Unformatted text preview: 8/10/11 PADP 8670 POLICY ANALYSIS I Analysis of Welfare Programs Angela Fer7g, Ph.D. Today's plan Consumer Choice Model Indifference Curve Budget Line Income and subsAtuAon effects ElasAcity Welfare Programs and the Budget Line Food Stamps EITC 1 8/10/11 Economic Theory of the Consumer We assume that consumers are raAonal decision-makers They purchase the bundle of goods that maximizes their happiness, or uAlity, subject to what they can afford The uAlity-maximizing bundle of goods is also called the opAmal bundle Indifference Curves An indifference curve shows all bundles of goods that provide the consumer with the same uAlity Thus indifference curves map out the consumer's preferences Pizza Pepsi 2 8/10/11 We assume that consumer preferences saAsfy a few basic rules Consumers have a preference ordering Preferences are complete (can decide between bundles) Preferences are transi7ve (If A is preferred to B and B is preferred to C, then A is preferred to C) If A is preferred to B, then bundles that are sufficiently "close" to A must also be preferred to B Preferences are con7nuous Are monotonic (or "non-saAated") Are bowed/convex (diminishing marginal rate of subsAtuAon) If bundle B has more of each good than bundle A, then B is preferred to A If bundle A has a liWle of both goods and bundle B has a lot of one good and very liWle of the other, then A is preferred to B Averages are preferred to extremes Indifference Curves The marginal rate of subsAtuAon is the amount of pizza you are willing to give up to get more pepsi. Pizza Changes in pepsi are the same Pepsi 3 8/10/11 Important Features of Indifference Curves Indifference curves are downward-sloping Y < 0 X > 0 If you gain some X, you have to lose some Y in order to remain indifferent Indifference curves cannot cross each other B A C Consumer must be indifferent between A and B (because C is just as good as both) But B has more of both goods than A, so should prefer B to A The Budget Line The equaAon for the budget line can be obtained by insisAng that total expenditures on X and Y not exceed the consumer's income: I = PXX + PYY Income = Expenditure on X + Expenditure on Y Solve this equaAon for Y in terms of X and you get: Y = (I / PY) (PX / PY)X Recall: Y=b+mX (equaAon for a line) This is the equaAon of a line in X-Y space with slope -(PX/PY) and verAcal intercept (I/PY) 4 8/10/11 Graph of the Budget Line Graph the budget line if income is equal to I, the price of X is PX and the price of Y is PY: Y I / PY Slope = -PX / PY X I / PX Changes in the Budget Line The locaAon of the budget line changes if prices or income change Suppose income increases: Y Suppose the price of good X increases: Y X X 5 8/10/11 Consumer Equilibrium The consumer's objecAve is to maximize uAlity This means the consumer tries to reach the highest possible indifference curve subject to staying on the budget line We say the consumer is in "equilibrium" when he / she consumes the uAlity-maximizing (or opAmal) bundle OpAmal bundle occurs at tangent between indifference curve and budget line. Y1* X1* Effects of Change in Income Suppose the consumer has an increase in income. How does this affect the uAlity- maximizing bundle? Y2* Y1* 2 1 X1* X2* 6 8/10/11 Effect of Change in Price Suppose there is an increase in the price of X. What happens to the opAmal bundle? Y2* Y1* 2 1 X2* X1* SubsAtuAon and Income Effects The overall effect of a price change (movement from 1 to 2 on previous page) can be decomposed into two components: a "subsAtuAon effect" and an "income effect" 7 8/10/11 SubsAtuAon Effect The subsAtuAon effect is the change in behavior resulAng purely from the fact that there is a price change (holding uAlity constant) With a steeper budget line, Y 3 1 consumer would choose a different bundle even on the same indifference curve X Income Effect The income effect is the change in behavior resulAng purely from the fact that "real income" has changed (holding prices constant) Y Parallel shin to lower budget line because real income falls when a price rises Consumer first subsAtutes toward Y on same indiff curve b/c price of X increases 1 3 = subs7tu7on effect Then falls to lower indiff curve because real income has decreased 3 2 = income effect 