Solution Manual for Public Finance, 10th Edition
Solution Manual for Public Finance, 10th Edition offers step-by-step solutions to help you understand tough concepts with ease.
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Part 1 – Getting Started
1-1
Instructor’s Manual to accompany
Public Finance, Tenth Edition, by Harvey S. Rosen and Ted Gayer
Chapter 1 – Introduction
Brief Outline
1. Public Finance and Ideology
a. The Organic View of Government
b. The Mechanistic View of Government
c. The Viewpoint of This Book
2. Government at a Glance
a. Legal Framework
i. Federal Government
ii. State and Local Governments
b. Size of Government
c. Expenditures
d. Revenues
e. Our Agenda
Suggested Answers to End-of-Chapter Discussion Questions
1.
a. McCain’s statement is consistent with an organic conception of government.
Individuals and their goals are less important than the state.
b. Locke makes a clear statement of the mechanistic view of the state in which
individual liberty is of paramount importance.
c. Chavez’s statement is consistent with an organic view of government. The
individual has significance only as part of society as a whole.
2. Libertarians believe in a very limited government and are skeptical about the ability of
government to improve social welfare. Social democrats believe that substantial
government intervention is required for the good of individuals. Someone with an
organic conception of the state believes that the goals of society are set by the state and
individuals are valued only by their contribution to the realization of social goals.
a. A law prohibiting receiving compensation for organ donation would be opposed
by libertarians, as they would want the market to decide who buys and who sells
organs and at what price the organs would be sold. Social democrats also might
oppose the law if they consider that such a law would prevent organ donation
from happening as frequently. However, they are likely to support the law on the
grounds that paying for organ donation would coerce financially desperate people
to sell their organs. The law would protect the individual from making a poor
1-1
Instructor’s Manual to accompany
Public Finance, Tenth Edition, by Harvey S. Rosen and Ted Gayer
Chapter 1 – Introduction
Brief Outline
1. Public Finance and Ideology
a. The Organic View of Government
b. The Mechanistic View of Government
c. The Viewpoint of This Book
2. Government at a Glance
a. Legal Framework
i. Federal Government
ii. State and Local Governments
b. Size of Government
c. Expenditures
d. Revenues
e. Our Agenda
Suggested Answers to End-of-Chapter Discussion Questions
1.
a. McCain’s statement is consistent with an organic conception of government.
Individuals and their goals are less important than the state.
b. Locke makes a clear statement of the mechanistic view of the state in which
individual liberty is of paramount importance.
c. Chavez’s statement is consistent with an organic view of government. The
individual has significance only as part of society as a whole.
2. Libertarians believe in a very limited government and are skeptical about the ability of
government to improve social welfare. Social democrats believe that substantial
government intervention is required for the good of individuals. Someone with an
organic conception of the state believes that the goals of society are set by the state and
individuals are valued only by their contribution to the realization of social goals.
a. A law prohibiting receiving compensation for organ donation would be opposed
by libertarians, as they would want the market to decide who buys and who sells
organs and at what price the organs would be sold. Social democrats also might
oppose the law if they consider that such a law would prevent organ donation
from happening as frequently. However, they are likely to support the law on the
grounds that paying for organ donation would coerce financially desperate people
to sell their organs. The law would protect the individual from making a poor
Part 1 – Getting Started
1-1
Instructor’s Manual to accompany
Public Finance, Tenth Edition, by Harvey S. Rosen and Ted Gayer
Chapter 1 – Introduction
Brief Outline
1. Public Finance and Ideology
a. The Organic View of Government
b. The Mechanistic View of Government
c. The Viewpoint of This Book
2. Government at a Glance
a. Legal Framework
i. Federal Government
ii. State and Local Governments
b. Size of Government
c. Expenditures
d. Revenues
e. Our Agenda
Suggested Answers to End-of-Chapter Discussion Questions
1.
a. McCain’s statement is consistent with an organic conception of government.
Individuals and their goals are less important than the state.
b. Locke makes a clear statement of the mechanistic view of the state in which
individual liberty is of paramount importance.
c. Chavez’s statement is consistent with an organic view of government. The
individual has significance only as part of society as a whole.
2. Libertarians believe in a very limited government and are skeptical about the ability of
government to improve social welfare. Social democrats believe that substantial
government intervention is required for the good of individuals. Someone with an
organic conception of the state believes that the goals of society are set by the state and
individuals are valued only by their contribution to the realization of social goals.
a. A law prohibiting receiving compensation for organ donation would be opposed
by libertarians, as they would want the market to decide who buys and who sells
organs and at what price the organs would be sold. Social democrats also might
oppose the law if they consider that such a law would prevent organ donation
from happening as frequently. However, they are likely to support the law on the
grounds that paying for organ donation would coerce financially desperate people
to sell their organs. The law would protect the individual from making a poor
1-1
Instructor’s Manual to accompany
Public Finance, Tenth Edition, by Harvey S. Rosen and Ted Gayer
Chapter 1 – Introduction
Brief Outline
1. Public Finance and Ideology
a. The Organic View of Government
b. The Mechanistic View of Government
c. The Viewpoint of This Book
2. Government at a Glance
a. Legal Framework
i. Federal Government
ii. State and Local Governments
b. Size of Government
c. Expenditures
d. Revenues
e. Our Agenda
Suggested Answers to End-of-Chapter Discussion Questions
1.
a. McCain’s statement is consistent with an organic conception of government.
Individuals and their goals are less important than the state.
b. Locke makes a clear statement of the mechanistic view of the state in which
individual liberty is of paramount importance.
c. Chavez’s statement is consistent with an organic view of government. The
individual has significance only as part of society as a whole.
2. Libertarians believe in a very limited government and are skeptical about the ability of
government to improve social welfare. Social democrats believe that substantial
government intervention is required for the good of individuals. Someone with an
organic conception of the state believes that the goals of society are set by the state and
individuals are valued only by their contribution to the realization of social goals.
a. A law prohibiting receiving compensation for organ donation would be opposed
by libertarians, as they would want the market to decide who buys and who sells
organs and at what price the organs would be sold. Social democrats also might
oppose the law if they consider that such a law would prevent organ donation
from happening as frequently. However, they are likely to support the law on the
grounds that paying for organ donation would coerce financially desperate people
to sell their organs. The law would protect the individual from making a poor
Chapter 1 - Introduction
1-2
decision. The organic view might also oppose the law because the society might
become healthier if more individuals received transplants, although they would
believe that individuals should donate for the good of society, rather than for
compensation.
b. Libertarians oppose the law mandating helmet use for motorcyclists, arguing that
individuals can best decide whether or not to use helmets without government
coercion. Social democrats take the position that the mandate saves lives and
ultimately benefits individuals. The organic view would probably lead to
favoring the mandate on the grounds that reduced health care costs caused by
fewer injuries benefit society.
c. Libertarians oppose the law mandating child safety seats, arguing that individuals
can best decide whether or not to use child safety seats without government
coercion. Social democrats take the position that the mandate saves lives and
ultimately benefits individuals. The organic view would probably lead to
favoring the mandate on the grounds that reduced health care costs caused by
fewer accidents benefit society.
d. Libertarians would probably oppose a law prohibiting prostitution, while social
democrats would likely favor such a law. The organic view depends on the type
of society policymakers are attempting to achieve. The law would probably be
favored on moral grounds.
e. Libertarians would probably oppose a law prohibiting polygamy, while social
democrats would likely favor such a law. The organic view depends on the type
of society policymakers are attempting to achieve. The law would probably be
favored on moral grounds.
f. Libertarians would likely oppose the ban on trans fats in restaurants, believing
that consumers will demand restaurants remove trans fats if they believe that is
important. Social democrats would probably support the ban because consumers
might not understand how bad trans fats are for their health. Those with an
organic view would probably favor the ban because the scientific literature
suggests that people who avoid trans fats are healthier, therefore the ban would
reduce health care costs.
3. The mechanistic view of government says that the government is a contrivance created by
individuals to better achieve their individual goals. Within the mechanistic tradition,
people could disagree on the tax on saturated fats to reduce obesity. Libertarians would
say that people can decide what is best for themselves - whether to consume saturated
fats - and do not need prodding from the government. In contrast, social democrats might
argue that people are too short sighted to know what is good for them, so that
government-provided inducements are appropriate.
1-2
decision. The organic view might also oppose the law because the society might
become healthier if more individuals received transplants, although they would
believe that individuals should donate for the good of society, rather than for
compensation.
b. Libertarians oppose the law mandating helmet use for motorcyclists, arguing that
individuals can best decide whether or not to use helmets without government
coercion. Social democrats take the position that the mandate saves lives and
ultimately benefits individuals. The organic view would probably lead to
favoring the mandate on the grounds that reduced health care costs caused by
fewer injuries benefit society.
c. Libertarians oppose the law mandating child safety seats, arguing that individuals
can best decide whether or not to use child safety seats without government
coercion. Social democrats take the position that the mandate saves lives and
ultimately benefits individuals. The organic view would probably lead to
favoring the mandate on the grounds that reduced health care costs caused by
fewer accidents benefit society.
d. Libertarians would probably oppose a law prohibiting prostitution, while social
democrats would likely favor such a law. The organic view depends on the type
of society policymakers are attempting to achieve. The law would probably be
favored on moral grounds.
e. Libertarians would probably oppose a law prohibiting polygamy, while social
democrats would likely favor such a law. The organic view depends on the type
of society policymakers are attempting to achieve. The law would probably be
favored on moral grounds.
f. Libertarians would likely oppose the ban on trans fats in restaurants, believing
that consumers will demand restaurants remove trans fats if they believe that is
important. Social democrats would probably support the ban because consumers
might not understand how bad trans fats are for their health. Those with an
organic view would probably favor the ban because the scientific literature
suggests that people who avoid trans fats are healthier, therefore the ban would
reduce health care costs.
3. The mechanistic view of government says that the government is a contrivance created by
individuals to better achieve their individual goals. Within the mechanistic tradition,
people could disagree on the tax on saturated fats to reduce obesity. Libertarians would
say that people can decide what is best for themselves - whether to consume saturated
fats - and do not need prodding from the government. In contrast, social democrats might
argue that people are too short sighted to know what is good for them, so that
government-provided inducements are appropriate.
Chapter 1 - Introduction
1-2
decision. The organic view might also oppose the law because the society might
become healthier if more individuals received transplants, although they would
believe that individuals should donate for the good of society, rather than for
compensation.
b. Libertarians oppose the law mandating helmet use for motorcyclists, arguing that
individuals can best decide whether or not to use helmets without government
coercion. Social democrats take the position that the mandate saves lives and
ultimately benefits individuals. The organic view would probably lead to
favoring the mandate on the grounds that reduced health care costs caused by
fewer injuries benefit society.
c. Libertarians oppose the law mandating child safety seats, arguing that individuals
can best decide whether or not to use child safety seats without government
coercion. Social democrats take the position that the mandate saves lives and
ultimately benefits individuals. The organic view would probably lead to
favoring the mandate on the grounds that reduced health care costs caused by
fewer accidents benefit society.
d. Libertarians would probably oppose a law prohibiting prostitution, while social
democrats would likely favor such a law. The organic view depends on the type
of society policymakers are attempting to achieve. The law would probably be
favored on moral grounds.
e. Libertarians would probably oppose a law prohibiting polygamy, while social
democrats would likely favor such a law. The organic view depends on the type
of society policymakers are attempting to achieve. The law would probably be
favored on moral grounds.
f. Libertarians would likely oppose the ban on trans fats in restaurants, believing
that consumers will demand restaurants remove trans fats if they believe that is
important. Social democrats would probably support the ban because consumers
might not understand how bad trans fats are for their health. Those with an
organic view would probably favor the ban because the scientific literature
suggests that people who avoid trans fats are healthier, therefore the ban would
reduce health care costs.
3. The mechanistic view of government says that the government is a contrivance created by
individuals to better achieve their individual goals. Within the mechanistic tradition,
people could disagree on the tax on saturated fats to reduce obesity. Libertarians would
say that people can decide what is best for themselves - whether to consume saturated
fats - and do not need prodding from the government. In contrast, social democrats might
argue that people are too short sighted to know what is good for them, so that
government-provided inducements are appropriate.
