Public Economics

Chapter 2: Theoretical Tools of Public Finance

Gruber, J, Public Finance and Public Policy, 7th Ed., New York, Worth
Publishers

Tirtha Chatterjee
Policy evaluation

• Temporary Assistance to Needy Families (TANF)

• Cash payments to single parents whose income is below a specified level
• But the program is expensive- debate is about reducing the benefits
• Opinion in favour of reducing benefits-TANF encourages them to stay at home rather
than go to work.
• Opinion Against : if cash payments are cut, staying home single mothers penalized
• You have been asked to assess
• Impact of cutting cash benefits to low-income single mothers on labour market participation
• Will it encourage or discourage them to work
• the net welfare implications for the state if these benefits are cut.

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How will you do it

• Theoretical tools- Chapter 2

• Indifference curve/ budget constraints, utility maximization
• Firm profit maximization
• supply and demand
• Market equilibrium
• Consumer and producer surplus and Welfare analysis

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Utility Maximization

• Indifference curves
• An individual’s preferences over all possible choices of goods
• Utility functions
• mathematical mapping of individual choices over goods into their level of well-being
• Budget constraint
• Amount of resources with which she can finance her purchases
• Given a budget constraint, what bundle of goods makes a consumer best off?
• Constrained utility maximization
• Indifference curves and budget constraint

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Preferences & ICs
• Consumers prefer ICs farther away from origin- More is better
• ICs slope downward- Upward sloping ICs violate more is better assumption

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Utility function

• Describes how the consumption of those goods translates to utility

U= f(X1, X2, X3,…)

• X1, X2, X3 - goods consumed by the individual and f is some mathematical function
• Marginal Utility
• additional increment to utility from consuming an additional unit of a good
• Diminishing Marginal Utility-
• consumption of each additional unit of a good makes an individual less happy than the
consumption of the previous unit

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Utility function

• Marginal rate of Substitution

• rate at which a consumer is willing to trade off the good on the vertical axis for the good on the
horizontal axis.
MRS = -MUX / MUY :
• Y is a good on vertical axis and X on horizontal axis
• MRS shows how the relative marginal utilities evolve over the indifference curve
• Moving down the IC, MUY rises and MUX falls- MRS falls
• Higher quantity implies lower MU.

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Budget constraint

• Mathematical representation of all combinations of goods an individual can afford

to buy if she spends her entire income.
Y=PX * QX + PY * QY
• Horizontal intercept- if individual buys only X & no Y - units of X
• Similarly, Vertical intercept- if individual buys only Y and no X- units of Y
• Slope is rate at which the market allows her to trade off good Y for good X
Slope= -PX / PY

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 Constrained utility maximization
• Highest IC an individual can reach given
budget constraint
• IC that is tangent to the budget constraint
• Farthest-out attainable IC, given income & prices.
• Marginal Rate of Substitution
• rate at which she is willing to trade cakes for
movies.
• Price Ratio
• rate at which the market allows her to trade cakes
for movies.

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 Any other point individual is worse off
• Point B - slope of IC> slope of budget constraint
MRS>Price ratio
• Andrea is willing to give up more cakes for movies than
the market requires.
• She can make herself better off by reducing her cake
purchases and increasing her movie purchases
• move from B to A.
• At point C, Andrea is willing to give up less cakes for
movies than what the market requires
• She will be better off by consuming more cakes and
reducing her movie purchase
• Move from C to A
• Thus, the optimal choice is the one at which:
MRS=-MUM / MUC =-PM / PC

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 Effects of Price change= Substitution effect + income effect

• If price of movies increase

• Budget constraint steeper
• Optimal consumption is at C now
• Price effect = SE+IE
• When price of one good increases relative
to another, you choose less of that good for
two reasons
• SE: it is relatively more expensive
• IE: because you are effectively poorer when
price increases

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 Demand curves- derived from constrained choice outcomes

• As price changes, optimal dd changes

• Relationship b/w price & quantity demanded.

• Elasticity of demand: % change in quantity

demanded of a good caused by each 1% change in
the price of that good.
• Next we look at the supply side

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Production function

• Production function- relationship b/w firm input use and output

• Marginal productivity of input
• impact of a one-unit change in an input, holding other inputs constant, on the firm’s output
• Diminishing marginal productivity
• Marginal productivity of an input diminishes with each additional unit of the input used in
production, keeping the other input constant

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Cost function

• The total costs of production, TC, are determined by

TC= rK + wL,
• r is the price of capital (rental rate), and w is the price of labor (wage rate).

