CHAPTER 2 THEORETICAL TOOLS OF PUBLIC FINANCE 41

Point F marks the end of the new budget constraint, where Joelle can have
2,000 hours of leisure and $3,000 in food consumption because of the $3,000
TANF benefit guarantee. How will single mothers react to this policy change?
In answering this question, it is important to return to the concepts of
income and substitution effects introduced earlier. Suppose, for example, that
Joelle earned less than $6,000 before this benefit change. In that case, there is
no substitution effect associated with the policy change from a $5,000 benefit
guarantee to a $3,000 benefit guarantee. There is no change in the relative
price of leisure, which remains at $5 per hour, so the slope of the budget con-
straint doesnt change. Whether Joelle gets a $5,000 or a $3,000 check from
the government has no impact on the return from working an additional
hour ($5 on net), so the price of leisure is unchanged. With relative prices of
food and leisure unchanged, there is no desire for substitution across the
goods.
There is, however, a clear income effect for Joelle.When the TANF guaran-
tee is reduced, she is poorer. Poorer individuals will reduce their consumption
of all normal goods, including leisure. Taking less leisure means working more.
In other words, since there is less money available to finance consumption,
women will have to work harder. Thus, on net, there is a reduction in leisure
from the income effect of reducing the TANF guarantee.
Suppose, instead, that Joelle earned between $6,000 and $10,000 before the
benefit change. Once again, this benefit change would reduce her income,
which will cause her to choose less leisure (and more labor). There is also,
however, a change in the price of leisure. In this range of earnings, before the
benefits change, an hour of work netted Joelle only $5 per hour, due to the
reduction in TANF benefits from additional earnings. Now, since she is no
longer eligible for TANF in this income range, an hour of work nets her $10.
This relative increase in the price of leisure (taking leisure used to cost $5 but
now costs $10 in forgone earnings) will lead to a substitution effect toward less
leisure. Thus, in this range the income and substitution effects work together
to reduce leisure.
How Large Will the Labor Supply Response Be? This example illustrates
the power of economic theory. The constrained maximization model implies
that a reduction in the benefit guarantee will lead to less leisure and therefore
more work among single mothers. The model does not say, however, how size-
able this response will be. This depends on how much Joelle earned before the
benefit change, and the size of the income and substitution effects on her
leisure/labor decision.
To illustrate the different possible magnitudes of the response, Figures 2-10
and 2-11 show two different cases. In both cases, we consider utility functions
for consumption and leisure, where the utility derived from each is propor-
tional to its natural logarithm (ln).This is a convenient form for utility functions
that shares most of the properties of the square root utility function we used
for CDs and movies, most notably diminishing marginal utility. As noted ear-
lier, the square root and log forms are just two of many possible forms for
utility.