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Equilibrium and Social Welfare: Theoretical Tools of Public Finance

1) The document discusses the impact of reducing Temporary Assistance for Needy Families (TANF) guarantees on the labor supply and consumption of two single mothers, Sarah and Naomi. 2) When TANF is reduced from $5,000 to $3,000, Sarah responds by increasing her labor supply from 90 to 345 hours to compensate for the loss of benefits, while her consumption falls by $725. 3) Naomi greatly prefers leisure to consumption. When TANF is reduced, she does not increase her labor supply at all and simply accepts the reduction in her consumption from $5,000 to $3,000. 4) The document concludes that while theory alone

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97 views1 page

Equilibrium and Social Welfare: Theoretical Tools of Public Finance

1) The document discusses the impact of reducing Temporary Assistance for Needy Families (TANF) guarantees on the labor supply and consumption of two single mothers, Sarah and Naomi. 2) When TANF is reduced from $5,000 to $3,000, Sarah responds by increasing her labor supply from 90 to 345 hours to compensate for the loss of benefits, while her consumption falls by $725. 3) Naomi greatly prefers leisure to consumption. When TANF is reduced, she does not increase her labor supply at all and simply accepts the reduction in her consumption from $5,000 to $3,000. 4) The document concludes that while theory alone

Uploaded by

penelopegerhard
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CHAPTER 2 THEORETICAL TOOLS OF PUBLIC FINANCE 43

hours of leisure and work 90 hours per year (point A, where her indifference
curve is tangent to the budget constraint with a $5,000 guarantee). At that
level of labor supply, her wage earnings are $900. Because her TANF guaran-
tee is reduced by $0.50 for each $1 of earnings, however, her total income is
the $900 in earnings plus a net TANF benefit of $5,000 0.5 $900
$4,550. So her total consumption expenditures are $900 $4,550 $5,450.
(The mathematics of this example is shown in the appendix to this chapter.)
When the TANF guarantee is reduced to $3,000, Sarah chooses to reduce
her leisure since she is now poorer (the income effect), moving to point B on
the new budget constraint. At that point, she takes only 1,655 hours of leisure
per year, works 345 hours, and earns $3,450. For this mother, the governor is
right; the reduction in TANF guarantee has raised her labor supply from
90 hours to 345 hours. Note that because Sarahs TANF benefits are reduced by
half her earnings, her TANF benefits are now $3,000 0.5 $3,450 $1,275.
Thus, her total budget is $4,725; her consumption has fallen by $725 from the
days of the higher TANF guarantee ($5,450 $4,725 $725). Her consump-
tion has not fallen by the full $2,000 cut in the guarantee because she has
compensated for the guarantee reduction by working harder.
Figure 2-11 illustrates the case of a different single mother, Naomi, with a
utility function U 75 ln(C) 300 ln(L). Naomi puts a much larger
weight on leisure relative to consumption, when compared to Sarah. (Her
indifference curves are steeper, indicating that a larger increase in consumption
is required to compensate for any reduction in leisure.) For Naomi, the optimal
choice when the TANF guarantee is $5,000 is to not work at all; she consumes
2,000 hours of leisure and $5,000 of food (point A). When the guarantee is
reduced to $3,000, this mother continues not to work, and just lets her con-
sumption fall to $3,000. That is, she cares so much more about leisure than
about consumption that she wont supplement her TANF guarantee with
earnings even at the lower guarantee level. For this mother, the secretary is
right; the reduction in TANF guarantee has had no effect on labor supply, it
has simply cut her level of food consumption.
Thus, theory alone cannot tell you whether this policy change will increase
labor supply, or by how much. Theoretically, labor supply could rise, but it
might not. To move beyond this uncertainty, you will have to analyze available
data on single mother labor supply, and the next chapter presents the empirical
methods for doing so. From these various methods, you will conclude that the
governor is right: there is strong evidence that cutting TANF benefits will
increase labor supply.

2.3
Equilibrium and Social Welfare
he disagreement we have been discussing is over whether the labor sup-
T ply of single mothers will rise or not when TANF benefits are cut. As a
good public finance economist, however, you know not to stop there. What

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