1-2
decision. The organic view might also oppose the law because the society might
become healthier if more individuals received transplants, although they would
believe that individuals should donate for the good of society, rather than for
compensation.
b. Libertarians oppose the law mandating helmet use for motorcyclists, arguing that
individuals can best decide whether or not to use helmets without government
coercion. Social democrats take the position that the mandate saves lives and
ultimately benefits individuals. The organic view would probably lead to
favoring the mandate on the grounds that reduced health care costs caused by
fewer injuries benefit society.
c. Libertarians oppose the law mandating child safety seats, arguing that individuals
can best decide whether or not to use child safety seats without government
coercion. Social democrats take the position that the mandate saves lives and
ultimately benefits individuals. The organic view would probably lead to
favoring the mandate on the grounds that reduced health care costs caused by
fewer accidents benefit society.
d. Libertarians would probably oppose a law prohibiting prostitution, while social
democrats would likely favor such a law. The organic view depends on the type
of society policymakers are attempting to achieve. The law would probably be
favored on moral grounds.
e. Libertarians would probably oppose a law prohibiting polygamy, while social
democrats would likely favor such a law. The organic view depends on the type
of society policymakers are attempting to achieve. The law would probably be
favored on moral grounds.
f. Libertarians would likely oppose the ban on trans fats in restaurants, believing
that consumers will demand restaurants remove trans fats if they believe that is
important. Social democrats would probably support the ban because consumers
might not understand how bad trans fats are for their health. Those with an
organic view would probably favor the ban because the scientific literature
suggests that people who avoid trans fats are healthier, therefore the ban would
reduce health care costs.
3. The mechanistic view of government says that the government is a contrivance created by
individuals to better achieve their individual goals. Within the mechanistic tradition,
people could disagree on the tax on saturated fats to reduce obesity. Libertarians would
say that people can decide what is best for themselves - whether to consume saturated
fats - and do not need prodding from the government. In contrast, social democrats might
argue that people are too short sighted to know what is good for them, so that
government-provided inducements are appropriate.
Part 1 – Getting Started
1-3
4.
a. If the size of government is measured by direct expenditures, the mandate does
not directly increase it. Costs of compliance, however, may be high and would
appear as an increase in a “regulatory budget.”
b. This ban would not increase government expenditures, but the high costs of
compliance would increase the regulatory budget.
c. It’s hard to say whether this represents an increase or decrease in the size of
government. One possibility is that GDP stayed the same, and government
purchases of goods and services fell. Another is that government purchases of
goods and services grew, but at a slower rate than the GDP. One must also
consider coincident federal credit and regulatory activities and state and local
budgets.
d. The federal budget would decrease if grants-in-aid were reduced. However, if
state and local governments offset this by increasing taxes, the size of the
government sector as a whole would not go down as much as one would have
guessed.
5. The inflation erodes the real value of the debt by 0.036 x £904 billion or £32.54 billion.
The fact that inflation reduces the real debt obligation means that this figure should be
included as revenue to the government.
6. If you consider the size of government as the extent to which society’s resources are
subject to control by the government, the both Policy 1 and Policy 2 would increase the
size of government by the same amount. While it seems Policy 1 has no effect of the size
of the government because it only mandates private spending, it causes resources to be
under the control of the government. Policy 2 seems to affect the size of the government
because it changes revenues and transfers, but the cost to each household is the same as
in Policy 1, a $5000 expenditure on health insurance or in additional taxes.
7. Relative to GDP, defense spending grew from 5.0 percent of GDP in 1981 to 6.0 percent
of GDP in 1985 and then grew from 3.9 percent of GDP in 2007 to 4.7 percent of GDP
in 20011. The increase from 2007 to 2011 was proportionally larger, but both increases
were the same in terms of the percentage point increase.
8.
a. For the years 1997 to 2001, the absolute change in federal expenditures was
$261.7 billion [$1862.8 - $1,601.2 billion],
the change in federal expenditures in real terms (2001 dollars) was $146.26
billion [inflation rate = (90.727-84.628)/84.628=7.21%, $1,862 billion –
$1,601(1+0.0721)=$146.26 billion],
the change in real government expenditures per capita was $241.26 [real
government expenditures per capita in 1997 (2001 dollars):
$1,601.1*(1+1.0721)/0.227912 = $6,289.72; real government expenditures per
1-3
4.
a. If the size of government is measured by direct expenditures, the mandate does
not directly increase it. Costs of compliance, however, may be high and would
appear as an increase in a “regulatory budget.”
b. This ban would not increase government expenditures, but the high costs of
compliance would increase the regulatory budget.
c. It’s hard to say whether this represents an increase or decrease in the size of
government. One possibility is that GDP stayed the same, and government
purchases of goods and services fell. Another is that government purchases of
goods and services grew, but at a slower rate than the GDP. One must also
consider coincident federal credit and regulatory activities and state and local
budgets.
d. The federal budget would decrease if grants-in-aid were reduced. However, if
state and local governments offset this by increasing taxes, the size of the
government sector as a whole would not go down as much as one would have
guessed.
5. The inflation erodes the real value of the debt by 0.036 x £904 billion or £32.54 billion.
The fact that inflation reduces the real debt obligation means that this figure should be
included as revenue to the government.
6. If you consider the size of government as the extent to which society’s resources are
subject to control by the government, the both Policy 1 and Policy 2 would increase the
size of government by the same amount. While it seems Policy 1 has no effect of the size
of the government because it only mandates private spending, it causes resources to be
under the control of the government. Policy 2 seems to affect the size of the government
because it changes revenues and transfers, but the cost to each household is the same as
in Policy 1, a $5000 expenditure on health insurance or in additional taxes.
7. Relative to GDP, defense spending grew from 5.0 percent of GDP in 1981 to 6.0 percent
of GDP in 1985 and then grew from 3.9 percent of GDP in 2007 to 4.7 percent of GDP
in 20011. The increase from 2007 to 2011 was proportionally larger, but both increases
were the same in terms of the percentage point increase.
8.
a. For the years 1997 to 2001, the absolute change in federal expenditures was
$261.7 billion [$1862.8 - $1,601.2 billion],
the change in federal expenditures in real terms (2001 dollars) was $146.26
billion [inflation rate = (90.727-84.628)/84.628=7.21%, $1,862 billion –
$1,601(1+0.0721)=$146.26 billion],
the change in real government expenditures per capita was $241.26 [real
government expenditures per capita in 1997 (2001 dollars):
$1,601.1*(1+1.0721)/0.227912 = $6,289.72; real government expenditures per
Chapter 1 - Introduction
1-4
capita in 2001 (2001 dollars): $1862.8/0.285225 billion = $6,530.98; $6,530.98-
$6,289.72=$241.26],
and the change in expenditures per GDP is -$0.01106 billion [$601.1/$8,332.4 –
$1,862.8/$10,286.2].
For the years 2007 to 2011, the absolute change in federal expenditures was
$874.4 billion [$3,603.1 billion - $2,728.7 billion],
the change in federal expenditures in real terms (2011 dollars) was $691.9 billion
[inflation rate = (113.338-106.231)/106.231=6.69%, $3,603.1 billion –
$2728.7(1+0.10669) = $691.9 billion],
the change in real government expenditures per capita was $1,899.78 [real
government expenditures per capita in 2007 (2011 dollars):
$2,728*(1+1.10669)/0.3017 = $9,647.14;
real government expenditures per capita in 2011 (2011 dollars): [$3,603/0.3120
billion = $11,546.92; $11,546.92$9,647.14=$1,899.78],
and the change in expenditures per GDP is -$0.0442 billion [$2,728.7 /$14,028 –
$3,603.1/$15,094].
b. The health spending and “other” categories had the largest relative increases
changes from 1997 to 2001 and 2007 to 2011. Net interest had the only decrease
in spending.
1997 2001
relative
change from
1997 to 2001 2007 2011
relative
change from
2007 to 2011
Defense 285.7 321.2 12.426% 579.8 751.3 29.579%
Health 123.8 172.2 39.095% 266.4 372.5 39.827%
Medicare 190.0 217.4 14.421% 375.4 485.7 29.382%
Income secruity 235.0 269.8 14.809% 366.0 597.4 63.224%
Social Security 365.3 433.0 18.533% 586.2 730.8 24.667%
Net Interest 244.0 206.2 -15.492% 237.1 230.0 -2.995%
Other 157.3 243.1 54.545% 317.9 435.5 36.993%
9.
a. The 1997 to 2001 absolute change in federal tax revenues was $411.9 billion
(=$1991.1 - $1579.5), while from 2007 to 2011 the same change was -$264.5
billion (=$2303.5-$2568.0).
In real terms, the 1997 to 2001 change in federal tax revenues was $298.04
(inflation over period 7.21%, real change =$1991.1-($1579.2*1.0721). For 2007
1-4
capita in 2001 (2001 dollars): $1862.8/0.285225 billion = $6,530.98; $6,530.98-
$6,289.72=$241.26],
and the change in expenditures per GDP is -$0.01106 billion [$601.1/$8,332.4 –
$1,862.8/$10,286.2].
For the years 2007 to 2011, the absolute change in federal expenditures was
$874.4 billion [$3,603.1 billion - $2,728.7 billion],
the change in federal expenditures in real terms (2011 dollars) was $691.9 billion
[inflation rate = (113.338-106.231)/106.231=6.69%, $3,603.1 billion –
$2728.7(1+0.10669) = $691.9 billion],
the change in real government expenditures per capita was $1,899.78 [real
government expenditures per capita in 2007 (2011 dollars):
$2,728*(1+1.10669)/0.3017 = $9,647.14;
real government expenditures per capita in 2011 (2011 dollars): [$3,603/0.3120
billion = $11,546.92; $11,546.92$9,647.14=$1,899.78],
and the change in expenditures per GDP is -$0.0442 billion [$2,728.7 /$14,028 –
$3,603.1/$15,094].
b. The health spending and “other” categories had the largest relative increases
changes from 1997 to 2001 and 2007 to 2011. Net interest had the only decrease
in spending.
1997 2001
relative
change from
1997 to 2001 2007 2011
relative
change from
2007 to 2011
Defense 285.7 321.2 12.426% 579.8 751.3 29.579%
Health 123.8 172.2 39.095% 266.4 372.5 39.827%
Medicare 190.0 217.4 14.421% 375.4 485.7 29.382%
Income secruity 235.0 269.8 14.809% 366.0 597.4 63.224%
Social Security 365.3 433.0 18.533% 586.2 730.8 24.667%
Net Interest 244.0 206.2 -15.492% 237.1 230.0 -2.995%
Other 157.3 243.1 54.545% 317.9 435.5 36.993%
9.
a. The 1997 to 2001 absolute change in federal tax revenues was $411.9 billion
(=$1991.1 - $1579.5), while from 2007 to 2011 the same change was -$264.5
billion (=$2303.5-$2568.0).
In real terms, the 1997 to 2001 change in federal tax revenues was $298.04
(inflation over period 7.21%, real change =$1991.1-($1579.2*1.0721). For 2007
Part 1 – Getting Started
1-5
to 2011, the change in federal tax revenues was $-436.30 (inflation over period
6.69%, real change = $2303.5-$2568.0*1.0669).
The change in real tax revenues per capita for 1997 to 2001 was $778.16
(=($1991.1/.285225-$1579.2*(1.0721)/0.272958)) and for 2007 to 2011 was $-
1699.26 (=($2303.5/.312040-$2568.0*(1.0669)/0.301696)).
The change in the tax revenues per GDP from 1997 to 2001 was 0.004
(=$1991.1/10286.2-$1579.5/8332.4) and from 2007 to 2011 was 0.0530
($2303.5/15094-$2568.0/14028).
b. From 1997 to 2001, social insurance taxes had the largest relative increase. From
2007 to 2011, the excise tax had the largest relative increase. From 1997 to 2001
and 2007 to 2011, social corporate taxes revenue had the largest relative decrease.
1997 2001
relative
change from
1997 to 2001 2007 2011
relative change
from 2007 to
2011
Individual Income Tax 737.5 994.3 34.820% 1163.5 1091.5 -6.188%
Corporate Tax 182.3 151.1 -17.115% 370.2 181.1 -51.080%
Social Insurance 539.4 694.0 28.661% 869.6 818.8 -5.842%
Excise Tax 120.1 151.7 26.311% 164.7 212.1 28.780%
1-5
to 2011, the change in federal tax revenues was $-436.30 (inflation over period
6.69%, real change = $2303.5-$2568.0*1.0669).
The change in real tax revenues per capita for 1997 to 2001 was $778.16
(=($1991.1/.285225-$1579.2*(1.0721)/0.272958)) and for 2007 to 2011 was $-
1699.26 (=($2303.5/.312040-$2568.0*(1.0669)/0.301696)).
The change in the tax revenues per GDP from 1997 to 2001 was 0.004
(=$1991.1/10286.2-$1579.5/8332.4) and from 2007 to 2011 was 0.0530
($2303.5/15094-$2568.0/14028).
b. From 1997 to 2001, social insurance taxes had the largest relative increase. From
2007 to 2011, the excise tax had the largest relative increase. From 1997 to 2001
and 2007 to 2011, social corporate taxes revenue had the largest relative decrease.
1997 2001
relative
change from
1997 to 2001 2007 2011
relative change
from 2007 to
2011
Individual Income Tax 737.5 994.3 34.820% 1163.5 1091.5 -6.188%
Corporate Tax 182.3 151.1 -17.115% 370.2 181.1 -51.080%
Social Insurance 539.4 694.0 28.661% 869.6 818.8 -5.842%
Excise Tax 120.1 151.7 26.311% 164.7 212.1 28.780%
Loading page 6...