• Marginal cost is the incremental cost to producing one more unit

• Diminishing marginal productivity generally implies rising marginal costs.

• Each additional unit of production means using labor that is less productive
• At the same wage rate, the costs of that production are rising.

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Profit maximization

• Profit is the difference between revenues and costs.

• Profit is maximized when revenue from the next unit equals the cost of producing
that next unit
MR=MC
• In a competitive industry, the revenue from any unit is the market price
• Firm’s profit maximization rule is to produce until price equals marginal cost.

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Supply curves- derived from profit maximization

• Relationship between price and how much producers will supply to the market.
• At any price, producers will supply a quantity such that P=MC
• Marginal cost curve is the firm’s supply curve
• showing the relationship between price and quantity.
• As quantity rises, and marginal costs rise
• Firm will require higher and higher prices to justify producing additional units.

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Market Equilibrium

• Individual demand curves are aggregated to generate market demand curve

• Supplies of each firm is added to generate aggregate supply curve
• Market-level dd & ss curves interact to determine the market equilibrium,
• Price and quantity pair that will satisfy both demand and supply.
• Competitive market equilibrium represents the unique point at which quantity
demanded equals quantity supplied at the equilibrium price.
• Next, we explore social efficiency- producer surplus and consumer surplus from trade

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 Social efficiency- Consumer surplus

• Gain to consumers from trades in a market for

consumer goods
• Shaded area below the demand curve and
above the equilibrium price
• Each point on a demand curve represents the
consumer’s willingness to pay for that quantity
• Depends on elasticity of demand and market
equilibrium price
• As demand is more inelastic- CS is larger
• Inelastic demand arises from a lack of good
substitutes, consumers get enormous surplus out of
consuming that particular good
• Essential food commodities

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 Social efficiency- Producer surplus

• Benefit derived by producers from the sale of a

unit above and beyond their cost of producing
that unit
• Graphically- area above the ss (MC) curve and
below the equilibrium price
• Depends on price elasticity of supply and
market equilibrium price
• As ss curve more inelastic, PS rises

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 Social surplus

• Producer surplus + consumer

surplus
• Also called social efficiency,
• Total surplus received by
consumers and producers in a
market.

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 First Fundamental Theorem of Welfare Economics

• The competitive equilibrium

maximizes social efficiency
• Suppose Government restricts the
price
• Suppliers react by reducing their
quantity produced
• Producer surplus falls by area B
+E.

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 First Fundamental Theorem of Welfare Economics

• Consumer surplus- two effects

• Smaller quantity is supplied,
consumers are worse off by D
• On the other hand, because
consumers pay a lower price for
movies, consumer surplus rises by
area B

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 First Fundamental Theorem of Welfare Economics

• Society loses surplus D + E.

• This area is called deadweight loss
• Reduction in social efficiency from
preventing trades for which benefits
exceed costs.

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Second Fundamental Theorem of Welfare Economics

• Society can attain any efficient outcome by a suitable redistribution of resources

and free trade.
• In practice, society often faces an equity–efficiency trade-off,
• the choice between having a bigger economic pie and having a more fairly distributed pie.
• government’s equity–efficiency decisions is modelled in the context of a social
welfare function (SWF).
• SWF maps the set of individual utilities in society into an overall social utility
function.
• Government can incorporate the equity–efficiency trade-off into its decision making.

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Second Fundamental Theorem of Welfare Economics

• If a government policy impedes efficiency and shrinks the economic pie, then citizens
as a whole are worse off.
• If, however, that shrinkage in the size of the pie is associated with redistribution that
is valued by society
• This redistribution might compensate for the decrease in efficiency and lead to an
overall increase in social welfare
• SWF can have several forms
• If SWF is such that the government cares solely about efficiency,
• Then competitive market outcome will be the most efficient & welfare maximizing outcome
• Utilitarian and Rawlsian SWF

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Utilitarian SWF

• Maximize sum of individual utilities

SWF = U1 + U2 +… UN
• Utilities of all individuals are given equal weight and summed to get total social
welfare.
• Transfer from person 1 to person 2 is welfare maximizing as long as utility gain to
person 1 is greater than the utility loss to person 2.
• Society is indifferent between one util for a poor person and one util for a rich person
• Assume Util to be a unit of well-being

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Utils and dollars are not the same

• Society is not indifferent b/w one $ to a poor person & one $ to a rich person;
• Society is indifferent b/w one util to the poor person and one util to the rich person.
• Distinction b/w dollars & util is important - diminishing marginal utility of income
• Richer people gain a much smaller marginal utility from an extra dollar than poorer
people
• Utilitarian SWF is maximized with a perfectly equal distribution of income
• If individuals are identical, and if there is no efficiency cost of redistribution

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Rawlsian Social Welfare Function

• Named after philosopher John Rawls.

