Week 2

2.
1 Constrained Utility
Maximization
Theoretical Tools of
Public Finance
2.2 Putting the Tools to Work:

TANF and Labor Supply among
Single Mothers
2.3 Equilibrium and Social
Welfare
2.4 Welfare Implications of
Benefit Reductions: The TANF
Example Continued
2.5 Conclusion
Public Finance and Public Policy Jonathan Gruber Third Edition Copyright 2010 Worth Publishers
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Temporary assistance for needy families (TANF)

program, provide cash payments to a single mother
whose income is below some specified level.
The governor believes that a major problem with

the cash transfer program is that, by only providing
income to very low income single mothers, it
encourages them to stay at home rather than go to
work.
To provide incentives for these mothers to work,

the governor wants to cut back on these cash
benefits.
The secretary of the department disagrees.
He thinks that single mothers who are home

with their children are incapable of finding jobs that
pay a wage high enough to encourage them to work.
In his view, if the state cuts the cash payments,

it will simply penalize those single mothers who are
staying home.
This debate to be assessed by what extent

cutting cash benefits to low -income single mothers
will encourage them to work, and by evaluating the
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C H AP T E R 2 T H E O R E T I C AL T O O LS O F P U B LI C F I N AN C E
Addressing when should Govt. interven

How should govt. intervene
theoretical tools are a set of tools used to

understand economic decision making.
They are primarily graphical and
mathematical.
empirical tools The set of tools designed to

analyze data and answer questions raised by
theoretical analysis. ---quantitative impacts
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2.1
Constrained Utility Maximization

utility function A mathematical
function representing an individuals set
of preferences, which translates her
well-being from different consumption
bundles into units that can be
compared in order to determine choice.
constrained utility maximization The

process of maximizing the well-being
(utility) of an individual, subject to her
resources (budget constraint).
models Mathematical or graphical

representations of reality.
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2.1

Preferences and Indifference Curves
indifference curve A graphical
representation of all bundles of
goods that make an individual
equally well off. Because these
bundles have equal utility, an
individual is indifferent as to
which bundle he consumes.
Indifference curves have two essential properties, both of which follow
naturally from the more-is-better assumption:
1. Consumers prefer higher indifference curves.
2. Indifference curves are always downward sloping.
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2.1

Preferences and Indifference Curves : A curve that shows
consumption bundles that give the consumer same level of utility.
FIGURE 2-1
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2.1

Preferences and Indifference Curves
FIGURE 2-2
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2.1

Utility Mapping of Preferences
Underlying the derivation of indifference curves is the notion that each
individual has a well-defined utility function.
A utility function is some mathematical representation
U = f(X1, X2, X3, ),
where
X1, X2, X3, and so on
are the goods consumed by the individual and
f
is some mathematical function that describes how the consumption of
those goods translates to utility.
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2.1

Marginal Utility
marginal utility The additional

increment to utility obtained by
consuming an additional unit of
a good.
This utility function described exhibits the important principle of

diminishing marginal utility: the consumption of each additional unit of
a good makes an individual less happy than the consumption of the
previous unit.
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2.1

Marginal Utility
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2.1

Marginal Rate of Substitution
marginal rate of substitution
(MRS) The rate at which a
consumer is willing to trade one
good for another. The MRS is
equal to the slope of the
indifference curve, the rate at
which the consumer will trade
the good on the vertical axis for
the good on the horizontal axis.
MRS MU M / MU C
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MarginalRateofSubstitution
The negative of the slope of the indifference curve at

any point is called the marginal rate of substitution
(MRS)
Quantity of y
dy
MRS
dx
U U1
y1
y2
U1
x1
x2
Quantity of x
12
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MarginalRateofSubstitution
MRS changes as x and y change

reflects the individuals willingness to trade y for x
At (x1, y1), the indifference curve is steeper.

The person would be willing to give up more
y to gain additional units of x
Quantity of y
At (x2, y2), the indifference curve

is flatter. The person would be
willing to give up less y to gain
additional units of x
y1
y2
U1
x1
x2
Quantity of x
13
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2.1

Marginal Rate of Substitution : If the consumer has more and more of good A,
They will be less and less willing to give up some of good B to get additional
unit of A.
FIGURE 2-4
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MarginalUtility
Suppose that an individual has a utility function of

the form
utility = U(x,y)
The total differential of U is
U
U
dU
dx
dy
x
y
Along any indifference curve,

utility is constant (dU = 0)
15
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DerivingtheMRS
Therefore, we get:
dy
MRS
dx
Uconstant
U
x
U
y
MRS is the ratio of the

marginal utility of x to the
marginal utility of y
16
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2.1