Part 1 - Getting Started
2-1
Chapter 2 – Tools of Positive Analysis
Brief Outline
1. The Role of Theory
2. Causation versus Correlation
3. Experimental Studies
a. Conducting an Experimental Study
b. Pitfalls of Experimental Studies
4. Observational Studies
a. Conducting an Observational Study
b. Pitfalls of Observational Studies
5. Quasi-Experimental Studies
a. Conducting a Quasi-Experimental Study
b. Pitfalls of Quasi-Experimental Studies
6. Conclusions
Answers to End-of-Chapter Questions
1. A change in the marginal tax rate changes the individual’s net wage. This generates both
an income effect and a substitution effect. As long as leisure is a normal good, these
effects work in opposite directions. Hence, one cannot tell a priori whether labor supply
increases or decreases. If there were no political or legal impediments, an experimental
study could be conducted in which a control group confronts the status quo, and an
experimental group faces the new tax regime. Other things that affect work effort would
impact both the control group and the experimental group, so any difference in work
effort between the two groups could be attributed to the change in marginal tax rates.
2. This is a valid criticism of the study of New York Homelessness. It reflects the problem
of causality. Two things may be correlated, but it can be difficult to determine which
causes the other. The remedy would be to set up a study in which individuals are
randomly assigned to groups. In an experimental study, the group offered job training,
counseling services, and emergency money would not necessarily be more motivated
than a group not signed up for those services, so if they do not become homeless, it could
be attributed to the programs.
3. The workers who spend time on a computer probably have other skills and abilities that
contribute to higher wages, so training children to use computers would not necessarily
cause their earnings potential to improve. This study illustrates the difficulty of
determining cause and effect based on correlations. The data do not reveal whether using
a computer causes higher earnings, or whether other factors cause workers to use
computers and to earn higher wages.
4. The text points out the pitfalls of social experiments: the problem of obtaining a random
sample and the problems of extending results beyond the scope of the experiment.
Participants in the study had found it to their advantage to be a part of the experiment,
which may have resulted in a self-selected population unrepresentative of the wider group
of health care consumers. In addition, the RAND Health Insurance Experiment was of
limited duration, after which the participants would move to some other health plan. This
2-1
Chapter 2 – Tools of Positive Analysis
Brief Outline
1. The Role of Theory
2. Causation versus Correlation
3. Experimental Studies
a. Conducting an Experimental Study
b. Pitfalls of Experimental Studies
4. Observational Studies
a. Conducting an Observational Study
b. Pitfalls of Observational Studies
5. Quasi-Experimental Studies
a. Conducting a Quasi-Experimental Study
b. Pitfalls of Quasi-Experimental Studies
6. Conclusions
Answers to End-of-Chapter Questions
1. A change in the marginal tax rate changes the individual’s net wage. This generates both
an income effect and a substitution effect. As long as leisure is a normal good, these
effects work in opposite directions. Hence, one cannot tell a priori whether labor supply
increases or decreases. If there were no political or legal impediments, an experimental
study could be conducted in which a control group confronts the status quo, and an
experimental group faces the new tax regime. Other things that affect work effort would
impact both the control group and the experimental group, so any difference in work
effort between the two groups could be attributed to the change in marginal tax rates.
2. This is a valid criticism of the study of New York Homelessness. It reflects the problem
of causality. Two things may be correlated, but it can be difficult to determine which
causes the other. The remedy would be to set up a study in which individuals are
randomly assigned to groups. In an experimental study, the group offered job training,
counseling services, and emergency money would not necessarily be more motivated
than a group not signed up for those services, so if they do not become homeless, it could
be attributed to the programs.
3. The workers who spend time on a computer probably have other skills and abilities that
contribute to higher wages, so training children to use computers would not necessarily
cause their earnings potential to improve. This study illustrates the difficulty of
determining cause and effect based on correlations. The data do not reveal whether using
a computer causes higher earnings, or whether other factors cause workers to use
computers and to earn higher wages.
4. The text points out the pitfalls of social experiments: the problem of obtaining a random
sample and the problems of extending results beyond the scope of the experiment.
Participants in the study had found it to their advantage to be a part of the experiment,
which may have resulted in a self-selected population unrepresentative of the wider group
of health care consumers. In addition, the RAND Health Insurance Experiment was of
limited duration, after which the participants would move to some other health plan. This
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Chapter 2 - Tools of Positive Analysis
2-2
design could induce certain behavior in the short-run that would not necessarily be
present if the health insurance coverage were permanent rather than transitory. Further,
physicians’ “standard practices” are largely determined by the circumstances of the
population as a whole, not the relatively small experimental group.
5. The scenario set up by the change in unemployment lends itself to a difference in
difference approach, in which the first difference is across time and the second difference
is across income level. The researcher would measure the change in unemployment
duration for high earners between the period of lower benefits and the period of higher
benefits, and then compare this change to the change for the low earners. The treatment
group would be the high earners and the control group would be the low earners. The
assumption that must hold for unbiased estimates is that in the absence of the policy
change, both the treatment and control groups would have experienced the same change
in unemployment duration across the periods preceding and following the policy change.
6. Since only five states reduced income taxes, we could examine what happened in a
control group of states (those with an income tax but with no change in the tax rates) and
compare savings rates between the two. This is important because other factors affect
savings rates, but if other factors affected both the control group and the treatment group,
then we can conclude that the treatment (lower taxes) caused the change in savings. If,
for example, the saving rate for the five states with lower taxes (the treatment group)
increased by two percent, while the savings rate for the other states (the control group)
increased by one percent, then we could conclude that lower taxes caused the saving rate
to increase by one percent—the difference between the two percent increase in the
treatment group and the one percent increase in the control group. The assumption that
must hold for this difference in difference approach to be valid is that in the absence of
the income tax cut, the savings rates of the treatment rates would have increased by the
same percentage as the savings rates of the control states.
7. Correlation does not, in general, reveal anything about causation. Spitzer is assuming that
because there is no correlation between higher marginal tax rates and slowing economic
activity in the data, that marginal tax rates can be raised without harming economic
growth. The assumption ignores that other factors could be playing in the economy that
would mitigate the effect of higher marginal tax rates. Further, current higher marginal
tax rates could imply lower future economic growth, which may not be reflected in the
data to which he was referring.
8. There is a weak, positive relationship between deficits and interest rates, implying that
larger deficits lead to lower interest rates. Inferences based on these data along would be
problematic because there are only a few data points and because it would be more
informative to look at deficits relative to some benchmark, such as GDP, and to express
both interest rates and deficits in real terms, rather than nominal terms. It would also be
useful to control for other factors that can affect interest rates, such as monetary policy
and the level of economic activity. Most importantly, the correlation found here does not
necessarily indicate a causal relationship.
2-2
design could induce certain behavior in the short-run that would not necessarily be
present if the health insurance coverage were permanent rather than transitory. Further,
physicians’ “standard practices” are largely determined by the circumstances of the
population as a whole, not the relatively small experimental group.
5. The scenario set up by the change in unemployment lends itself to a difference in
difference approach, in which the first difference is across time and the second difference
is across income level. The researcher would measure the change in unemployment
duration for high earners between the period of lower benefits and the period of higher
benefits, and then compare this change to the change for the low earners. The treatment
group would be the high earners and the control group would be the low earners. The
assumption that must hold for unbiased estimates is that in the absence of the policy
change, both the treatment and control groups would have experienced the same change
in unemployment duration across the periods preceding and following the policy change.
6. Since only five states reduced income taxes, we could examine what happened in a
control group of states (those with an income tax but with no change in the tax rates) and
compare savings rates between the two. This is important because other factors affect
savings rates, but if other factors affected both the control group and the treatment group,
then we can conclude that the treatment (lower taxes) caused the change in savings. If,
for example, the saving rate for the five states with lower taxes (the treatment group)
increased by two percent, while the savings rate for the other states (the control group)
increased by one percent, then we could conclude that lower taxes caused the saving rate
to increase by one percent—the difference between the two percent increase in the
treatment group and the one percent increase in the control group. The assumption that
must hold for this difference in difference approach to be valid is that in the absence of
the income tax cut, the savings rates of the treatment rates would have increased by the
same percentage as the savings rates of the control states.
7. Correlation does not, in general, reveal anything about causation. Spitzer is assuming that
because there is no correlation between higher marginal tax rates and slowing economic
activity in the data, that marginal tax rates can be raised without harming economic
growth. The assumption ignores that other factors could be playing in the economy that
would mitigate the effect of higher marginal tax rates. Further, current higher marginal
tax rates could imply lower future economic growth, which may not be reflected in the
data to which he was referring.
8. There is a weak, positive relationship between deficits and interest rates, implying that
larger deficits lead to lower interest rates. Inferences based on these data along would be
problematic because there are only a few data points and because it would be more
informative to look at deficits relative to some benchmark, such as GDP, and to express
both interest rates and deficits in real terms, rather than nominal terms. It would also be
useful to control for other factors that can affect interest rates, such as monetary policy
and the level of economic activity. Most importantly, the correlation found here does not
necessarily indicate a causal relationship.
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Part 1 - Getting Started
3-1
Chapter 3 – Tools of Normative Analysis
Brief Outline
1. Welfare Economics
a. Pure Economy Exchange
b. Production Economy
2. The First Fundamental Theorem of Welfare Economics
3. Fairness and the Second Fundamental Theorem of Welfare Economics
4. Market Failure
a. Market Power
b. Nonexistence of Markets
c. Overview
5. Buying into Welfare Economics
Answers to End-of-Chapter Questions
1.
a. In this particular insurance market, one would not expect asymmetric information
to be much of a problem – the probability of a hurricane is common knowledge.
Moral hazard could be an issue – people are more likely to build near a beach if
they have hurricane insurance. Still, one would expect the market for hurricane
insurance to operate fairly efficiently.
b. There is substantial asymmetric information in the markets for medical insurance
for consumers and also malpractice insurance for physicians. For efficient
consumption, the price must be equal to the marginal cost, and the effect of
insurance may be to reduce the perceived price of medical care consumption.
That would lead to consumption above the efficient level. Because of the roles of
regulation, insurance, taxes, and the shifting of costs from the uninsured to the
insured, there is little reason to expect the market to be efficient.
c. In the stock market, there is good information and thousands of buyers and
sellers. We expect, in general, efficient outcomes.
d. From a national standpoint, there is a good deal of competition and information
with regards to MP3 players and music. The outcome will likely be efficient for
MP3 players and music. However, some firms might exercise some market
power through high brand awareness and proprietary downloading systems.
e. The private market allocation is likely inefficient without government
intervention. Student loan markets may suffer from asymmetric information – the
student knows better than the lender whether he will repay the loan or default on
it, a form of adverse selection. Government intervention does not “solve” the
adverse selection problem in this case (because participation in the student loan
program is not compulsory), but it may create a market that would not exist
without intervention.
3-1
Chapter 3 – Tools of Normative Analysis
Brief Outline
1. Welfare Economics
a. Pure Economy Exchange
b. Production Economy
2. The First Fundamental Theorem of Welfare Economics
3. Fairness and the Second Fundamental Theorem of Welfare Economics
4. Market Failure
a. Market Power
b. Nonexistence of Markets
c. Overview
5. Buying into Welfare Economics
Answers to End-of-Chapter Questions
1.
a. In this particular insurance market, one would not expect asymmetric information
to be much of a problem – the probability of a hurricane is common knowledge.
Moral hazard could be an issue – people are more likely to build near a beach if
they have hurricane insurance. Still, one would expect the market for hurricane
insurance to operate fairly efficiently.
b. There is substantial asymmetric information in the markets for medical insurance
for consumers and also malpractice insurance for physicians. For efficient
consumption, the price must be equal to the marginal cost, and the effect of
insurance may be to reduce the perceived price of medical care consumption.
That would lead to consumption above the efficient level. Because of the roles of
regulation, insurance, taxes, and the shifting of costs from the uninsured to the
insured, there is little reason to expect the market to be efficient.
c. In the stock market, there is good information and thousands of buyers and
sellers. We expect, in general, efficient outcomes.
d. From a national standpoint, there is a good deal of competition and information
with regards to MP3 players and music. The outcome will likely be efficient for
MP3 players and music. However, some firms might exercise some market
power through high brand awareness and proprietary downloading systems.
e. The private market allocation is likely inefficient without government
intervention. Student loan markets may suffer from asymmetric information – the
student knows better than the lender whether he will repay the loan or default on
it, a form of adverse selection. Government intervention does not “solve” the
adverse selection problem in this case (because participation in the student loan
program is not compulsory), but it may create a market that would not exist
without intervention.