• Social welfare is maximized by maximizing the well-being of the worst-off person in
society.
SW = min (U1, U2, …, UN)
• If individuals are identical, and redistribution does not have efficiency costs, both
SWF would call for an equal distribution of income
• Rawlsian SWF will in general suggest more redistribution than will a utilitarian SWF.
• Concerned with the well being of the worst off member

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Criteria besides SWF

• Commodity egalitarianism view

• All that matters is that individuals have met a basic level of need for goods such as housing or
medical care, and that once they have met this basic level, income distribution is irrelevant

• Equality of opportunity
• Individuals are guaranteed an equal chance to succeed, but if some do and others do not, that is not
the concern of the government.

Tirtha Chatterjee
Applying theoretical tools to evaluate TANF

Tirtha Chatterjee
Policy evaluation

• Temporary Assistance to Needy Families (TANF)

• Cash payments to single parents whose income is below a specified level
• But the program is expensive- debate is about reducing the benefits
• Opinion in favour of reducing benefits-TANF encourages them to stay at home rather
than go to work.
• Opinion Against : if cash payments are cut, staying home single mothers penalized
• You have been asked to assess
• Impact of cutting cash benefits to low-income single mothers on labour market participation
• Will it encourage or discourage them to work
• the net welfare implications for the state if these benefits are cut.

Tirtha Chatterjee
 What is the TANF program?

• Monthly support check to families with incomes below a threshold level

• There are two aspects to the program
• The first is a benefit guarantee,
• the baseline amount of money to which recipients are entitled when they enroll in the program.
• The second is a benefit reduction rate
• Rate at which baseline amount is reduced if recipients have other income.
• For example, a benefit reduction rate of 100% implies that TANF recipients lose a dollar of the benefit
guarantee for each dollar of other income they earn.
• Benefit reduction rate of 50% implies they lose $0.50 of the benefit guarantee for each $1 they earn.

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 TANF

• Impact of policy change from $5000 benefit guarantee to $3000 has to be evaluated
• We are interested in identifying whether this will increase or decrease labour supply
• Wage increase or decrease changes the opportunity cost of leisure
• The effect will depend on Utility function and Indifference Curves of individuals
• In this example we look at some fictitious women (single mothers) & try to study the
impact of decrease in TANF benefits

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 TANF- First example- Joelle

• Say, Joelle is a single mother- two sources of income- her job + TANF benefits
• Joelle’s choice- work more and earn more but cost is less time spent with family
• If leisure is normal good, more work makes her worse off, but she can buy more food
• How does Joelle decide on the optimal amount of labor supply?
• Utility maximization framework
• one good (food consumption) and one “bad” (labour, as we assume she prefers leisure to labour)

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 Budget constraint- with no TANF
• Suppose Joelle can work up to 2,000
hours per year at a wage of $10 per hour
• By working one less hour in a year, Joelle will
lower her consumption by $10 and increase her
leisure time by one hour.
• Hourly wage rate = “price” of 1 hour of
leisure.
• Let us assume price of food is $1 per unit
of food.
• Tradeoff- each hour of work brings her
10 units of food, and each hour off from
work (leisure) costs her 10 units of food.

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 Budget constraint- with TANF

• Let’s assume a benefit guarantee of $5,000 &

benefit reduction rate of 50%.
• The original budget constraint is the line ABC.
• If Joelle chooses <1,000 hours of leisure,
earning $10,000 to $20,000
• Once she earns $10,000, she is no longer
eligible for TANF
• benefit reduction rate of 50%, her $5000 gets
deducted
• Budget constraint remains the segment AB.