Budget Constraints
budget constraint A mathematical
representation of all the combinations of
goods an individual can afford to buy if she
spends her entire income.
opportunity cost The cost of any

purchase is the next best alternative use
of that money, or the forgone opportunity.
When a persons budget is fixed, if he buys one thing he is, by definition, reducing the
money he has to spend on other things. Indirectly, this purchase has the same effect
as a direct good-for-good trade.
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2.1

Budget Constraints
FIGURE 2-5
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2.1

Putting It All Together: Constrained Choice
FIGURE 2-6
Marginal analysis, the consideration of the costs and benefits of an additional unit of
consumption or production, is a central concept in modeling an individuals choice of
goods and a firms production decision.
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2.1

The Effects of Price Changes: Substitution and Income Effects
FIGURE 2-7
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2.1

Income and Substitution Effects
substitution effect Holding
utility constant, a relative rise in
the price of a good will always
cause an individual to choose
less of that good.
income effect A rise in the price
of a good will typically cause an
individual to choose less of all
goods because her income can
purchase less than before.
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2.1

Income and Substitution Effects
normal goods Goods for which

demand increases as income rises.
inferior goods Goods for which

demand falls as income rises.
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2.2
Putting the Tools to Work: TANF and Labor Supply

among Single Mothers
Identifying the Budget Constraint
FIGURE 2-8
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2.2

The Effect of TANF on the Budget Constraint
Effects of Changes in Benefit Guarantee
FIGURE 2-9
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2.2

How Large Will the Labor Supply Response Be?
FIGURE 2-10
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2.2

How Large Will the Labor Supply Response Be?
FIGURE 2-11
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2.3
Equilibrium and Social Welfare
welfare economics The study

of the determinants of well-being,
or welfare, in society.
Demand Curves
demand curve A curve showing
the quantity of a good demanded
by individuals at each price.
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2.3

Demand Curves
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2.3

Demand Curves
Elasticity of Demand
elasticity of demand The

percentage change in the
quantity demanded of a good
caused by each 1% change in
the price of that good.
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2.3

Demand Curves
Elasticity of Demand
There are several key points to make about elasticities of demand:
They are typically negative, since quantity demanded typically falls as

price rises.
They are typically not constant along a demand curve.
A vertical demand curve is one for which the quantity demanded does not
change when price rises; in this case, demand is perfectly inelastic.
A horizontal demand curve is one where quantity demanded changes

infinitely for even a very small change in price; in this case, demand is
perfectly elastic.
The effect of one goods prices on the demand for another good is the
cross-price elasticity, and with the particular utility function we are using
here, that cross-price elasticity is zero. Typically, however, a change in
the price of one good will affect demand for other goods as well.
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2.3

Supply Curves
supply curve A curve showing the
quantity of a good that firms are willing to
supply at each price.
marginal productivity The impact of a
one unit change in any input, holding other
inputs constant, on the firms output.
marginal cost The incremental cost to a
firm of producing one more unit of a good.
profits The difference between a firms
revenues and costs, maximized when
marginal revenues equal marginal costs.
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2.3

Equilibrium
market The arena in which

demanders and suppliers interact.
market equilibrium The

combination of price and quantity
that satisfies both demand and
supply, determined by the
interaction of the supply and
demand curves.
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2.3

Equilibrium
FIGURE 2-13
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2.3

Social Efficiency
Social efficiency represents the net gains to society from all trades that are
made in a particular market, and it consists of two components: consumer
and producer surplus.
Consumer Surplus
consumer surplus The benefit that

consumers derive from consuming a
good, above and beyond the price
they paid for the good.
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2.3

Social Efficiency
Consumer Surplus
FIGURE 2-14
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2.3

Social Efficiency
Producer Surplus
producer surplus The benefit

that producers derive from
selling a good, above and
beyond the cost of producing
that good.
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2.3

Social Efficiency
Producer Surplus
FIGURE 2-15
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2.3

Social Efficiency
Social Surplus
total social surplus (social

efficiency) The sum of
consumer surplus and
producer surplus.
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2.3

Social Efficiency
Social Surplus
FIGURE 2-16
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2.3

Competitive Equilibrium Maximizes Social Efficiency
First Fundamental Theorem
of Welfare Economics The
competitive equilibrium, where
supply equals demand,
maximizes social efficiency.
deadweight loss The
reduction in social efficiency
from preventing trades for
which benefits exceed costs.
It is sometimes confusing to know how to draw deadweight loss triangles. The key to
doing so is to remember that deadweight loss triangles point to the social optimum,
and grow outward from there.
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2.3

