Chapter 7 Government Subsidies

and Income Support for the Poor Lecture 07

Review

What is the relevant cost when doing benefit

cost analysis?

What does this have to do with employed and

unemployed construction workers?

You are trying to decide where to go on vacation. In

country A, your risk of death is 1 in 10,000, and you

would pay $600 to go on that vacation. In country B,

your risk of death is 1 in 20,000, and you would pay

$900 to go on that vacation. Suppose that you’re

indifferent between these two destinations, save for

the differential risk of death. Based on your

willingness to pay for these vacations, what is your

value of a statistical life

Review

What is the difference in the willingness to pay for the

two trips?

ANS: _____________

What is the difference in the probability of death?

ANS: __________________

Willing to Pay _______per ________ chance in dying.

For a entire statistical life saved, you would be willing

to pay ____________________

Poverty

Why do we care about poverty?

What are some of the ways that poverty

is helped in the US?

◦ Is the government the only way?

◦ Using the analysis of this class, why might the

government get into the helping poverty?

What do you think would be important

attributes of a welfare Program?

Poverty in the US What is Poverty?

◦ Example

How should we Define Poverty?

Once Poverty is Defined in US, how does it

compare to other countries?

◦ Consider Congo in Africa

Poverty

Who Benefits from government support

for the poor?

◦ Is it just those who are receiving the income

support?

◦ If they are the only ones who benefit, how did

the legislation appear?

◦ Do you think there is a type of insurance role

with poverty programs?

Poverty Who is eligible in the US?

◦ How should we decide?

◦ ___________ – Ensure that people belong to a

particular group such as:

Disabled, Elderly, needy women with children

◦ Once we have Determine that you legitimately

cannot work, is that all?

Warren Buffet gets in a car accident, can’t work give him

welfare?

◦ ____________ - those that pass the status test also

have to have incomes and asset levels that are below

the minimally required amounts to be eligible

◦ Pass Both tests Entitled to the government

transfers, hence the name, __________________

Poverty

What are the programs in the US

◦ Cash Transfers

___________________________________

“Workfare” – do not have the option of not working

For the poor

________________________

For the Old

_______________________

General Assistance to the poor that paid out during tax

filing

If you are working, you may qualify

Poverty

What are the Programs in the US

◦ In-Kind Transfers

◦ Def: Non-Cash benefits that increase the

quantities of certain goods and services that

will be consumed by the recipient.

___________

___________: Medical care for the poor at

government expense

Poverty

Where does the government put its

money?

Welcome

Today

◦ Warm-Up

◦ Presentation Schedule

◦ Tools for Analyzing Poverty Programs

Indifference Curves

Budget Constraints

In class exercise

◦ Subsidy VS cash transfer

You try it

Next Time – Continue in Chapter 7

CONSUMPTION BUNDLE A CONSUMPTION BUNDLE B

2 slices of pizza and 1 can of Coke 1 slice of pizza and 2 cans of Coke

We assume that the consumer will always be able to decide

which of the following is true:

• The consumer prefers bundle A to bundle B.

• The consumer prefers bundle B to bundle A.

• The consumer is indifferent between bundle A

and bundle B; that is, the consumer receives

equal utility from the two bundles.

Consumer Preferences

Consumer Preferences

QM (quantity

of movies)

QCD

(quantity of

CDs)

0 1 2

1

2

Bundle “A” gives 2

CDs and 1 movie

A

B

Bundle “B” gives 1

CD and 2 movies C

Bundle “C” gives

2 CDs and 2

movies

Bundle “C” gives

higher utility than

either “A” or “B”

QM (quantity

of movies)

QCD

(quantity of

CDs)

0 1 2

1

2 A

B

C

IC1

IC2

“A” and “B” both

give 2 “utils” and

lie on the same

indifference curve

Bundle “C” gives

higher utility than

either “A” or “B”

Bundle “C” gives 4

“utils” and is on a

higher indifference

curve

Higher utility as

move toward

northeast in the

quadrant.

As you move along a given indifference curve, you give up some

of one good, but get more of the other. You are therefore

INDIFFERENT

Can Indifference Curves Ever Cross?

Indifference Curves

No, indifference curves should never

cross.

Poverty – Tools of analysis

In order to be able to do an economic analysis

of Poverty Programs, we need some tools.

Indifference curve A curve that shows the combinations of

consumption bundles that give the consumer the same utility.

