QUESTION 5

Consider a welfare program in which individuals who do not earn any income receive $150 in benefits but benefits decrease with earned income: for each dollar earned 50 cents of benefits are withdrawn and this is so for any earnings above $0.

(a) Assume that an individual can earn $15 per hour and has no other income. Sketch her budget constraint with and without the program in effect. Carefully label the axes, intercepts and kink points.

(b) For an individual earning $150 dollars before the introduction of the welfare plan explain how hours of work and total income are affected by the introduction of such a welfare plan. Use the diagram to (i) illustrate the income and substitution effects of the welfare program and (ii) show how a fixed subsidy could lead that individual to the same level of utility at lower cost.

(c) For an individual earning $300 dollars before the introduction of the welfare plan explain how hours of work and total income are affected by the introduction of such a welfare plan. Use the diagram to show how a fixed subsidy of the same magnitude as the decreasing subsidy the individual receives within the welfare program would have allowed the individual to reach a higher level of utility.

(d) Discuss the advantages and disadvantages of means testing welfare benefits.