Exercises on Public Goods



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Exercises on Public Goods
Q. 1

The operation of large trucks in Econoville causes damages to public roads. The marginal external cost function of operating large trucks in Econoville is: where m is the number of miles large trucks are driven in Econoville in thousands. The marginal benefit of large truck operation in Econoville is: How many miles do large trucks drive in Econoville if they are not forced to pay for damage to roads? If Econoville charges a fee for every thousand miles a large truck drives in Econoville, what is the optimal fee? If the profitability of large truck operation in Econoville increases the marginal benefit function to: . Is it optimal for Econoville to reduce the fee and if so by how much?


Q. 2

Bonnie and Clyde are business partners. Whenever they work, they have to work together. Their only source of income is profit from their partnership. Their total profit per year is 50H, where H is the number of hours that they work per year. Since they must work together,they both must work the same number of hours, so the variable “hours of

labor” is like a public “bad” for the two person community consisting of Bonnie and Clyde. Bonnie’s utility function is UB(CB,H) = CB .02H2 and Clyde’s utility function is UC(CC,H) = CC .005H2, where CB and CC are the annual amounts of money spent on consumption for Bonnie and for Clyde.
(a) If the number of hours that they both work is H, what is the ratio of Bonnie’s marginal utility of hours of work to her marginal utility of private goods? What is the ratio of Clyde’s marginal utility of hours of work to his marginal utility of private goods?
(b) If Bonnie and Clyde are both working H hours, then the total amount of money that would be needed to compensate them both for having to work an extra hour is the sum of what is needed to compensate Bonnie and the amount that is needed to compensate Clyde. This amount is approximately equal to the sum of the absolute values of their marginal rates of substitution between work and money. Write an expression for this amount as a function of H. How much extra money will they make if they work an extra hour?
(c) Write an equation that can be solved for the Pareto optimal number of hours for Bonnie and Clyde to work. Find the Pareto optimal H. (Hint: Notice that this model is formally the same as a model with one public good H and one private good, income.)
Q. 3

This problem is set in a fanciful location, but it deals with a very practical issue that concerns residents of this earth. The question is, “In a Democracy, when can we expect that a majority of citizens will favor having the government supply pure private goods publicly?” This problem also deals with the efficiency issues raised by public provision of private goods. We leave it to you to see whether you can think of important examples of publicly supplied private goods.

On the planet Jumpo there are two goods, aerobics lessons and bread. The citizens all have Cobb-Douglas utility functions of the form Ui(Ai,Bi) = Ai1/2Bi1/2 , where Ai and Bi are i’s consumptions of aerobics lessons and bread. Although tastes are all the same, there are two different income groups, the rich and the poor. Each rich creature on Jumpo has an income of 100 fondas and every poor creature has an income of 50 fondas (the currency unit on Jumpo). There are two million poor creatures and one million rich creatures on Jumpo. Bread is sold in the usual way, but aerobics lessons are provided by the state despite the fact that they are private goods. The state gives the same amount of aerobics lessons to every creature on Jumpo. The price of bread is 1 fonda per loaf. The cost to the state of aerobics lessons is 2 fondas per lesson. This cost of the state-provided lessons is paid for by taxes collected from the citizens of Jumpo. The government has no other expenses than providing aerobics lessons and collects no more or less taxes than the amount needed to pay for them. Jumpo is a democracy, and the amount of aerobics to be supplied will be determined by majority vote.
(a) Suppose that the cost of the aerobics lessons provided by the state is paid for by making every creature on Jumpo pay an equal amount of taxes. On planets, such as Jumpo, where every creature has exactly one head, such a tax is known as a “head tax.” If every citizen of Jumpo gets 20 lessons, how much will be total government expenditures on lessons? How much taxes will every citizen have to pay? If 20 lessons are given, how much will a rich creature have left to spend on bread after it has paid its taxes? How much will a poor creature have left to spend on bread after it has paid its taxes?
(b) More generally, when everybody pays the same amount of taxes, if x lessons are provided by the government to each creature, what is the total cost to the government? How much tax dose one creature have to pay?
(c) Suppose that the aerobics lessons are paid for by a head tax and all lessons are provided by the government in equal amounts to everyone. How many lessons would the rich people prefer to have supplied? How many would the poor people prefer to have supplied? (Hint: In each case you just have to solve for the Cobb-Douglas demand

with an appropriate budget.)


(e) If the outcome is determined by majority rule, how many aerobics lessons will be provided? How much bread will the rich get? How much bread will the poor get?
(d) Suppose that aerobics lessons are “privatized,” so that no lessons are supplied publicly and no taxes are collected. Every creature is allowed to buy as many lessons as it likes and as much bread as it likes. Suppose that the price of bread stays at 1 fonda per unit and the price of lessons stays at 2 fondas per unit. How many aerobics lessons will the rich get? How many will the poor get? How much bread will the rich get? How much bread will the poor get?
(f) Suppose that aerobics lessons remain publicly supplied but are paid for by a proportional income tax. The tax rate is set so that tax revenue pays for the lessons. If A aerobics lessons are offered to each creature on Jumpo, the tax bill for a rich person will be 3A fondas and the tax bill for a poor person will be 1.5A fondas. If A lessons

are given to each creature, show that total tax revenue collected will be the total cost of A lessons.


(g) With the proportional income tax scheme discussed above, what budget constraint would a rich person consider in deciding how many aerobics lessons to vote for? What is the relevant budget constraint for a poor creature? With these tax rates, how many aerobics lessons per creature would the rich favor? How many would the poor favor? What quantity of aerobics lessons per capita would be chosen under majority rule?

How much bread would the rich get?. How much bread would the poor get?


(h) Calculate the utility of a rich creature under a head tax, under privatization, and under a proportional income tax. Now calculate the utility of each poor creature

under the head tax, under privatization, and under a proportional income tax.


(i) Is privatization Pareto superior to the head tax? Is a proportional income tax Pareto superior to the head tax? Is privatization Pareto superior to the proportional income tax? Explain the last two answers.


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