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Loosening the poverty trap: reducing government assistance by 50 cents for every $1 earned

The graph shows a downward sloping line that extends from $28,000 on the y-axis to $18,000 on the y-axis (from 0 to 2,500 on the x-axis). Two points R and S appear on the line. Another line starts at (0, $20,000) and ends at (2,500, 0). A dashed plum line extends horizontally from $18,000 on the y-axis and meets with the vertical line extending from 2,500 on the x-axis. Another dashed plum line extends from $16,000 on the y-axis and intersects with the vertical line extending from 500 on the x-axis at point P. Beneath the x-axis is an arrow pointing to the right indicating leisure (hours) and an arrow pointing to the left indicating labor (hours).
On the original labor-leisure opportunity set, the lower budget set shown by the smaller dashed line in the figure, the preferred choice P is 500 hours of leisure and $16,000 of income. Then, the government created an antipoverty program that guarantees $18,000 in income even to those who work zero hours, shown by the larger dashed line. In addition, every $1 earned means phasing out 50 cents of benefits. This program leads to the higher budget set shown in the diagram. The hope is that this program will provide incentives to work the same or more hours, despite receiving income assistance. However, it is possible that the recipients will choose a point on the new budget set like S, with less work, more leisure, and greater income, or a point like R, with the same work and greater income.
The labor-leisure tradeoff with assistance reduced by 50 cents for every dollar earned
Amount Worked (hours) Total Earnings Government Support Total Income
0 0 $18,000 $18,000
500 $4,000 $16,000 $20,000
1,000 $8,000 $14,000 $22,000
1,500 $12,000 $12,000 $24,000
2,000 $16,000 $10,000 $26,000
2,500 $20,000 $8,000 $28,000

The next module will consider a variety of government support programs focused specifically on the poor, including welfare, SNAP (food supplement), Medicaid, and the earned income tax credit (EITC). Although these programs vary from state to state, it is generally a true statement that in many states from the 1960s into the 1980s, if poor people worked, their level of income barely rose—or did not rise at all—after the reduction in government support payments was factored in. The following Work It Out feature shows how this happens.

Calculating a budget constraint line

Jason earns $9.00 an hour, and a government antipoverty program provides a floor of $10,000 guaranteed income. The government reduces government support by $0.50 for each $1.00 earned. What are the horizontal and vertical intercepts of the budget constraint line? Assume the maximum hours for work or leisure is 2,500 hours.

Step 1. Determine the amount of the government guaranteed income. In this case, it is $10,000.

Step 2. Plot that guaranteed income as a horizontal line on the budget constraint line.

Step 3. Determine what Jason earns if he has no income and enjoys 2,500 hours of leisure. In this case, he will receive the guaranteed $10,000 (the horizontal intercept).

Step 4. Calculate how much Jason’s salary will be reduced by due to the reduction in government income. In Jason’s case, it will be reduced by one half. He will, in effect, net only $4.50 an hour.

Step 5. If Jason works 1,000 hours, at a maximum what income will Jason receive? Jason will get the government assistance of $10,000. He will net only $4.50 for every hour he chooses to work. If he works 1,000 hours at $4.50, his earned income is $4,500 plus the government income of $10,000. Thus the total maximum income (the vertical intercept) is $10,000 + $4,500 = $14,500.

Key concepts and summary

A poverty trap occurs when government-support payments for the poor decline as the poor earn more income. As a result, the poor do not end up with much more income when they work, because the loss of government support largely or completely offsets any income that is earned by working. The bite of the poverty trap can be reduced by phasing out government benefits more slowly, as well as by imposing requirements for work as a condition of receiving benefits and a time limit on benefits.

Problems

Susan is a single mother with three children. She can earn $8 per hour and works up to 2,000 hours per year. However, if she does not earn any income at all, she will receive government benefits totaling $16,000 per year. For every $1 of income she earns, her level of government support will be reduced by $1. Create a table, patterned after [link] . The first column should show Susan’s choices of how many hours to work per year, up to 2,000 hours. The second column should show her earnings from work. The third column should show her level of government support, given her earnings. The final column should show her total income, combining earnings and government support.

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Cardinal utility is the satisfaction derived by the consumers from the consumption of goods and services while ordinal is ranked in terms of preference.
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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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