Question

# Solving Moral Hazard by Lowering the Benefit Reduction Rate An individual can earn \$15 per hour...

Solving Moral Hazard by Lowering the Benefit Reduction Rate

An individual can earn \$15 per hour if he or she works. Assume an individual can work up to 200 hours in a month, or not work at all and consume 200 hours of leisure. Draw the budget constraints that show the monthly consumption-leisure trade-off between the following three welfare programs.

a. The government guarantees \$900 per month in income and reduces that benefit by \$1 for each \$1 of labor income earned.

b. The government guarantees \$600 per month in income and reduces that benefit by \$1 for every \$2 of labor income earned.

c. Which system, (a) or (b), distorts individuals’ labor supply decisions the least? Why?

A) The equivalent of \$900 per month is \$ 60 of labor (at the rate of \$15 per hour) or 720-60=660 hours of leisure.

B) The equivalent of \$600 of income is 40(600/15) hours of labor or 680(720-40) hours of leisure. The entire \$600 guarantee would be eliminated after the recipient earned \$1200 or worked 1200/15 = 80 hours, which yields 720 – 80 = 640 hours of leisure.

C) (B), distorts individuals’ labor supply decisions the least because a labor is getting \$600 per month in income and reduces that benefit by \$1 for every \$2 of labor income earned.

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