2 3 1 X 8 8/10/11 DirecAons of SubsAtuAon and Income Effects The subsAtuAon effect always works like this: The consumer subsAtutes toward the good that gets relaAvely cheaper and away from the one that gets relaAvely more expensive This is because when the opportunity cost of something increases, people do less of it If PX , the subsAtuAon effect always means X and Y Which way the income effect works depends on whether the good is "normal" or "inferior." Normal: consumpAon increases when income increases (so if PX , income effect means X ) Inferior: consumpAon decreases when income increases (so if PX , income effect means X ) Effects of Price Changes for Normal and Inferior Goods Normal good: SubsAtuAon and income effects work in same direcAon If PX , then X (negaAve price-quanAty relaAonship) Inferior good: SubsAtuAon and income effects work in opposite direcAons SubsAtuAon: If PX , then X // Income: If PX , then X If sub effect is larger than income effect, then you sAll get a negaAve price-quanAty relaAonship If income effect is larger than sub effect, then you get a posiAve price-quanAty relaAonship ("Giffen good") 9 8/10/11 SubsAtuAon and Income effects for an inferior good Y 1 3 = subsAtuAon 3 2 = income 1 2 = total X is inferior because X increases when real income decreases (32) 1 2 3 Sub Income X ElasAcity In order to predict how consumers will behave when prices and income change, we need to understand elasAcity Price elasAcity of demand: D = %QD / %P InelasAc: Even though there is a large price change, the quanAty change is small P P D <1 P P Q Q Q Q ElasAc: Even with a small price change, the quanAty change is large D >1 D 10 8/10/11 ElasAcity Income elasAcity of demand: I = %Q / %I If I > 0, the good is normal If I < 0, the good is inferior Welfare programs change consumers budget lines 11 8/10/11 Analysis of Food Stamp Program EssenAally lowers price of food All other Goods ($) 1 3 = subsAtuAon 3 2 = income 1 2 = total 1 3 Uf2 Uf1 2 Sub Income Food Group Exercise Draw the income and subsAtuAon effects if food stamps only covered foods that people did not like to eat. How would the diagram differ from the last slide? 12 8/10/11 In-kind welfare transfers are inefficient IntuiAon: If we provide food stamps to people with low demand for food, then we could provide them a smaller cash equivalent and both parAes would be beWer off. In-kind Welfare Transfers are Inefficient, seen graphically All other Goods ($) A & B give the same uAlity , but A is cheaper (B is not affordable under the cash program) inefficient A B Uf2 Uf1 cash Food stamp program Food 13 8/10/11 In-kind transfers are inefficient, but we can modify policy to reduce inefficiency All other Goods ($) max subsidy RestricAon: Can't buy unlimited number of food stamps. Improvement: EssenAally a cash program for high-food- consumpAon households which reduces the inefficiency of the program. Low-food consumpAon households go from A to B (with income and subsAtuAon effects) High-food consumpAon households go from C to D (income effect only) A B C D Uf1 Food Analysis of Earned Income Tax Credit All other goods ($) AB: TANF (blue line), safety net but 100% tax rate, big disincenAve to work ACD: EITC tax credit of 40% AC: (TANF + earnings) + 40% of earnings from EITC CD: keep 100% of earnings + 40% from EITC DE: EITC phase out rate D C B A $40,000 E $17,000 $14,000 $10,000 Leisure Labor-Leisure Diagram 14 8/10/11 Welfare is inefficient; EITC is beWer All other goods ($) $40,000 $17,000 $14,000 $10,000 Uwelfare+EITC Uwelfare U1 Leisure Much less work disincenAve Group Exercise Using Labor-Leisure Diagram: 1. How would unemployment insurance change the budget line? 2. How would a $3000 health insurance subsidy for low-income households change the budget line? In each case, examine the work incenAves. 15 8/10/11 Discussion of Gruber Simon 2008 What is crowd-out? What do the authors find? How can policy designers avoid crowd-out? What other program might be affected by crowd-out? For next Ame Read Ch. 16 Read Free Clinic paper write one page summary to hand in as part of homework 3 Read Exxon Valdez arAcle and email me 2 discussion quesAons by Sunday night (Sep 11) Homework 3 16 ...
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