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Chapter 3 - Tools of Normative Analysis
3-2
f. The market for housing is likely to be relatively efficient. Some inefficiencies
may exist, such as asymmetric information—the seller knows more about the
house than the buyer—and differentiated products. But, the market has developed
to mitigate these inefficiencies. For example, a buyer can employ a home
inspector to help him understand more about the quality of the home. Also, a
large number of homes on the market increases competition.
2. The social welfare function of W=f(Ua, Ub) implies that the welfare of society depends on
the utility of the individuals. It does not imply that the utility of the individual depends
on the welfare of society as then-Senator Obama’s comment suggests.
3. The First Theorem of Welfare Economics says that market transactions only occur when
the transactions would be in the best interest of both parties. In contrast, the psychologist
seems to view the kidney market as hurting one or both parties involved.
4. If insurers in California could no longer use location to determine automobile insurance
rates, some of the higher costs incurred by urban residents would be shifted to rural and
suburban residents. This change would reduce efficiency, but the purpose of the policy is
to improve equity, based on an argument that it is unfair that urban residents should have
to pay more for insurance because they are more likely to be involved in accidents.
Social welfare increases if the additional utility enjoyed by urban residents offsets the
loss in utility to rural and suburban residents.
5.
a. Point A is the initial allocation.
b. Given the initial allocation in the Edgeworth Box above, one can see that both the
seller and buyer can reach a higher indifference curve at point B by trading tickets
Other goods Other goods
Tickets
TicketsBuyer
Seller
A
B
3-2
f. The market for housing is likely to be relatively efficient. Some inefficiencies
may exist, such as asymmetric information—the seller knows more about the
house than the buyer—and differentiated products. But, the market has developed
to mitigate these inefficiencies. For example, a buyer can employ a home
inspector to help him understand more about the quality of the home. Also, a
large number of homes on the market increases competition.
2. The social welfare function of W=f(Ua, Ub) implies that the welfare of society depends on
the utility of the individuals. It does not imply that the utility of the individual depends
on the welfare of society as then-Senator Obama’s comment suggests.
3. The First Theorem of Welfare Economics says that market transactions only occur when
the transactions would be in the best interest of both parties. In contrast, the psychologist
seems to view the kidney market as hurting one or both parties involved.
4. If insurers in California could no longer use location to determine automobile insurance
rates, some of the higher costs incurred by urban residents would be shifted to rural and
suburban residents. This change would reduce efficiency, but the purpose of the policy is
to improve equity, based on an argument that it is unfair that urban residents should have
to pay more for insurance because they are more likely to be involved in accidents.
Social welfare increases if the additional utility enjoyed by urban residents offsets the
loss in utility to rural and suburban residents.
5.
a. Point A is the initial allocation.
b. Given the initial allocation in the Edgeworth Box above, one can see that both the
seller and buyer can reach a higher indifference curve at point B by trading tickets
Other goods Other goods
Tickets
TicketsBuyer
Seller
A
B
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Part 1 - Getting Started
3-3
and other goods without either person being worse off. Therefore, the current
allocation is inefficient.
c. A situation in which the original allocation is efficient and the trading does not
affect efficiency is shown below at point A.
6.
a. Social indifference curves are straight lines with slope of –1. As far as society is
concerned, the “util” to Augustus is equivalent to the “util” to Livia.
Other goods Other goods
Tickets
TicketsBuyer
Seller
A
3-3
and other goods without either person being worse off. Therefore, the current
allocation is inefficient.
c. A situation in which the original allocation is efficient and the trading does not
affect efficiency is shown below at point A.
6.
a. Social indifference curves are straight lines with slope of –1. As far as society is
concerned, the “util” to Augustus is equivalent to the “util” to Livia.
Other goods Other goods
Tickets
TicketsBuyer
Seller
A
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Chapter 3 - Tools of Normative Analysis
3-4
b. Social indifference curves are straight lines with slope of –2. This reflects the fact
that society values a “util” to Augustus twice as much as a “util” to Livia.
c.
3-4
b. Social indifference curves are straight lines with slope of –2. This reflects the fact
that society values a “util” to Augustus twice as much as a “util” to Livia.
c.
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Part 1 - Getting Started
3-5
7. Musgrave (1959) developed the concept of merit goods to describe commodities that
ought to be provided even if the members of society do not demand them. “Sin taxes”
work the opposite way and apply to commodities that members of society might demand,
but ought not to have.
8.
a. There is no obvious reason why there is a market failure with burglar alarm calls;
the Los Angeles police could set a response fee equal to the marginal cost.
b. There is no obvious reason that the production of a documentary film about rock
music and the fall of the Soviet Union would improve welfare in the United
States.
c. There is no economic reason why cherry pies should be regulated, especially
since there are no such regulations for apple, blueberry, or peach frozen pies.
d. It is hard to imagine a basis in welfare economics for this guarantee to the
domestic sugar producers, unless the utilities of sugar producers are given great
weight in the social welfare function.
e. This is not an efficient policy. If the problem is that too much water is being
consumed, then the answer is to increase the price of water. On that basis, people
can decide whether or not they want to buy toilets that require less water. Water,
like most other resources, is a private good.
f. There is no obvious reason that the preservation of video game history would
improve welfare.
9. In this case, the “Edgeworth Box” is actually a line because there is only one good on the
island. The set of possible allocations is a straight line, 100 units long. Every allocation
is Pareto efficient, because the only way to make one person better off is to make another
person worse off. There is no theory in the text to help us decide whether an allocation is
fair. Although splitting the peanuts even between the people may be fair, it may not be
fair if the calorie “needs” of the people are different. With a social welfare function, we
can make assessments on whether redistribution for society as a whole is a good thing.
10. Social welfare is maximized when Mark’s marginal utility of income is equal to Judy’s
marginal utility of income. Taking the derivative of Mark’s utility function to find his
marginal utility function yields MUM = 50/(IM1/2) and taking the derivative of Judy’s
utility function yields MUJ = 100/(IJ1/2). If we set MUM equal to MUJ, the condition for
maximization becomes IJ = 4IM and, since the fixed amount of income is $300, this
means that Mark should have $60 and Judy should have $240 if the goal is to maximize
social welfare = UM + UJ.
3-5
7. Musgrave (1959) developed the concept of merit goods to describe commodities that
ought to be provided even if the members of society do not demand them. “Sin taxes”
work the opposite way and apply to commodities that members of society might demand,
but ought not to have.
8.
a. There is no obvious reason why there is a market failure with burglar alarm calls;
the Los Angeles police could set a response fee equal to the marginal cost.
b. There is no obvious reason that the production of a documentary film about rock
music and the fall of the Soviet Union would improve welfare in the United
States.
c. There is no economic reason why cherry pies should be regulated, especially
since there are no such regulations for apple, blueberry, or peach frozen pies.
d. It is hard to imagine a basis in welfare economics for this guarantee to the
domestic sugar producers, unless the utilities of sugar producers are given great
weight in the social welfare function.
e. This is not an efficient policy. If the problem is that too much water is being
consumed, then the answer is to increase the price of water. On that basis, people
can decide whether or not they want to buy toilets that require less water. Water,
like most other resources, is a private good.
f. There is no obvious reason that the preservation of video game history would
improve welfare.
9. In this case, the “Edgeworth Box” is actually a line because there is only one good on the
island. The set of possible allocations is a straight line, 100 units long. Every allocation
is Pareto efficient, because the only way to make one person better off is to make another
person worse off. There is no theory in the text to help us decide whether an allocation is
fair. Although splitting the peanuts even between the people may be fair, it may not be
fair if the calorie “needs” of the people are different. With a social welfare function, we
can make assessments on whether redistribution for society as a whole is a good thing.
10. Social welfare is maximized when Mark’s marginal utility of income is equal to Judy’s
marginal utility of income. Taking the derivative of Mark’s utility function to find his
marginal utility function yields MUM = 50/(IM1/2) and taking the derivative of Judy’s
utility function yields MUJ = 100/(IJ1/2). If we set MUM equal to MUJ, the condition for
maximization becomes IJ = 4IM and, since the fixed amount of income is $300, this
means that Mark should have $60 and Judy should have $240 if the goal is to maximize
social welfare = UM + UJ.
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Chapter 3 - Tools of Normative Analysis
3-6
11.
a. If the food is evenly distributed between Tang and Wilson, Tang will have 14.14
units of utility and Wilson will have 7.07 units of utility.
b. If the social welfare function is UT+UW, then the marginal utilities of both should
be equal to maximize social welfare. Equate MUT=1/(2FT1/2) to MUW=1/(4FW1/2)
and substitute FT=400-FW. Therefore, FT=320 and FW=80.
c. If the utility of both Tang and Wilson must be equal, then set UT=UW and
substitute FT=400-FW and solve. Therefore, FT=80 and FW=320.
12. Although Victoria’s marginal rate of substitution is equal to Albert’s, these are not equal
to the marginal rate of transformation and the allocation is, therefore, Pareto inefficient.
Both people would give up 2 cups of tea for 1 crumpet but, according to the production
function, could actually get 6 crumpets by giving up 2 cups of tea. By giving up tea and
getting crumpets through the production function, both utilities are raised.
13.
a. The marginal rates of substitution for coffee and for tea are constant for both
Hannah and Jose. Hannah would trade ¼ pound of coffee for 1/3 pound of tea to
remain equally satisfied. Similarly, Jose would trade ¼ pound of tea for 1/3
pound of coffee to remain equally satisfied. The constant MRS means linear
indifference curves
b. Green indifference curves are Jose’s and red indifference curves are Hannah’s.
Coffee
Tea
Tea
Hannah
Jose
Coffee
15
13
1110
3-6
11.
a. If the food is evenly distributed between Tang and Wilson, Tang will have 14.14
units of utility and Wilson will have 7.07 units of utility.
b. If the social welfare function is UT+UW, then the marginal utilities of both should
be equal to maximize social welfare. Equate MUT=1/(2FT1/2) to MUW=1/(4FW1/2)
and substitute FT=400-FW. Therefore, FT=320 and FW=80.
c. If the utility of both Tang and Wilson must be equal, then set UT=UW and
substitute FT=400-FW and solve. Therefore, FT=80 and FW=320.
12. Although Victoria’s marginal rate of substitution is equal to Albert’s, these are not equal
to the marginal rate of transformation and the allocation is, therefore, Pareto inefficient.
Both people would give up 2 cups of tea for 1 crumpet but, according to the production
function, could actually get 6 crumpets by giving up 2 cups of tea. By giving up tea and
getting crumpets through the production function, both utilities are raised.
13.
a. The marginal rates of substitution for coffee and for tea are constant for both
Hannah and Jose. Hannah would trade ¼ pound of coffee for 1/3 pound of tea to
remain equally satisfied. Similarly, Jose would trade ¼ pound of tea for 1/3
pound of coffee to remain equally satisfied. The constant MRS means linear
indifference curves
b. Green indifference curves are Jose’s and red indifference curves are Hannah’s.
Coffee
Tea
Tea
Hannah
Jose
Coffee
15
13
1110
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Part 1 - Getting Started
3-7
c. The contract curve follows the bottom and right borders of the Edgeworth Box. At
any interior point in the box, the parties will find it in their interest to trade until
they reach these borders. This is because Hannah would only choose to consume
tea once she has consumed all the coffee in the economy. Likewise, Jose would
only choose to consume coffee once he has consumed all the tea in the economy.
d. The initial allocation is not Pareto efficient. It is possible to make one better off
without making the other worse off.
14.
a. False. As shown in the text, equality of the marginal rates of substitution is a
necessary, but not sufficient, condition. The MRS for each individual must also
equal the MRT.
b. Uncertain. As long as the allocation is an interior solution in the Edgeworth box,
the marginal rates of substitution must be equal across individuals. This need not
be true, however, at the corners where one consumer has all the goods in the
economy.
c. False. A policy that leads to a Pareto improvement results in greater efficiency,
but social welfare depends on equity as well as efficiency. A policy that improves
efficiency but creates a loss in equity might reduce social welfare.
d. False. Moving to a point on the utility possibilities curve may not result in a
Pareto improvement because one party may receive less utility on the curve than
they received at the interior point.
3-7
c. The contract curve follows the bottom and right borders of the Edgeworth Box. At
any interior point in the box, the parties will find it in their interest to trade until
they reach these borders. This is because Hannah would only choose to consume
tea once she has consumed all the coffee in the economy. Likewise, Jose would
only choose to consume coffee once he has consumed all the tea in the economy.
d. The initial allocation is not Pareto efficient. It is possible to make one better off
without making the other worse off.
