CHAPTER 2 THEORETICAL TOOLS OF PUBLIC FINANCE 57

To consider a simple example, imagine that society has a utilitarian SWF,

and that each individual in society has a utility function of the form U
C,
where C consumption income. Imagine further that 10% of citizens are
single mothers who have an initial income of $10,000, and the remaining 90%
of citizens have an initial income of $50,000. Suppose that if we cut TANF
benefits, the income of single mothers falls to $5,000, while the income of
everyone else rises to $51,000. Under this policy, the average level of income
in society rises from $46,000 to $46,400, so total social efficiency has risen.Yet
social welfare has fallen; the average utility level has fallen from 211.2 to 210.3
(computed by averaging across all citizens the square root of income both
before and after this change). This is because we are adding small amounts of
income to the high-income majority, who already have a low marginal utility
of income, but we are taking large amounts of income away from the low-
income minority, who have a very high marginal utility of income. While this
policy move raises efficiency, it harms equity even more in the context of
this SWF.
Measuring empirically the cost to society from this reduced equity is quite
difficult. Essentially, the analyst must make some assumption about how socie-
ty values the well-being of different groups, such as single mothers versus
other taxpayers.

2.5
Conclusion
his chapter has shown both the power and the limitations of the theoreti-
T cal tools of economics. On the one hand, by making relatively straightfor-
ward assumptions about how individuals and firms behave, we are able to
address complicated questions such as how TANF benefits affect the labor sup-
ply of single mothers, and the implications of that response for social welfare.
On the other hand, while we have answered these questions in a general sense,
we have been very imprecise about the potential size of the changes that occur
in response to changes in TANF benefits. That is, theoretical models can help
point to the likely impacts of policy changes on individual decisions and social
welfare, but they cannot tell us the magnitude of those effects.To do so, we have
to turn to empirical economics, which we will do in the next chapter.

HIGHLIGHTS
Policy debates such as that over the appropriate level
of Temporary Assistance for Needy Families
(TANF) benefits motivate the need for theoretical
modeling of individual and firm decision-making
behaviors.
Modeling the impact of policy changes on individual
behavior requires the use of utility-maximization
models in which individuals maximize their well-
being, subject to market prices and their available
resources.
Individual well-being, or utility, is maximized when
individuals choose the bundle of goods that equates
the rate at which they want to trade off one good
for another (the marginal rate of substitution) with
the rate at which the market allows them to trade
off one good for another (the price ratio).