Plotting Dave’s

Preferences

for Pizza and Coke

Poverty – Tools of Analysis

Budget Constraint: the amount of money a

consumer has to spend on goods and services

Dave has $10

Coke Costs $1

How many cokes can he

consume if he just buys coke?

Pizza Costs $2

L

5

Poverty – Tools of Analysis Economic Agents Seek to Maximize

Utility Subject to a budget constraint

Poverty – Tools of Analysis Shifts in the Budget constraint – 2 things

1. Changes in the price of a good

◦ What Happens to the quantity we can buy when

the Price of a good falls?

◦ How would that be represented in the Budget

constraint graph?

Poverty – Tools of Analysis

What happens

to the amount

of goods we

can buy when

our income

goes up?

How do we

show that on

a graph?

In Class Question

Jacob receives an allowance of $5 per week. He spends

all of his allowance on ice cream cones and cans of

Lemon Fizz soda.

1. If the price of ice cream cones is $.50 per cone and

the price of Lemon Fizz is $1 per can, draw a graph

showing Jacob’s budget constraint. Put ice cream

cones on the vertical axis.

2. Indicate on the graph the maximum number of each

good Jacob can buy.

3. Assume Jacob buys 8 cones and 1 can of soda.

Draw an indifference curve representing Jacob’s

choice assuming he has chosen optimally.

4. Suppose that the price of cones rises to $1 per

cone. Draw the new Budget constraint and new

indifference curve

Subsidies Distort Prices

Remember there is information contained

within Prices.

◦ When that information is altered, what

happens?

◦ Loss of efficiency as people make decisions

not based on social marginal cost, but on a

distorted cost

The Superiority of an Income Grant

All Other

Goods

I

Housing

I’

U1

U2

B U3

I’’

A

C

•Cash Transfer allows person to

obtain a higher level of satisfaction

•Cash Transfer allows more freedom

of choice

•Subsidy is associated with a loss of

Utility of U3-U2 (aka DWL)

•How much better of a person

would be if you just gave them

cash instead of the subsidy

Let I equal income

Let U be a Indifference Curve

(aka “U”tility curve)

Your Turn

Using budget constraints and indifference

curves, show that a person can be better of if

given a cash transfer rather than a subsidy ◦ Use goods Y on the y-axis and X on the x-axis

◦ Draw initial budget constraint and Utility maximizing bundle

using an indifference curve

◦ Show the effect of a subsidy for good X on the Budget

constraint.

◦ Show the indifference curve and utility maximizing point with

the subsidy in place

◦ Next show the effect of a cash transfer that would allow the

person to consume the subsidized bundle.

◦ Show that the person is able to obtain a higher indifference

curve with the cash transfer.

◦ What is the loss in utility associated with the Subsidy?

Excess Burden of a Subsidy We just showed the excess burden in terms of utility.

Now let’s show it in terms of the market for housing.

Cost of the Program =

_____________

•Benefits of the

Program to those

who are getting

cheaper housing:

________

•Benefits to those

who are now able to

get their own

housing _____

•Total Benefits:

_____

•Excess Costs: ____

Key point: The government could just give people the cash equivalent of BEE’C and

not waste EAE’

Excess Burden of a Subsidy:

Medicaid In general, Medicaid can

be viewed as reducing

to zero the money

price of medical

services to most

eligible low-income

persons

The dollar value of the

gain in well-being for

recipients of Medicaid

is less than the cost of

the program to

taxpayers

Graph Considers the Poor only

Excess Burden of a Subsidy:

Medicaid •DL demand for Low

Income

•D0 demand for the rest

•What is DM? How is it

obtained?

•How much do the poor

want if the price is zero?

•How then is D’M formed?

The Food Stamp Program

Food Stamps are Called a Fixed Allotment

Subsidy

◦ Def: Gives recipients the right to consume a fixed

amount, through allocation of the good or through

vouchers for the good.

◦ Differs from price subsidies in that people receive the

good itself, not a discount on the good.

◦ Because food stamps are so modest, there is little

distortion in the market.

◦ Food stamps are essentially equal to a cash transfer

The Food Stamp Program

Compare Hyman Figure 7.7

Draw Together

The Food Stamp Program Is there ever a loss of Utility? – Draw Together

Work Incentives We have talked about utility effects, effects on the

product market, now let’s look at the effect on work.

Start with a Pure

Income effect

Work Incentives

Welfare programs that are phased out as you

earn.