14.
a. False. As shown in the text, equality of the marginal rates of substitution is a
necessary, but not sufficient, condition. The MRS for each individual must also
equal the MRT.
b. Uncertain. As long as the allocation is an interior solution in the Edgeworth box,
the marginal rates of substitution must be equal across individuals. This need not
be true, however, at the corners where one consumer has all the goods in the
economy.
c. False. A policy that leads to a Pareto improvement results in greater efficiency,
but social welfare depends on equity as well as efficiency. A policy that improves
efficiency but creates a loss in equity might reduce social welfare.
d. False. Moving to a point on the utility possibilities curve may not result in a
Pareto improvement because one party may receive less utility on the curve than
they received at the interior point.
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Part 2 – Public Expenditure: Public Goods and Externalities
4-1
Chapter 4 – Public Goods
Brief Outline
1. Public Goods Defined
2. Efficient Provision of Public Goods
a. Deriving the Efficiency Condition
b. Problems in Achieving Efficiency
c. The Free Rider Problem
3. Privatization
a. Public versus Private Provision
b. Public versus Private Production
4. Public Goods and Public Choice
Answers to End-of-Chapter Questions
1.
a. Wilderness area is an impure public good – at some point, consumption becomes
nonrival; it is, however, nonexcludable.
b. Satellite television is nonrival in consumption, although it is excludable; therefore
it is an impure public good.
c. Medical school education is a private good.
d. Television signals are nonrival in consumption and not excludable (when
broadcast over the air). Therefore, they are a public good.
e. An automatic teller machine is rival in consumption, at least at peak times. It is
also excludable as only those patrons with ATM cards that are accepted by the
machine can use the machine. Therefore the ATM is a private good.
2.
a. False. Efficient provision of a public good occurs at the level where total
willingness to pay for an additional unit equals the marginal cost of producing the
additional unit.
b. False. Due to the free rider problem, it is unlikely that a private business firm
could profitably sell a product that is non-excludable. However, recent research
reveals that the free rider problem is an empirical question and that we should not
take the answer for granted. Public goods may be privately supported through
volunteerism, such as when people who attend a fireworks display voluntarily
contribute enough to pay for the show.
c. Uncertain. This statement is true if the road is not congested, but when there is
heavy traffic, adding another vehicle can interfere with the drivers already using
the road.
d. False. There will be more users in larger communities, but all users have access
to the quantity that has been provided since the good is nonrival, so there is no
4-1
Chapter 4 – Public Goods
Brief Outline
1. Public Goods Defined
2. Efficient Provision of Public Goods
a. Deriving the Efficiency Condition
b. Problems in Achieving Efficiency
c. The Free Rider Problem
3. Privatization
a. Public versus Private Provision
b. Public versus Private Production
4. Public Goods and Public Choice
Answers to End-of-Chapter Questions
1.
a. Wilderness area is an impure public good – at some point, consumption becomes
nonrival; it is, however, nonexcludable.
b. Satellite television is nonrival in consumption, although it is excludable; therefore
it is an impure public good.
c. Medical school education is a private good.
d. Television signals are nonrival in consumption and not excludable (when
broadcast over the air). Therefore, they are a public good.
e. An automatic teller machine is rival in consumption, at least at peak times. It is
also excludable as only those patrons with ATM cards that are accepted by the
machine can use the machine. Therefore the ATM is a private good.
2.
a. False. Efficient provision of a public good occurs at the level where total
willingness to pay for an additional unit equals the marginal cost of producing the
additional unit.
b. False. Due to the free rider problem, it is unlikely that a private business firm
could profitably sell a product that is non-excludable. However, recent research
reveals that the free rider problem is an empirical question and that we should not
take the answer for granted. Public goods may be privately supported through
volunteerism, such as when people who attend a fireworks display voluntarily
contribute enough to pay for the show.
c. Uncertain. This statement is true if the road is not congested, but when there is
heavy traffic, adding another vehicle can interfere with the drivers already using
the road.
d. False. There will be more users in larger communities, but all users have access
to the quantity that has been provided since the good is nonrival, so there is no
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Chapter 4 – Public Goods
4-2
reasons larger communities would necessarily have to provide a larger quantity of
the nonrival good.
3. We assume that Cheetah’s utility does not enter the social welfare function; hence, her
allocation of labor supply across activities does not matter.
a. The public good is patrol; the private good is fruit.
b. Recall that efficiency requires MRSTARZAN + MRSJANE = MRT. MRSTARZAN =
MRSJANE = 2. But MRT = 3. Therefore, MRSTARZAN + MRSJANE MRT. To
achieve an efficient allocation, Cheetah should patrol more.
4. The Search for Extra-Terrestrial Intelligence is a public good because it is nonrival and
presumably non-excludable. The government should pay for the research only if the
SMB is greater than the SMC.
5. Wine and liquor are both rival and excludable goods, so public sector production is not
justified on the basis of public goods. Therefore, it makes no economic sense to have
public production.
6. It is unlikely that if Pemex were privatized that the situation would lead to a monopoly
situation. Comparing oil production to telephone service is not a correct comparison. In
the case of the telephone company, there was only one provider of telephone service. In
the case of oil production, there would be only one producer in Mexico, but many
competitors providing oil from which Mexico could buy. The newly privatized company
would have to compete to sell its goods. It would likely become more efficient than the
state run company because of this competition.
7. These amenities being present in private airports alone would not be enough to
recommend that airports be privately run. If fliers desire such amenities, it is not clear
that they cannot be provided in public airports via renting space. One would also need
information on the cost of running the airports and distributional issues that might exist
for publicly run airports versus privately run airports before recommending that airports
be privately run.
8. The experimental results on free-riding suggest that members of the community might
voluntarily contribute about half of the required amount. The reason these citizens
wanted to use private fundraising was because the state government redistributed tax
dollars from wealthy districts to poor districts (the so-called Robin Hood plan), so using
private donations was a way to avoid losing tax dollars to other districts.
9. Books are not a public good. They are both rival (two people cannot read a book at the
same time) and excludable (you can keep a person from reading a book). But if the goods
libraries provide are a sense of community or a better educated populace, these would
qualify as public goods. If the public good aspect of the library is to produce a better
educated populace, then perhaps the classic books are a better choice.
4-2
reasons larger communities would necessarily have to provide a larger quantity of
the nonrival good.
3. We assume that Cheetah’s utility does not enter the social welfare function; hence, her
allocation of labor supply across activities does not matter.
a. The public good is patrol; the private good is fruit.
b. Recall that efficiency requires MRSTARZAN + MRSJANE = MRT. MRSTARZAN =
MRSJANE = 2. But MRT = 3. Therefore, MRSTARZAN + MRSJANE MRT. To
achieve an efficient allocation, Cheetah should patrol more.
4. The Search for Extra-Terrestrial Intelligence is a public good because it is nonrival and
presumably non-excludable. The government should pay for the research only if the
SMB is greater than the SMC.
5. Wine and liquor are both rival and excludable goods, so public sector production is not
justified on the basis of public goods. Therefore, it makes no economic sense to have
public production.
6. It is unlikely that if Pemex were privatized that the situation would lead to a monopoly
situation. Comparing oil production to telephone service is not a correct comparison. In
the case of the telephone company, there was only one provider of telephone service. In
the case of oil production, there would be only one producer in Mexico, but many
competitors providing oil from which Mexico could buy. The newly privatized company
would have to compete to sell its goods. It would likely become more efficient than the
state run company because of this competition.
7. These amenities being present in private airports alone would not be enough to
recommend that airports be privately run. If fliers desire such amenities, it is not clear
that they cannot be provided in public airports via renting space. One would also need
information on the cost of running the airports and distributional issues that might exist
for publicly run airports versus privately run airports before recommending that airports
be privately run.
8. The experimental results on free-riding suggest that members of the community might
voluntarily contribute about half of the required amount. The reason these citizens
wanted to use private fundraising was because the state government redistributed tax
dollars from wealthy districts to poor districts (the so-called Robin Hood plan), so using
private donations was a way to avoid losing tax dollars to other districts.
9. Books are not a public good. They are both rival (two people cannot read a book at the
same time) and excludable (you can keep a person from reading a book). But if the goods
libraries provide are a sense of community or a better educated populace, these would
qualify as public goods. If the public good aspect of the library is to produce a better
educated populace, then perhaps the classic books are a better choice.
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Part 2 – Public Expenditure: Public Goods and Externalities
4-3
10. Hiring private military firms to provide military support in Afghanistan, Iraq, or Darfur
would be similar to the example of airport security in the text. One might argue that a
private firm would not provide adequate training, use unethical or especially aggressive
methods to shorten the conflict, thus lowering costs to increase profits. Proponents
would argue that such things could be stipulated in a well-written contract. However, no
contract can specify every possible contingency. In high conflict situations this may be
especially true as the opposing side will not be predictable.
11.
a. Zach’s marginal benefit schedule shows that the marginal benefit of a lighthouse
starts at $90 and declines, and Jacob’s marginal benefit starts at $40 and declines.
Neither person values the first lighthouse at its marginal cost of $100, so neither
person would be willing to pay for a lighthouse acting alone.
b. Zach’s marginal benefit is MBZACH=90-Q, and Jacob’s is MBJACOB=40-Q. The
marginal benefit for society as a whole is the sum of the two marginal benefits, or
MB=130-2Q (for Q≤40), and is equal to Zach’s marginal benefit schedule
afterwards (for Q>40). The marginal cost is constant at MC=100, so the
intersection of aggregate marginal benefit and marginal cost occurs at a quantity
less than 40. Setting MB=MC gives 130-2Q=100, or Q=15. Net benefit can be
measured as the area between the demand curve and the marginal benefit of the
15th unit. The net benefit is $112.5 for each person, for a total of $225.
12. Each day the private decision of each shepherd would equate private cost with private
benefit. Therefore, 7 would show up because then each shepherd would graze four
sheep. If the shepherds graze less than four sheep, then they will stay home. The net
benefits to society are 0 sheep (the benefit to the seven shepherds is 4 sheep (7x4=28) and
the cost to society is 4 sheep per shepherd (7x4=28)). The efficient number of shepherds
to show up at the meadow is the number that will maximize social net benefits, which
happens where the social marginal benefit equals the social marginal cost. This occurs at
four shepherds, where the net social benefits equal 12 sheep (4x7 – 4x4). Access to the
meadow is an impure public good. It is rival – if one shepherd has access to the meadow,
the others have less access. It is, however, non-excludable because it is difficult to keep
shepherd from grazing the meadow.
13. Britney’s marginal benefit is MBBRITNEY=12-Z, and Paris’s is MBPARIS=8-2Z. The
marginal benefit for society as a whole is the sum of the two marginal benefits, or
MB=20-3Z (for Z≤4), and is equal to Britney’s marginal benefit schedule afterwards (for
Z>4). The marginal cost is constant at MC=16. Setting MB=MC along the first segment
gives 20-3Z=16, or Z=4/3, which is the efficient level of snowplowing. Note that if
either Britney or Paris had to pay for the entire cost herself, no snowplowing would occur
since the marginal cost of $16 exceeds either of their individual marginal benefits from
the first unit ($12 or $8). Thus, this is clearly a situation when the private market does
not work very well. Also note, however, that if the marginal cost were somewhat lower,
(e.g., MC≤8), then it is possible that Paris could credibly free ride, and Britney would
provide the efficient allocation. This occurs because if Britney believes that Paris will
free ride, Britney provides her optimal allocation, which occurs on the second segment of
society’s MB curve, which is identical to Britney’s MB curve (note that Paris gets zero
4-3
10. Hiring private military firms to provide military support in Afghanistan, Iraq, or Darfur
would be similar to the example of airport security in the text. One might argue that a
private firm would not provide adequate training, use unethical or especially aggressive
methods to shorten the conflict, thus lowering costs to increase profits. Proponents
would argue that such things could be stipulated in a well-written contract. However, no
contract can specify every possible contingency. In high conflict situations this may be
especially true as the opposing side will not be predictable.
11.
a. Zach’s marginal benefit schedule shows that the marginal benefit of a lighthouse
starts at $90 and declines, and Jacob’s marginal benefit starts at $40 and declines.
Neither person values the first lighthouse at its marginal cost of $100, so neither
person would be willing to pay for a lighthouse acting alone.
b. Zach’s marginal benefit is MBZACH=90-Q, and Jacob’s is MBJACOB=40-Q. The
marginal benefit for society as a whole is the sum of the two marginal benefits, or
MB=130-2Q (for Q≤40), and is equal to Zach’s marginal benefit schedule
afterwards (for Q>40). The marginal cost is constant at MC=100, so the
intersection of aggregate marginal benefit and marginal cost occurs at a quantity
less than 40. Setting MB=MC gives 130-2Q=100, or Q=15. Net benefit can be
measured as the area between the demand curve and the marginal benefit of the
15th unit. The net benefit is $112.5 for each person, for a total of $225.
