(This problem is challenging.) The welfare system in industrialized countries provides income to some needy families. Typically, the maximum payment goes to families that earn no income; then, as families begin to earn income, the welfare payment declines gradually and eventually disappears. Let’s consider the possible effects of a welfare system on a family’s labour supply.

a. Draw a budget constraint for a family assuming that the welfare system did not exist. On the same diagram, draw a budget constraint that reflects the existence of the welfare system.

b. Adding indifference curves to your diagram, show how the welfare system could reduce the number of hours worked by the family. Explain, with reference to both the income and substitution effects.

c. Using your diagram from part (b), show the effect of the welfare system on the well-being of the family.