Suppose that utility function takes this form: U1 = f(y1) + U2, where 1 and 2

stand for different individuals, and y1 is the income of 1, f(y1)>0 whenever y1>0
and f(y1) increases with y1. Meanwhile, the utility function for 2 is U2 = y2,
where y2 is the income of 2.
1. (a) Is there any externality involved? Please first explain the meaning of
externality. Then, explain why the above form of utility satisfies or does
not
satisfy the conditions of externality.
2. (b) Suppose that the marginal utility of income for 1, or MUI1 (i.e. f’), is a
downward sloping line along the horizontal axis y1, where the area
beneath MUI1 is the total utility of 1. Suppose that 1 does not realize that
a one-unit increase in y1 can only be achieved by a one-unit decrease in
y2. Draw a diagram of MUI1 to illustrate which y1 is the level that 1 will
choose. There is no other constraint on how much income person 1 can
pursue.
3. (c) Now, 1 realizes that if y1 is increased by 1 unit, y2 will be reduced by
1 unit, and person 1’s utility will thus be reduced according to U1 =
f(y1)+U2. Add this element into the above diagram to show how it will
affect 1’s choice of y1. Suppose that when y1 is attained as (b) shows,
y2=0. Indicate also the total utility of 1 at his new choice of y1.
4. (d) Nevertheless, (c) assumes that 1 can directly give the extra income
to person 2 by reducing y1. Realistically, person 1 cannot do this. Then,
how a government can attain efficiency in this case?
5. (e) Is the outcome in (c) more or less efficient than in (b)? Please
explain.
6. (f) Consider two social welfare functions: W=U1+U2 and W=min(U1,U2).
Does
the outcome in (c) attain a higher welfare than that in (b) under the two
functions? Please explain.
7. (g) Now, imagine that there are two people of the same utility function
as U1
but there is again only one person of the utility function as U2. Revisit (c)
and (d). Suppose that the two type-1 persons actually can directly give
income to person 2 by reducing their own incomes. Someone argues that
the government in this case has no role to play. Please comment and
explain.