12. Each day the private decision of each shepherd would equate private cost with private
benefit. Therefore, 7 would show up because then each shepherd would graze four
sheep. If the shepherds graze less than four sheep, then they will stay home. The net
benefits to society are 0 sheep (the benefit to the seven shepherds is 4 sheep (7x4=28) and
the cost to society is 4 sheep per shepherd (7x4=28)). The efficient number of shepherds
to show up at the meadow is the number that will maximize social net benefits, which
happens where the social marginal benefit equals the social marginal cost. This occurs at
four shepherds, where the net social benefits equal 12 sheep (4x7 – 4x4). Access to the
meadow is an impure public good. It is rival – if one shepherd has access to the meadow,
the others have less access. It is, however, non-excludable because it is difficult to keep
shepherd from grazing the meadow.
13. Britney’s marginal benefit is MBBRITNEY=12-Z, and Paris’s is MBPARIS=8-2Z. The
marginal benefit for society as a whole is the sum of the two marginal benefits, or
MB=20-3Z (for Z≤4), and is equal to Britney’s marginal benefit schedule afterwards (for
Z>4). The marginal cost is constant at MC=16. Setting MB=MC along the first segment
gives 20-3Z=16, or Z=4/3, which is the efficient level of snowplowing. Note that if
either Britney or Paris had to pay for the entire cost herself, no snowplowing would occur
since the marginal cost of $16 exceeds either of their individual marginal benefits from
the first unit ($12 or $8). Thus, this is clearly a situation when the private market does
not work very well. Also note, however, that if the marginal cost were somewhat lower,
(e.g., MC≤8), then it is possible that Paris could credibly free ride, and Britney would
provide the efficient allocation. This occurs because if Britney believes that Paris will
free ride, Britney provides her optimal allocation, which occurs on the second segment of
society’s MB curve, which is identical to Britney’s MB curve (note that Paris gets zero
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Chapter 4 – Public Goods
4-4
marginal benefit for Z>4). Since Paris is completely satiated with this good at Z=4, her
threat to free ride is credit if Britney provides Z>4. See the graph below.
MBBritney
MBParis
4-4
marginal benefit for Z>4). Since Paris is completely satiated with this good at Z=4, her
threat to free ride is credit if Britney provides Z>4. See the graph below.
MBBritney
MBParis
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Part 2 – Public Expenditure: Public Goods and Externalities
5-1
Chapter 5 – Externalities
Brief Outline
1. The Nature of Externalities
2. Graphical Analysis
a. Implications
b. Conclusion
3. Private Responses
a. Bargaining and the Coase Theorem
b. Mergers
c. Social Conventions
4. Public Responses to Externalities: Taxes and Subsidies
a. Taxes
b. Subsidies
5. Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
a. Emissions Fee
b. Cap-and-Trade
c. Emissions Fee versus Cap-and-Trade
d. Command-and-Control Regulation
6. The US Response
a. Progress with Incentive-Based Approaches
7. Implications for Income Distributions
a. Who Benefits?
b. Who Bears the Cost?
8. Positive Externalities
a. A Cautionary Note
Answers to End-of-Chapter Questions
1. Before passengers were charged for checked bags, they would choose whether to check
bags or carry them on based on whether they were willing to trade time for the hassle of
dealing with carry-on bags. That is, passengers who valued saving time by not having to
deal with baggage claim more than the cost of dealing with carry-on baggage will choose
to carry on. The fact that passengers are now charged for checked baggage but not for
baggage carried onto the plane will inefficiently allocate overhead space. Passengers will
carry on more and bigger bags to save the fee charged, resulting in full overhead luggage
containers. Overhead space will go to the first passengers on the plane, rather than being
distributed more evenly. Bags checked (without a charge) at the gate forces some who
would choose to carry on even without the fee to have to check, which is a loss in
efficiency. Those who elect to carry on to avoid the fee, but would rather check their
bags, also result in an inefficiency.
2. The Coase theorem suggests that the church and the comedy club could negotiate. If the
church possessed the right to the “noise” in the building, the comedy club could pay the
church to be quiet. If the comedy club possessed the right to quiet in the building, the
church could compensate the club for the noise.
5-1
Chapter 5 – Externalities
Brief Outline
1. The Nature of Externalities
2. Graphical Analysis
a. Implications
b. Conclusion
3. Private Responses
a. Bargaining and the Coase Theorem
b. Mergers
c. Social Conventions
4. Public Responses to Externalities: Taxes and Subsidies
a. Taxes
b. Subsidies
5. Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
a. Emissions Fee
b. Cap-and-Trade
c. Emissions Fee versus Cap-and-Trade
d. Command-and-Control Regulation
6. The US Response
a. Progress with Incentive-Based Approaches
7. Implications for Income Distributions
a. Who Benefits?
b. Who Bears the Cost?
8. Positive Externalities
a. A Cautionary Note
Answers to End-of-Chapter Questions
1. Before passengers were charged for checked bags, they would choose whether to check
bags or carry them on based on whether they were willing to trade time for the hassle of
dealing with carry-on bags. That is, passengers who valued saving time by not having to
deal with baggage claim more than the cost of dealing with carry-on baggage will choose
to carry on. The fact that passengers are now charged for checked baggage but not for
baggage carried onto the plane will inefficiently allocate overhead space. Passengers will
carry on more and bigger bags to save the fee charged, resulting in full overhead luggage
containers. Overhead space will go to the first passengers on the plane, rather than being
distributed more evenly. Bags checked (without a charge) at the gate forces some who
would choose to carry on even without the fee to have to check, which is a loss in
efficiency. Those who elect to carry on to avoid the fee, but would rather check their
bags, also result in an inefficiency.
2. The Coase theorem suggests that the church and the comedy club could negotiate. If the
church possessed the right to the “noise” in the building, the comedy club could pay the
church to be quiet. If the comedy club possessed the right to quiet in the building, the
church could compensate the club for the noise.
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Chapter 5 - Externalities
5-2
3. It is the case that a carbon tax would be passed on to the consumer. The tax raises costs
to the producer for producing the final good. These increased costs would decrease
supply, which will increase the price of that final good. In a cap and trade system,
businesses must purchase permits in order to emit carbon. If the cost of purchasing and
using abatement equipment is less than the cost of buying a permit, the business will use
abatement equipment. In either case (buying a permit or using abatement equipment)
costs for the producer increase, decreasing supply and increasing the price of the final
good. If the carbon tax and the number of permits issued in the cap and trade system
were set appropriately, the outlays for both programs would be the same.
4.
a. The number of parties per month that would be provided privately is P.
b. See schedule MSBp.
c. P*. Give a per-unit subsidy of $b per party to induce the correct number of
parties.
d. The optimal subsidy is $b. The total subsidy=abcd. “Society” comes out ahead by
ghc, assuming the subsidy can be raised without any efficiency costs.
(Cassanova’s friends gain gchd; Cassanova loses chd but gains abcd, which is a
subsidy cost to government.)
5. The payment for signing a waiver is a negotiation as suggested by the Coase Theorem. If
residents accept the payment and sign the waiver, they are signaling that the noise cost to
them is less than the payment. If the residents choose not to accept the payment and sign
the waiver, the payment is not great enough to cover the cost of the noise. The Coase
Theorem suggest in this case that further negotiation could occur.
6. On the surface, the tax on saturated fat seems like a Pigouvian tax, if you assume that the
$3 is equivalent to the level of the damage from the saturated fats. The commentator is
not correct in his criticism that the tax is levied on an input rather an outcome. If the tax
is properly set and is the direct cause of unhealthy consumers, the efficient level of
saturated fat will be consumed. However, this tax suffers from the problem of assuming
that the saturated fat leads directly to poor health outcomes and is the only source of
unhealthy outcomes. Some consumers are healthy no matter the level of consumption of
5-2
3. It is the case that a carbon tax would be passed on to the consumer. The tax raises costs
to the producer for producing the final good. These increased costs would decrease
supply, which will increase the price of that final good. In a cap and trade system,
businesses must purchase permits in order to emit carbon. If the cost of purchasing and
using abatement equipment is less than the cost of buying a permit, the business will use
abatement equipment. In either case (buying a permit or using abatement equipment)
costs for the producer increase, decreasing supply and increasing the price of the final
good. If the carbon tax and the number of permits issued in the cap and trade system
were set appropriately, the outlays for both programs would be the same.
4.
a. The number of parties per month that would be provided privately is P.
b. See schedule MSBp.
c. P*. Give a per-unit subsidy of $b per party to induce the correct number of
parties.
d. The optimal subsidy is $b. The total subsidy=abcd. “Society” comes out ahead by
ghc, assuming the subsidy can be raised without any efficiency costs.
(Cassanova’s friends gain gchd; Cassanova loses chd but gains abcd, which is a
subsidy cost to government.)
5. The payment for signing a waiver is a negotiation as suggested by the Coase Theorem. If
residents accept the payment and sign the waiver, they are signaling that the noise cost to
them is less than the payment. If the residents choose not to accept the payment and sign
the waiver, the payment is not great enough to cover the cost of the noise. The Coase
Theorem suggest in this case that further negotiation could occur.
6. On the surface, the tax on saturated fat seems like a Pigouvian tax, if you assume that the
$3 is equivalent to the level of the damage from the saturated fats. The commentator is
not correct in his criticism that the tax is levied on an input rather an outcome. If the tax
is properly set and is the direct cause of unhealthy consumers, the efficient level of
saturated fat will be consumed. However, this tax suffers from the problem of assuming
that the saturated fat leads directly to poor health outcomes and is the only source of
unhealthy outcomes. Some consumers are healthy no matter the level of consumption of
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Part 2 – Public Expenditure: Public Goods and Externalities
5-3
saturated fats. Others are unhealthy even with no consumption of the saturated fats. And
many consumers will simply reallocate their consumption to nontaxed unhealthy foods.
7.
a. It is very likely that the farmer could negotiate with the neighbors, provided
property rights are clearly defined. The Coase Theorem is therefore applicable.
b. It is unlikely that negotiation could result in an efficient outcome in this case. It is
likely that there are a great number of farmers involved in both harvesting ants
and growing trees, making negotiation very difficult.
c. Property rights are not being enforced, making negotiation through the Coase
Theorem impossible.
d. There are too many people involved for private negotiation.
8.
a. The price of imported oil does not reflect the increased political risk by
effectively subsidizing authoritarian regimes like those in Saudi Arabia.
b. The tax would estimate the marginal damage (e.g., the increased instability in the
Middle East, etc.) by importing oil from Saudi Arabia.
c. The supply of TGRs is vertical at 104.5 billion if government seeks to reduce
consumption of gasoline to 104.5 billion. Consumers must have one TGR in
order to buy one gallon of gasoline, plus they must pay the price at the pump.
Limiting TGRs effectively limits the demand for gasoline, so the price per gallon
will fall, but consumers must have TGRs in order to purchase gasoline. If the
market price of one TGR is $0.75, this means that supply and demand intersect at
$0.75, as shown in the graph. This kind of program curbs consumption without
giving government more revenue because consumers are purchasing the TGRs
from each other. However, the total amount of TGRs is limited by government.
Those consumers seeking to purchase more gasoline than allowed by the initial
allocation of TGRs can purchase additional TGRs from other consumers at the
market price of $0.75. By choosing to use a TGR to purchase gasoline, a
consumer incurs an opportunity cost equal to $0.75 since they cannot sell the
TGR once it has been used.
5-3
saturated fats. Others are unhealthy even with no consumption of the saturated fats. And
many consumers will simply reallocate their consumption to nontaxed unhealthy foods.
7.
a. It is very likely that the farmer could negotiate with the neighbors, provided
property rights are clearly defined. The Coase Theorem is therefore applicable.
b. It is unlikely that negotiation could result in an efficient outcome in this case. It is
likely that there are a great number of farmers involved in both harvesting ants
and growing trees, making negotiation very difficult.
c. Property rights are not being enforced, making negotiation through the Coase
Theorem impossible.
d. There are too many people involved for private negotiation.
8.
a. The price of imported oil does not reflect the increased political risk by
effectively subsidizing authoritarian regimes like those in Saudi Arabia.
b. The tax would estimate the marginal damage (e.g., the increased instability in the
Middle East, etc.) by importing oil from Saudi Arabia.
c. The supply of TGRs is vertical at 104.5 billion if government seeks to reduce
consumption of gasoline to 104.5 billion. Consumers must have one TGR in
order to buy one gallon of gasoline, plus they must pay the price at the pump.
Limiting TGRs effectively limits the demand for gasoline, so the price per gallon
will fall, but consumers must have TGRs in order to purchase gasoline. If the
market price of one TGR is $0.75, this means that supply and demand intersect at
$0.75, as shown in the graph. This kind of program curbs consumption without
giving government more revenue because consumers are purchasing the TGRs
from each other. However, the total amount of TGRs is limited by government.
Those consumers seeking to purchase more gasoline than allowed by the initial
allocation of TGRs can purchase additional TGRs from other consumers at the
market price of $0.75. By choosing to use a TGR to purchase gasoline, a
consumer incurs an opportunity cost equal to $0.75 since they cannot sell the
TGR once it has been used.
