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
 Consumer Preferences
Consumer Preferences
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.
QCD Bundle “C” gives
(quantity of Bundle “A” gives 2 and
2 CDs
higher utility2 than
CDs) movies“A” or “B”
either
CDs and 1 movie

Bundle “B” gives 1

A C CD and 2 movies
2

1 B

0 1 2 QM (quantity
of movies)
QCD Bundle “C” gives 4Higher utility as
“A” and “B” both
(quantity of give 2 “utils” “utils”
and and
higher is than
utility on a move toward
CDs) lie on the sameeither “A”
higher or “B” northeast in the
indifference
indifference curve quadrant.

A C
2

B
1 IC2

IC1

0 1 2 QM (quantity
As you move along a given indifference curve, you give up some of movies)
of one good, but get more of the other. You are therefore
INDIFFERENT
 Indifference Curves
Can Indifference Curves Ever Cross?

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

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
Let I equal income
Let U be a Indifference Curve •Cash Transfer allows person to
obtain a higher level of satisfaction
(aka “U”tility curve)
•Cash Transfer allows more freedom
of choice
•Subsidy is associated with a loss of
All Other
Utility of U3-U2 (aka DWL)
Goods
•How much better of a person
would be if you just gave them
C cash instead of the subsidy
I’’

A U3
B I’
U2

I U1
Housing
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 Graph Considers the Poor only
 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
Excess Burden of a Subsidy:
•DL demand for Low
Medicaid 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
Draw Together
Compare Hyman Figure 7.7
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.