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 Budget constraint- with TANF

• If Joelle chooses to take >= 1,000 hours of

leisure
• If Joelle works another hour, she earns $10 in
wages but loses $5 in TANF benefits.
• With the 50% benefit reduction rate
• Net return to working another hour is now $5
• Price of leisure falls to $5 per hour from $10
• Budget constraint is now flatter.

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 Budget constraint- with TANF

• Point D marks the end of the new budget

constraint
• 2,000 hours of leisure and $5,000 in food consumption
because of TANF benefit guarantee.
• Without TANF, if she had chosen to consume
2,000 hours of leisure, she would not work and no
income
• Point C

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 Budget constraint- Change in TANF policy

• Reducing income guarantee from $5,000 to

$3,000.
• Remember, now if he earns >= $6,000, $3,000 will
get deducted- not eligible for TANF
• He can earn >=$6,000, by working >= 600 hours
• If Joelle chooses to take <=1,400 hours of leisure
• She earns $6,000 to $20,000
• Budget constraint does not change, remaining as the
segment AE.

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 Budget constraint- Change in TANF policy

• If she takes >1,400 hours of leisure

• Budget constraint once again flattens
• She earns $10 in wages but loses $5 in TANF
benefits for each hour of work in this range, the
slope of the budget constraint along the segment EF
• Point F marks the end of the new budget constraint,
where Joelle can have 2,000 hours of leisure &
$3,000 in income
• $3,000 TANF benefit guarantee.

Tirtha Chatterjee
How will single mothers react to change in policy- substitution effect

• Suppose Joelle earned less than $6,000 before this benefit change.
• There is no change in relative price of leisure- $5 per hour
• slope of the budget constraint doesn’t change.
• Price of leisure is unchanged.
• $5,000 or a $3,000 check from the government has no impact when she earns <=6000
• With relative prices of food & leisure unchanged, no desire for substitution across
goods.
• There is no substitution effect associated with the policy change

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Joelle earned < $6,000 before this benefit change – Income Effect

• When TANF guarantee is reduced, she is poorer.

• $5,000 to $3,000
• Poorer individuals will reduce consumption of all normal goods, including leisure.
• Less leisure means working more.
• There is less money available to finance consumption
• Women will have to work harder.
• There is a reduction in leisure from income effect of reducing the TANF guarantee.

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Joelle earned between $6,000 and $10,000- IE & SE

• Income effect- reduces her income- less leisure (therefore more labour)
• Substitution effect-
• There is a change in the price of leisure.
• Before the benefits change, an hour of work netted Joelle $5 per hour
• Now, she is no longer eligible for TANF, an hour of work nets her $10.
• leisure used to cost $5 but now costs $10 in forgone earnings
• This relative increase in the price of leisure will lead to SE toward less leisure.
• Thus, in this range, the IE & SE work together to reduce leisure.

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What happens if Joelle earned >= $10,000 before the policy change?

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 How large will the labour supply response be?

• We consider two examples- Sarah and Naomi here

• The first mother, Sarah, has a utility function of the
form
U = 100*ln(C) +175*ln(L),
• where C is consumption and L is leisure
• Sarah values both consumption & leisure, but she
values leisure somewhat more

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Labour supply impact for Sarah
• Sarah, has a utility function of the form
U = 100*ln(C) +175*ln(L),
• For this utility function, the marginal rate of substitution is:

• Her budget constraint has two segments:

• We can solve for optimal amount of leisure and consumption

• Different budget constraints depending on hrs worked and therefore income earned and
hence different optimization problem

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Labour supply impact for Sarah

• We can solve for optimal amount of leisure and consumption

• We have to solve for it in both segments of the Budget constraint
• TANF and non-TANF segment
• We have to compute utility levels in both segments for the $5000 TANF policy
• Her optimal point will be where she gets higher utility
• Then we have to identify optimal levels in both segments for the $3000 TANF
policy
• Her optimal point will be where she gets higher utility
• We can compare Labour supply for the two TANF policies & identify the impact
of TANF reduction on labour supply

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Labour supply impact for Sarah

• We do this by first finding her optimal leisure and consumption bundle on each
of the two segments of the budget constraint, and
• Evaluate which of those choices leads to higher total utility.
• On the first (TANF) segment of the budget constraint, we solve the problem:

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Labour supply impact for Sarah

• Solving this equation, we obtain L is equal to 1,910

• When guarantee is $5,000, Sarah chooses to consume 1,910 hours of leisure and
work 90 hours per year - point A
• Her wage earnings are $900.
• Because her TANF guarantee 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.
• Her total consumption expenditures are $900 + $4,550 = $5,450.
• This implies a utility of 100 * ln(5,450) + 175 * ln(1,910) = 2,182.

