Economic Analysis and Public Policy

Problem Set

Ground Rules

You are encouraged to work with other class members on this problem set, but each person must write up their answers separately and in their own words. Answer questions in words and graphs unless noted otherwise. Please type answers and use 12- point front (graphs may be drawn by hand, but please make them clear.)

1. Budget Constraints

a. Assume that housing and food are the only goods available. A family's budget is
$800 a month. Assume the price of food is equal to $4 and the price of housing is equal to $5. Draw the budget constraint for this family.

b. Draw the budget constraint if the family is given a TANF grant of $1200 a month and prices and other income are the same as in part A. There is no restriction on how TANF grants may be spent.

c. Draw the budget constraint if instead of TANF the family is given a housing voucher worth $1200 a month and prices and other income are the same as in part A. Housing vouchers may only be spent on housing.

d. Draw the budget constraint if instead of a housing voucher the family is given public housing worth $1200 a month and prices and other income are the same as in part A. Assume public housing does not cost the family anything. Also assume that if a family lives in public housing, they cannot use their own money to increase the size of the public housing unit they are renting.
Hint: Even though public housing does not cost the family anything, your budget constraint must show the value of the public housing to the family. The reason is that the budget constraint shows all of the possible choices available to the family.

e. Draw a set of individual preferences so that:
1. The family is indifferent between all three options.
2. The family prefers TANF or a housing voucher to public housing.
3. The family prefers TANF to a housing voucher or public housing.

2. Suppose there are two goods available to the consumer: coffee and tea. Suppose the price of coffee decreases. What impact will the substitution effect and income effect have on the quantity demanded of coffee if coffee is a normal good? Explain. What impact will the substitution effect and income effect have on the quantity demanded of coffee if coffee is an inferior good? Explain. (Graph not needed.)

3. Draw two typical indifference curves for each of the following cases. What is the MRS in each case?

a. Name-brand aspirin and generic aspirin for a consumer who considers the two goods equal in every way.

b. Right gloves and left gloves for a consumer who only wants to wear gloves in pairs. Put right gloves on the x-axis.

c. Right gloves and left gloves for a rock star who regards right gloves as useless. That is, he only wears left gloves and does not care whether he has right gloves or not. Put right gloves on the x-axis.

4. Labor Supply

Consider a welfare system where welfare benefits are reduced by a dollar for every dollar that a person earns and another system where welfare benefits are reduced by 50 cents for every dollar that a person earns.

a. Use the model of labor supply we developed in class to plot an individual's leisure- income budget constraint under the two systems. Please provide detailed labels for your graph.

b. Which system is likely to result in more hours of work by a welfare recipient if we assume the recipient is not interested in working for an income more than his/her welfare benefits? Explain in words and graphically.

c. And if another person is willing to work for an income above his/her welfare benefits, under which system would this person choose to work more hours? Explain in words and graphically.

Hint: Plot the budget constraints under the two different welfare systems. Then pick a shape for each person's preferences (i.e. pick a position for each person's indifference curves) and determine the person's optimal combination of income and leisure under each system. Under which system does this person choose to work more hours?