From Social Efficiency to Social Welfare: The Role of Equity
social welfare The level of well-being

in society.
Second Fundamental Theorem of

Welfare Economics Society can
attain any efficient outcome by
suitably redistributing resources
among individuals and then allowing
them to freely trade.
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2.3

equityefficiency trade-off
The choice society must make
between the total size of the
economic pie and its distribution
among individuals.
social welfare function (SWF) A
function that combines the utility
functions of all individuals into an
overall social utility function.
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2.3

Utilitarian SWF
With a utilitarian social welfare function, societys goal is to maximize
the sum of individual utilities:
SWF = U1 + U2 + . . . + UN
The utilities of all individuals are given equal weight, and summed to
get total social welfare.
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2.3

Rawlsian Social Welfare Function
John Rawls suggested that societys goal should be to maximize the
well- being of its worst-off member. The Rawlsian SWF has the form:
SW = min (U1, U2, . . ., UN)
Since social welfare is determined by the minimum utility in society,

social welfare is maximized by maximizing the well-being of the worstoff person in society.
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2.3

Choosing an Equity Criterion
commodity egalitarianism
The principle that society
should ensure that individuals
meet a set of basic needs, but
that beyond that point income
distribution is irrelevant.
equality of opportunity The
principle that society should
ensure that all individuals have
equal opportunities for success
but not focus on the outcomes
of choices made.
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2.4
Welfare Implications of Benefit Reductions: The TANF

Example Continued
Efficiency
FIGURE 2-17
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2.4
Welfare Implications of Benefit Reductions: The TANF
Example Continued
Equity
Governments have programs such as TANF because their citizens care

not only about efficiency but also about equity, the fair distribution of
resources in society. For many specifications of social welfare, the
competitive equilibrium, while being the social efficiency-maximizing
point, may not be the social welfare-maximizing point.
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2.5
Conclusion
This chapter has shown both the power and the limitations of the theoretical
tools of economics.
On the one hand, by making relatively straightforward assumptions about
how individuals and firms behave, we are able to address complicated
questions such as how TANF benefits affect the labor supply of single
mothers, and the implications of that response for social welfare.
On the other hand, while we have answered these questions in a general
sense, we have been very imprecise about the potential size of the changes
that occur in response to changes in TANF benefits.
48 of 44

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2.

2.2 Putting the Tools to Work:

Temporary assistance for needy families (TANF)

The governor believes that a major problem with

To provide incentives for these mothers to work,

The secretary of the department disagrees.

He thinks that single mothers who are home

In his view, if the state cuts the cash payments,

This debate to be assessed by what extent

Addressing when should Govt. interven

theoretical tools are a set of tools used to

empirical tools The set of tools designed to

Constrained Utility Maximization

constrained utility maximization The

models Mathematical or graphical

Constrained Utility Maximization

Constrained Utility Maximization

Constrained Utility Maximization

Constrained Utility Maximization

Constrained Utility Maximization

marginal utility The additional

This utility function described exhibits the important principle of

Constrained Utility Maximization

Constrained Utility Maximization

The negative of the slope of the indifference curve at

MRS changes as x and y change

At (x1, y1), the indifference curve is steeper.

At (x2, y2), the indifference curve

Constrained Utility Maximization

Suppose that an individual has a utility function of

The total differential of U is

Along any indifference curve,

MRS is the ratio of the

Constrained Utility Maximization

opportunity cost The cost of any

Constrained Utility Maximization

Constrained Utility Maximization

Constrained Utility Maximization

Constrained Utility Maximization

Constrained Utility Maximization

normal goods Goods for which

inferior goods Goods for which

Putting the Tools to Work: TANF and Labor Supply

Putting the Tools to Work: TANF and Labor Supply

Putting the Tools to Work: TANF and Labor Supply

Putting the Tools to Work: TANF and Labor Supply

Equilibrium and Social Welfare

welfare economics The study

Equilibrium and Social Welfare

Equilibrium and Social Welfare

elasticity of demand The

Equilibrium and Social Welfare

They are typically negative, since quantity demanded typically falls as

They are typically not constant along a demand curve.

A horizontal demand curve is one where quantity demanded changes

Equilibrium and Social Welfare

Equilibrium and Social Welfare

market The arena in which

market equilibrium The

Equilibrium and Social Welfare

Equilibrium and Social Welfare

consumer surplus The benefit that

Equilibrium and Social Welfare