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Labour supply impact for Sarah

• Similarly, we can solve the problem again for the second (non-TANF) segment
of the budget constraint

• Taking the differential of utility with respect to leisure, and setting this to zero,
we can solve for an optimal L
• We find optimal L is equal to 1,273, and resulting consumption of 7,270.
• Plugging these values back into the utility function, we get a value for utility
from this choice of 2,140.

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Labour supply impact for Sarah

• Utlility in non-TANF budget constraint part = 2,140

• Utility from TANF budget constraint part = 2,182
• Individual will choose TANF segment
• Individual will choose point A on the first (TANF) segment of the budget
constraint.
• Optimal L = 1910 and work hours = 900
• Income = 5000+(2000-1910)*10*0.5= 5000+(90*5)= 5000+450 = 5450

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Labour supply impact for Sarah

• When TANF guarantee is reduced to $3,000

• We can solve a similar optimization
• Her TANF segment of budget constraint will be different now
• We can compare utility from two segments – TANF & non-TANF
• Once again, we find that utlility is maximized at the TANF part
• She takes only 1,655 hours of leisure per year, works 345 hours, and earns $3,450.
• For this mother, reduction in TANF guarantee has raised her labor supply
from 90 hours to 345 hours.
• Evaluator will conclude that reduction of TANF benefits increase labour supply

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 A different mother (Naomi) with a different utility function

• Utility function
U=75 * ln(C) + 300 * ln(L).
• Naomi puts much larger weight on leisure
relative to consumption, compared to
Sarah.
• ICs are steeper,
• Larger increase in consumption is required to
compensate for any reduction in leisure.
• For Naomi, optimal choice when the
TANF guarantee is $5,000 is to not work
at all

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A different mother (Naomi) with a different utility function

• The utility function that underlies the indifference curves is

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A different mother (Naomi) with a different utility function

• Doing so, we obtain an optimal value of leisure of 3,200.

• This value exceeds the maximum possible level of leisure, 2,000.
• The mother chooses to take that maximum value
• with leisure of 2,000 and consumption of 5,000, for a utility level of 2,919.
• Once again, we calculate optimal C & L for non-TANF segment & calculate utility
• We find utility from non-TANF lower than utility from TANF segment

Tirtha Chatterjee
A different mother (Naomi) with a different utility function

• When the guarantee is reduced to $3,000, we again find that utility from non-TANF
lower than TANF segment.
• she chooses the “corner” solution of 2,000 hours of leisure and 3,000 units of
consumption
• she continues not to work and just lets her consumption fall to $3,000.
• For this mother, reduction in TANF guarantee has had no effect on labor supply

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How large will the labour supply response be?

• Different individuals- Different ICs & different impact of policy change on labour
supply
• 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.
• We need empirical evidence to move beyond this uncertainty
• There are other tools for that- econometrics course

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Will this policy change make society as a whole better off?

• What are the benefits?

• improvement in efficiency from removing a barrier to labor supply by single mothers
• Barrier will not allow the competitive equilibrium
• raising single mothers’ labor supply and raising the size of the social surplus.
• What are the costs
• Reduction in equity that arise from reducing income support to one of the lowest-income
groups in our society.
• The job of public finance economists is to measure these efficiency and equity
consequences.
• to decide on appropriate policy choices.

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 Efficiency

• No TANF- X is equilibrium point

• With TANF- Y is new equilibrium
• Social efficiency fallen
• DWL = A + B + C + D + E.
• TANF benefits are cut- Z is
equilibrium
• S3 is right of S2 because we saw
labour supply increases with decrease
in benefit
• DWL has been reduced to D + E
• Social efficiency has grown by the
area A + B + C

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Equity

• If TANF is associated with increased inefficiency, why continue with the program?
• Beneficiary population largely live below the poverty line
• Cutting TANF would worsen outcomes for a population that is one of the worst off in
society.
• Could have dramatic equity costs that offset the efficiency gains.
• Measuring empirically the cost to society from this reduced equity is quite difficult.
• The analyst must make some assumption about how society values well-being of
different groups
• such as single mothers versus other taxpayers.

Tirtha Chatterjee