Question

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?

Answer 1

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.