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Chapter 5 - Externalities
5-4
9. The use of the drug to treat sick cows leads to a positive externality (the benefit enjoyed
by air travelers) as well as a negative externality (the costs created by a larger number of
rats and feral dogs). Banning the drug might raise or lower efficiency, depending on
whether the positive externality is larger or whether the negative externality is larger.
There are many ways to design incentive-based regulations. Policymakers could
determine the efficient level of drug usage and then either allocate or sell the right to use
the drug for sick cows.
10. The program matches prices to changes in demand, fluctuating as demand changes. This
results in higher efficiency. Drivers will respond efficiently by choosing to park based on
their willingness to pay.
11.
a. When the Little Pigs hog farm produces on its own, it sets marginal benefit equal
to marginal cost. This occurs at 4 units.
b. The efficient number of hogs sets marginal benefit equal to marginal social cost,
which is the sum of MC and MD. At 2 units, MB=MSC=1600.
c. The efficient number of hogs sets marginal benefit equal to marginal social costs.
At 3 hogs, MB=MSC=1600.
12. Private Marginal Benefit = 10 - X
Private Marginal Cost = $5
TGRs
$
104.5 billion
Supply of TGRs
Demand for TGRs
$0.75
5-4
9. The use of the drug to treat sick cows leads to a positive externality (the benefit enjoyed
by air travelers) as well as a negative externality (the costs created by a larger number of
rats and feral dogs). Banning the drug might raise or lower efficiency, depending on
whether the positive externality is larger or whether the negative externality is larger.
There are many ways to design incentive-based regulations. Policymakers could
determine the efficient level of drug usage and then either allocate or sell the right to use
the drug for sick cows.
10. The program matches prices to changes in demand, fluctuating as demand changes. This
results in higher efficiency. Drivers will respond efficiently by choosing to park based on
their willingness to pay.
11.
a. When the Little Pigs hog farm produces on its own, it sets marginal benefit equal
to marginal cost. This occurs at 4 units.
b. The efficient number of hogs sets marginal benefit equal to marginal social cost,
which is the sum of MC and MD. At 2 units, MB=MSC=1600.
c. The efficient number of hogs sets marginal benefit equal to marginal social costs.
At 3 hogs, MB=MSC=1600.
12. Private Marginal Benefit = 10 - X
Private Marginal Cost = $5
TGRs
$
104.5 billion
Supply of TGRs
Demand for TGRs
$0.75
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Part 2 – Public Expenditure: Public Goods and Externalities
5-5
External Cost = $2
Without government intervention, PMB = PMC; X = 5 units.
Social efficiency implies PMB = Social Marginal Costs = $5 + $2 = $7; X = 3 units.
Gain to society is the area of the triangle whose base is the distance between the efficient
and actual output levels, and whose height is the difference between private and social
marginal cost. Hence, the efficiency gain is ½ (5 - 3)(7 - 5) = 2
A Pigouvian tax adds to the private marginal cost the amount of the external cost at the
socially optimal level of production. Here a simple tax of $2 per unit will lead to
efficient production. This tax would raise ($2) (3 units) = $6 in revenue.
13.
a. The total cost of emissions reduction is minimized only when the marginal costs
are equal across all polluters, therefore a cost-effective solution requires that MC1
= MC2 or that 300e1 = 100e2. Substituting 3e1 for e2 in the formula e1 + e2 = 40
(since the policy goal is to reduce emissions by 40 units) yields the solution. It is
cost-effective for Firm 1 to reduce emissions by 10 units and for Firm 2 to reduce
emissions by 30 units.
b. In order to achieve cost-effective emission reductions, the emissions fee should
beset equal to $3,000. With this emissions fee, Firm 1 reduces 10 units and Firm
2 reduces 30 units, but Firm 1 has to pay $3,000 for each unit of pollution they
continue to produce, which gives them a tax burden of $3,000 x 90 (Firm 1
generated 100 units in the absence of government intervention) or $270,000.
Firm 2 has a lower tax burden because it is reducing emissions from 80 units to
50units. Firm 2 pays $3,000 x 50 = $150,000. As the text concludes, the firm
that cuts back pollution less isn’t really getting away with anything because it has
a larger tax liability than if it were to cut back more.
c. From an efficiency standpoint, the initial allocation of permits does not matter. If
the two firms could not trade permits, then Firm 2 would have to undertake all of
the emissions reduction. Initially, Firm 1’s MC is zero, while Firm 2’s MC is
$4,000, so there is a strong incentive for Firm 2 to purchase permits from Firm 1.
Trading should continue until MC1 = MC2, which is the cost-effective solution.
This means that the market price for permits will equal $3,000, the same as the
emissions fee. At this price, Firm 2 will purchase 10 permits from Firm 2,
allowing Firm 2 to reduce emissions by 30 rather than 40 and requiring Firm 1 to
reduce emissions by 10. This solution is the same as the solution achieved with
the emissions fee. However, Firm 1 is better off because instead of having to pay
taxes, it will receive a payment of $30,000 for its permits. Firm 2 must pay
$30,000 for the extra permits, but it also avoids the payment of taxes. The
government lost $420,000 in tax revenue. The firms must still pay the cost of
emissions reduction, plus Firm 2 must pay for the permits purchased from Firm 1.
5-5
External Cost = $2
Without government intervention, PMB = PMC; X = 5 units.
Social efficiency implies PMB = Social Marginal Costs = $5 + $2 = $7; X = 3 units.
Gain to society is the area of the triangle whose base is the distance between the efficient
and actual output levels, and whose height is the difference between private and social
marginal cost. Hence, the efficiency gain is ½ (5 - 3)(7 - 5) = 2
A Pigouvian tax adds to the private marginal cost the amount of the external cost at the
socially optimal level of production. Here a simple tax of $2 per unit will lead to
efficient production. This tax would raise ($2) (3 units) = $6 in revenue.
13.
a. The total cost of emissions reduction is minimized only when the marginal costs
are equal across all polluters, therefore a cost-effective solution requires that MC1
= MC2 or that 300e1 = 100e2. Substituting 3e1 for e2 in the formula e1 + e2 = 40
(since the policy goal is to reduce emissions by 40 units) yields the solution. It is
cost-effective for Firm 1 to reduce emissions by 10 units and for Firm 2 to reduce
emissions by 30 units.
b. In order to achieve cost-effective emission reductions, the emissions fee should
beset equal to $3,000. With this emissions fee, Firm 1 reduces 10 units and Firm
2 reduces 30 units, but Firm 1 has to pay $3,000 for each unit of pollution they
continue to produce, which gives them a tax burden of $3,000 x 90 (Firm 1
generated 100 units in the absence of government intervention) or $270,000.
Firm 2 has a lower tax burden because it is reducing emissions from 80 units to
50units. Firm 2 pays $3,000 x 50 = $150,000. As the text concludes, the firm
that cuts back pollution less isn’t really getting away with anything because it has
a larger tax liability than if it were to cut back more.
c. From an efficiency standpoint, the initial allocation of permits does not matter. If
the two firms could not trade permits, then Firm 2 would have to undertake all of
the emissions reduction. Initially, Firm 1’s MC is zero, while Firm 2’s MC is
$4,000, so there is a strong incentive for Firm 2 to purchase permits from Firm 1.
Trading should continue until MC1 = MC2, which is the cost-effective solution.
This means that the market price for permits will equal $3,000, the same as the
emissions fee. At this price, Firm 2 will purchase 10 permits from Firm 2,
allowing Firm 2 to reduce emissions by 30 rather than 40 and requiring Firm 1 to
reduce emissions by 10. This solution is the same as the solution achieved with
the emissions fee. However, Firm 1 is better off because instead of having to pay
taxes, it will receive a payment of $30,000 for its permits. Firm 2 must pay
$30,000 for the extra permits, but it also avoids the payment of taxes. The
government lost $420,000 in tax revenue. The firms must still pay the cost of
emissions reduction, plus Firm 2 must pay for the permits purchased from Firm 1.
Loading page 24...
Chapter 5 - Externalities
5-6
14. If marginal costs turn out to be lower than anticipated, cap-and-trade achieves too little
pollution reduction and an emissions fee achieves too much pollution reduction. With an
inelastic marginal social benefit function, cap-and-trade is not too bad from an efficiency
standpoint, while an emissions fee causes pollution reduction to be much greater than the
efficient level when marginal cost is lower than anticipated. When marginal social
benefits are elastic, the opposite is true.
5-6
14. If marginal costs turn out to be lower than anticipated, cap-and-trade achieves too little
pollution reduction and an emissions fee achieves too much pollution reduction. With an
inelastic marginal social benefit function, cap-and-trade is not too bad from an efficiency
standpoint, while an emissions fee causes pollution reduction to be much greater than the
efficient level when marginal cost is lower than anticipated. When marginal social
benefits are elastic, the opposite is true.
Loading page 25...
Part 2 – Public Expenditure: Public Goods and Externalities
6-1
Chapter 6 – Political Economy
Brief Outline
1. Direct democracy
a. Unanimity Rules
b. Majority Voting Rules
c. Logrolling
d. Arrow’s Impossibility Theorem
2. Representative Democracy
a. Elected Politicians
b. Public Employees
c. Special Interests
d. Other Actors
3. Explaining Government Growth
a. Conclusion
Answers to End-of-Chapter Questions
1.
a. Below, the preferences for each person.
b. C wins in every pair wise vote. Thus, there is a stable majority outcome, despite
the fact that persons 1, 2, and 3 have double-peaked preferences. This
demonstrates that although multi-peaked preferences may lead to voting
inconsistencies, this is not necessarily the case.
2. The passage of the agriculture bill in 2007 is consistent with the logrolling model.
Because the members of rural areas were able to trade votes with those in urban areas
3.
a. Neither issue would pass with majority voting as in both cases, two voters of the
three would vote against the each issue because they receive negative net benefits.
1
2
3
4
A B C D
Person 1
Person 2
Person 3
Person 4
Person 5
6-1
Chapter 6 – Political Economy
Brief Outline
1. Direct democracy
a. Unanimity Rules
b. Majority Voting Rules
c. Logrolling
d. Arrow’s Impossibility Theorem
2. Representative Democracy
a. Elected Politicians
b. Public Employees
c. Special Interests
d. Other Actors
3. Explaining Government Growth
a. Conclusion
Answers to End-of-Chapter Questions
1.
a. Below, the preferences for each person.
b. C wins in every pair wise vote. Thus, there is a stable majority outcome, despite
the fact that persons 1, 2, and 3 have double-peaked preferences. This
demonstrates that although multi-peaked preferences may lead to voting
inconsistencies, this is not necessarily the case.
2. The passage of the agriculture bill in 2007 is consistent with the logrolling model.
Because the members of rural areas were able to trade votes with those in urban areas
3.
a. Neither issue would pass with majority voting as in both cases, two voters of the
three would vote against the each issue because they receive negative net benefits.
1
2
3
4
A B C D
Person 1
Person 2
Person 3
Person 4
Person 5
Loading page 26...
Chapter 6 – Political Economy
6-2
This is not efficient because issue X has a positive total net benefit and should be
funded.
b. With logrolling, voters A and B can trade votes. A will vote for issue Y if B votes
for issue X, but C will not vote for either project. Both issues will pass with two
votes for and one against. This is not efficient because issue Y has a negative
total net benefit.
c. If side payments were allowed A could pay B to vote for issue X (A would not
pay C because C would require a higher payment than B), and B could pay A or C
to vote for issue Y. This would result in the same inefficient outcome as in b.
d. If side payments were allowed A would have to pay B at least 1 to vote for issue
X. A would only be willing to pay less than 6. B would have to pay A or C at
least 3, but no more than 4 to entice him to vote for issue Y.
4. Yes, it is consistent, because the theory says that when unanimity is required, no
decisions are likely to be made. A majority system might be more suitable, although it is
subject to cycling and other problems.
5. When the policy changed to allow and encourage female voting, female voters became
the majority, so it is sensible that the median voter is now a woman. Given this, the
median voter theorem suggests that politicians should shift their positions to more closely
align with the views of women.
6. When there is a vote over five options, there is the chance that a potential majority vote is
split between four relatively preferred options, and the fifth option wins. The winning
option may have been voted down if it had been a two-way vote with any of the other
options. Further, if preferences are not single-peaked, cycling and inconsistent public
decisions may emerge.
6-2
This is not efficient because issue X has a positive total net benefit and should be
funded.
b. With logrolling, voters A and B can trade votes. A will vote for issue Y if B votes
for issue X, but C will not vote for either project. Both issues will pass with two
votes for and one against. This is not efficient because issue Y has a negative
total net benefit.
c. If side payments were allowed A could pay B to vote for issue X (A would not
pay C because C would require a higher payment than B), and B could pay A or C
to vote for issue Y. This would result in the same inefficient outcome as in b.
d. If side payments were allowed A would have to pay B at least 1 to vote for issue
X. A would only be willing to pay less than 6. B would have to pay A or C at
least 3, but no more than 4 to entice him to vote for issue Y.
