answer to Question #300968 in Microeconomics for Hanny

Question

Consider an employee who does not receive employer-based health insurance and must divide her $1,000 per week in after-tax income between health insurance and “other goods.” In the graph below, draw this worker’s opportunity set if the price of health insurance is $200 per week and the price of “other goods” is $100 per week. On the same graph, draw this worker's opportunity set for the case where the employer agrees to give this employee $200 worth of health insurance per week (under current tax laws, this form of compensation is nontaxable).

Would this employee be better or worse off if, instead of the health insurance, the employer gave her a $200 per week raise that was taxable at a rate of 25 percent? Explain.

Answer 1

 In the graph below, draw this worker’s opportunity set if the price of health insurance is $200 per week and the price of “other goods” is $100 per week. On the same graph, draw this worker's opportunity set for the case where the employer agrees to give this employee $200 worth of health insurance per week (under current tax laws, this form of compensation is nontaxable).

The income of the consumer is $ 1000 that has to be divided between health insurance and other goods. The price of health insurance is $200 per week and the price of all goods is $100 per week.

The budget constraint of this consumer is as follows:

P_HIQ_HI + P_AOGQ_AOG = M

200Q_HI + 100Q_AOG = $1000

Now the employers agree to pay this employee $200 worth of health insurance per week. The graph below shows the original budget line and new budget line:

The red line represents an old budget line, whereas the blue line represents a new budget line. Because companies pay non-taxable health insurance worth $200 each week, the new budget line has a kink. Employees can purchase one extra unit of health insurance for $200 because it is non-cashable. As a result, the number of health insurance utilization has grown.

Would this employee be better or worse off if, instead of the health insurance, the employer gave her a $200 per week raise that was taxable at a rate of 25 percent? Explain.

The employee is better off if she has a strong preference for other goods. The employee prefers other goods, cash is preferred despite the fact that cash is taxed because it allows the employee to buy more than 10 units of other goods. Otherwise, an employee attains a greater indifference curve by participating in a non-taxable, employer-sponsored health insurance program.