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Diah uses two medicinal products to manage an ongoing condition: Floxudiene and Gluconam. Floxudiene is currently in the Pharmaceutical Benefits Scheme (PBS) and so it is subsidised. Its retail price is $40 per unit, but Diah only has to pay $20 per unit. She currently uses 150 units per year. Gluconam is not covered by the PBS and sells for $50 per unit. Diah currently consumes 100 units of Gluconam per year. Following changes to the PBS scheme, it is announced that Floxudiene is being removed from the scheme, and will now sell at $40 per unit. Gluconam will be included in the PBS for the first time and will sell at the subsidised price of $20 per unit. The government implements a scheme to compensate those affected by the price changes to Floxudiene and Gluconam. Diah is informed that she will receive no compensation as she has judged not to have been affected. When she enquires further she finds that the government used the Laspeyres measure to determine compensation amounts.
1. Assuming that Diah has smooth convex preferences, illustrate her situation and show why the government came to the decision it did. What problems are there with this decision?
2. Indicate an optimal bundle for Diah after the price changes, and show alternative measures of her welfare change, based both on expenditure and utility. Is there a way to say what her change in welfare really is?
3. Imagine that in fact Diah is required to combine 3 units of Floxudiene and 2 units of Gluconam in every dose in order for the medicine to be effective. Indicate the welfare measures previously shown in Questions 1 and 2. How would the government’s decision look in this case? What does this tell us about economic welfare and price changes?


1.Diah faces a smooth convex preference curve and therefore changes in the prices of goods will, in this scenario, cause no changes in her preference curve. Her preference curve has been given in figure 1. With the change in the Pharmaceutical Benefits Scheme (PBS), Diah will remain at point C1 that has been shown in Figure 1 below. This is because there is no change in the quantity consumed nor is there any change in Diah’s total expenditure. However, there is a fall in welfare as she consumes more units of Floxudiene in comparison to Gluconam. She could not make any welfare gains from the $30 fall in the prices of Gluconam due to the subsidy because the price of Floxudiene no longer received a subsidy and since it is consumed more, the impact of the removal of the $20 subsidy nullified the welfare gains that could have been made. The government can have multiple reasons to take this measure. It may be to support the suppliers of Gluconam or to stop the producers of Floxudiene from gaining monopoly power (Ward, et al. 2017). It may also be because the Government wants to remove inefficiencies from the system of the scheme.


FIGURE 1: Preference Curve

Source: Created by Author

2.The optimum bundle for Diah after the price change remains unchanged, as there is no change in her total expenditure. Before the shift in the subsidy her total expenditure was $8000 and it remains the same, as the change is costs due to the subsidy shift has not affected the total expenses. From the utility point of view even when the total expenditure is $8000, the units consumed could have been different given the price changes. After the price change, Diah is paying $6000 for Floxudiene that is double of what she was previously paying but is still getting the utility of her previous bundle of 150 units. Similarly, she used to pay $5000 for the same 50 units of Gluconam, which she is currently getting at $2000. Therefore, there is loss in terms of utility and welfare.


FIGURE 2: Preference Curve

Source: Created by Author

3.If 3 units of Floxudiene and 2 units of Gluconam is required for each dose, then the cost per dose before the shift in subsidy was $140 which has risen to $160 after the shift as the product used in higher quantity no longer has subsidy. In this case there is an increase in her cost and therefore the quantity of medicines produced by her will fall. This will lead to a loss in welfare because not only will she lose out on the benefits that she could have from the subsidy on Gluconam but she also has to reduce her production volume to meet the costs. The utility from this bundle is still low, as she will have to pay high costs for the same item which she used to get at a lower rate and which is more abundantly used in her product. Her preference curve will also not remain unchanged and the shift is reflected in the figure (Karnon, Edney, & Sorich 2017).


FIGURE 3: Shift in the Preference Curve

Source: Created by Author 



Harris, Carole A., Benjamin Daniels, Robyn L. Ward, and Sallie-Anne Pearson. "Retrospective comparison of Australia's Pharmaceutical Benefits Scheme claims data with prescription data in HER2-positive early breast cancer patients, 2008-2012." Public Health Research and Practice 27, no. 5 (2017): 1-9.

Karnon, J., Edney, L. and Sorich, M., 2017. Costs of paying higher prices for equivalent effects on the Pharmaceutical Benefits Scheme. Australian Health Review, 41(1), pp.1-6.


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