4. Yes, it is consistent, because the theory says that when unanimity is required, no
decisions are likely to be made. A majority system might be more suitable, although it is
subject to cycling and other problems.
5. When the policy changed to allow and encourage female voting, female voters became
the majority, so it is sensible that the median voter is now a woman. Given this, the
median voter theorem suggests that politicians should shift their positions to more closely
align with the views of women.
6. When there is a vote over five options, there is the chance that a potential majority vote is
split between four relatively preferred options, and the fifth option wins. The winning
option may have been voted down if it had been a two-way vote with any of the other
options. Further, if preferences are not single-peaked, cycling and inconsistent public
decisions may emerge.
Loading page 27...
Part 2 – Public Expenditure: Public Goods and Externalities
6-3
7. On the graph below, the price of taxi rides would increase from PC to PMed and the
number of taxi rides would decline from QC to QMed. This would result in a deadweight
loss to society of triangle dce.
8.
a. With the demand curve of Q=100-10P and a perfectly elastic supply curve at P=2,
the milk is sold at a price of $2, and a quantity of 80 units is sold.
b. The marginal revenue curve associated with the inverse demand curve P=10-
(1/10)Q is MR=10-(1/5)Q, while the marginal cost curve is MC=2. The cartel
would ideally produce a quantity where MR=MC, or 10-(1/5)Q=2, or Q=40. The
price associated with a cartel quantity of 40 units is P=10-(1/10)*40, or P=6.
c. The rent associated with the cartel is the product of the marginal profit per unit
and the number of units produced. The marginal profit per unit of milk is $4 (=$6
price - $2 marginal cost), while 40 units are produced. Thus, the rents equal
$160.
d. The most the cartel would be willing to contribute to politicians is the full
economic rent of $160. The cartel situation, the quantity of milk produced is too
low from society’s point of view. The deadweight loss triangle is computed using
the difference between the cartel output and competitive output as the “base” of
the triangle, and the difference between the cartel price and competitive price as
the “height.” Thus, the triangle is equal to (1/2)*(80-40)*($6-$2)=$40.
e. As Figure 6.5 in the textbook shows, the deadweight loss could now go as high as
the sum of the conventional deadweight loss and the rents, or $160 rents + $80
DWL = $240. This is because, as noted in the text, “rent-seeking can use up
Qmed
S=MC
Number of taxi rides
$
D
MR
QC
PC
PMed
f
cb
a d e
6-3
7. On the graph below, the price of taxi rides would increase from PC to PMed and the
number of taxi rides would decline from QC to QMed. This would result in a deadweight
loss to society of triangle dce.
8.
a. With the demand curve of Q=100-10P and a perfectly elastic supply curve at P=2,
the milk is sold at a price of $2, and a quantity of 80 units is sold.
b. The marginal revenue curve associated with the inverse demand curve P=10-
(1/10)Q is MR=10-(1/5)Q, while the marginal cost curve is MC=2. The cartel
would ideally produce a quantity where MR=MC, or 10-(1/5)Q=2, or Q=40. The
price associated with a cartel quantity of 40 units is P=10-(1/10)*40, or P=6.
c. The rent associated with the cartel is the product of the marginal profit per unit
and the number of units produced. The marginal profit per unit of milk is $4 (=$6
price - $2 marginal cost), while 40 units are produced. Thus, the rents equal
$160.
d. The most the cartel would be willing to contribute to politicians is the full
economic rent of $160. The cartel situation, the quantity of milk produced is too
low from society’s point of view. The deadweight loss triangle is computed using
the difference between the cartel output and competitive output as the “base” of
the triangle, and the difference between the cartel price and competitive price as
the “height.” Thus, the triangle is equal to (1/2)*(80-40)*($6-$2)=$40.
e. As Figure 6.5 in the textbook shows, the deadweight loss could now go as high as
the sum of the conventional deadweight loss and the rents, or $160 rents + $80
DWL = $240. This is because, as noted in the text, “rent-seeking can use up
Qmed
S=MC
Number of taxi rides
$
D
MR
QC
PC
PMed
f
cb
a d e
Loading page 28...
Chapter 6 – Political Economy
6-4
resources – lobbyists spend their time influencing legislators, consultants testify
before regulatory panels, and advertisers conduct public relations campaigns.
Such resources, which could have been used to produce new goods and services,
are instead consumed in a struggle over the distribution of existing goods and
services. Hence, the rents do not represent a mere lump-sum transfer; it is a
measure of real resources used up to maintain a position of market power.”
9. This is an example of possible rent-seeking. If Philip Morris supports limited cigarette
advertising, it is unlikely that there will be new entrants in the cigarette market because
establishing business would be more difficult with reduced advertising. Philip Morris
will maintain or develop market power.
10.
a. The outcome of the first election (M vs. H) is M. The outcome of the second
election (H vs. L) is L. The outcome of the third election (L vs. M) is M.
Majority rule leads to a stable outcome since M defeats both H and L. Giving one
person the ability to set the agenda would not affect the outcome in this case.
b. With the change in Eleanor’s preference ordering, majority rule no longer
generates a stable outcome. In a vote between M and H, the outcome is H. In a
vote between H and L, the outcome is L. In a vote between L and M, the outcome
is M. So, giving one person the ability to set the agenda affects the outcome. For
example, Abigail prefers H, so she might pit L against M first in order to
eliminate L and avoid having L defeat H.
6-4
resources – lobbyists spend their time influencing legislators, consultants testify
before regulatory panels, and advertisers conduct public relations campaigns.
Such resources, which could have been used to produce new goods and services,
are instead consumed in a struggle over the distribution of existing goods and
services. Hence, the rents do not represent a mere lump-sum transfer; it is a
measure of real resources used up to maintain a position of market power.”
9. This is an example of possible rent-seeking. If Philip Morris supports limited cigarette
advertising, it is unlikely that there will be new entrants in the cigarette market because
establishing business would be more difficult with reduced advertising. Philip Morris
will maintain or develop market power.
10.
a. The outcome of the first election (M vs. H) is M. The outcome of the second
election (H vs. L) is L. The outcome of the third election (L vs. M) is M.
Majority rule leads to a stable outcome since M defeats both H and L. Giving one
person the ability to set the agenda would not affect the outcome in this case.
b. With the change in Eleanor’s preference ordering, majority rule no longer
generates a stable outcome. In a vote between M and H, the outcome is H. In a
vote between H and L, the outcome is L. In a vote between L and M, the outcome
is M. So, giving one person the ability to set the agenda affects the outcome. For
example, Abigail prefers H, so she might pit L against M first in order to
eliminate L and avoid having L defeat H.
Loading page 29...
Part 2 – Public Expenditure: Public Goods and Externalities
7-1
Chapter 7 – Education
Brief Outline
1. Justifying Government Intervention in Education
a. Is Education a Public Good?
b. Does Education Generate Positive Externalities?
c. Is the Education Market Inequitable?
2. What Can Government Intervention in Education Accomplish?
a. Does Government intervention Crowd Out Private Education?
b. Does Government Spending Improve Educational Outcomes?
c. Public Spending and the Quality of Education
d. Does Education Increase Earnings?
3. New Directions for Public Education
a. Charter Schools
b. Vouchers
c. School Accountability
Answers to End-of-Chapter Questions
1. There are numerous rationales given for government provision of education. Even
though education is primarily a private good, many argue that educating a child provides
external benefits. However, the existence of a positive externality implies that
government should subsidize education rather than making it free and mandatory. Other
rationales are based on equity, including a belief in commodity egalitarianism. The
rationales do imply a lower level of provision of higher education versus primary and
secondary. Higher education has higher private benefits and fewer externalities,
therefore requires a lower level of provision.
2. It may be that national income is increased purely though private returns to education
summed up across the economy. If this is the case, one could not use an externality-based
argument to justify subsidization. However, if education quality increases the growth rate
of national income outside of the returns that accrue to individuals who consume the
education, then private decisions will yield a lower than efficient level of education
quality. This reasoning would allow for government subsidization that would improve the
quality of education.
3. If students are required to pay “a lifelong tithe on all earnings” there might be a distortion
in choices of careers among students. Under the tithe system, some students would
choose a lower paid (and less productive) career path, compared to the situation in which
they faced a standard bank loan. The tithe system would create inefficiencies by partially
removing incentives for students to pursue the highest-paying jobs.
4. If households are allowed to supplement public education with private lessons, then the
budget constraint in Figure 7.1 of the textbook is modified by drawing a line starting at
point x (consuming only public education) that runs to the southeast and is parallel to AB.
The figure below is then similar to the analysis of in-kind benefits like food stamps.
7-1
Chapter 7 – Education
Brief Outline
1. Justifying Government Intervention in Education
a. Is Education a Public Good?
b. Does Education Generate Positive Externalities?
c. Is the Education Market Inequitable?
2. What Can Government Intervention in Education Accomplish?
a. Does Government intervention Crowd Out Private Education?
b. Does Government Spending Improve Educational Outcomes?
c. Public Spending and the Quality of Education
d. Does Education Increase Earnings?
3. New Directions for Public Education
a. Charter Schools
b. Vouchers
c. School Accountability
Answers to End-of-Chapter Questions
1. There are numerous rationales given for government provision of education. Even
though education is primarily a private good, many argue that educating a child provides
external benefits. However, the existence of a positive externality implies that
government should subsidize education rather than making it free and mandatory. Other
rationales are based on equity, including a belief in commodity egalitarianism. The
rationales do imply a lower level of provision of higher education versus primary and
secondary. Higher education has higher private benefits and fewer externalities,
therefore requires a lower level of provision.
2. It may be that national income is increased purely though private returns to education
summed up across the economy. If this is the case, one could not use an externality-based
argument to justify subsidization. However, if education quality increases the growth rate
of national income outside of the returns that accrue to individuals who consume the
education, then private decisions will yield a lower than efficient level of education
quality. This reasoning would allow for government subsidization that would improve the
quality of education.
3. If students are required to pay “a lifelong tithe on all earnings” there might be a distortion
in choices of careers among students. Under the tithe system, some students would
choose a lower paid (and less productive) career path, compared to the situation in which
they faced a standard bank loan. The tithe system would create inefficiencies by partially
removing incentives for students to pursue the highest-paying jobs.
4. If households are allowed to supplement public education with private lessons, then the
budget constraint in Figure 7.1 of the textbook is modified by drawing a line starting at
point x (consuming only public education) that runs to the southeast and is parallel to AB.
The figure below is then similar to the analysis of in-kind benefits like food stamps.
Loading page 30...
Chapter 7 – Education
7-2
If parents pay for the public schooling (rather than perceiving it as being free), and the
schooling was paid for with a lump sum tax, then the budget constraint shifts in by an
amount that depends on the household’s share of the tax burden. If the household’s tax
burden exactly equals the cost of public school, the budget constraint is no longer the line
segment AB but rather the segment CDB, where the segment DB runs along the original
budget constraint, except that the minimum amount of schooling consumed is eP.
5. Making wealthy students pay more tuition only increases efficiency if it is reasonable to
assume that wealthy students will be paid more than less wealthy students at the end of
the education. If there are few externalities, then the demand for education should come
from the private benefits of the education, which is the present value of future earnings.
If wealthy students are paid better after college, their demand would be higher and they
would be willing to pay more for the education. In terms of equity, this policy seems to
be fair in that it gives less wealthy students a better chance at an education.
DC
ep
BA
A
Other Goods
Education
Public School is financed by taxes levied
on parents
ep
B
A
A
Other Goods
Education
Parents can supplement public
education with private lessons
7-2
If parents pay for the public schooling (rather than perceiving it as being free), and the
schooling was paid for with a lump sum tax, then the budget constraint shifts in by an
amount that depends on the household’s share of the tax burden. If the household’s tax
burden exactly equals the cost of public school, the budget constraint is no longer the line
segment AB but rather the segment CDB, where the segment DB runs along the original
budget constraint, except that the minimum amount of schooling consumed is eP.
5. Making wealthy students pay more tuition only increases efficiency if it is reasonable to
assume that wealthy students will be paid more than less wealthy students at the end of
the education. If there are few externalities, then the demand for education should come
from the private benefits of the education, which is the present value of future earnings.
If wealthy students are paid better after college, their demand would be higher and they
would be willing to pay more for the education. In terms of equity, this policy seems to
be fair in that it gives less wealthy students a better chance at an education.
DC
ep
BA
A
Other Goods
Education
Public School is financed by taxes levied
on parents
ep
B
A
A
Other Goods
Education
Parents can supplement public
education with private lessons
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