Public Economics: Week 1

Definitions to know:

 Pareto Efficiency
 Social Welfare Functions
o Libertarian
o Utilitarian
o Egalitarian
o Rawlsian
 Horizontal vs vertical equity
 Substitution vs Income effects
o Make sure to be able to distinguish these effects for inferior vs normal goods
 Bounded willpower
 Bounded rationality
 Bounded self-interest
 First Fundamental Theorem of Welfare Economics
 Second Fundamental Theorem of Welfare Economics

Short answer questions:

Outline the standard assumptions for which markets are efficient. Leaving aside equity
considerations (which are equally, if not more important) do organ transplants satisfy all
conditions for market efficiency? Why or why not?

Utilities frequently observe natural monopolies, as it is more efficient to produce or process

water, electricity or gas in large quantities. What would the outcome of a natural monopoly be in
terms of price and quantity if the firm were allowed to pursue its optimal pricing strategy? In
what ways could government intervene to enhance social welfare?

What are the two different ways a society could obtain economic efficiency? What are the
advantages and disadvantages of both?

An egalitarian and Rawlsian walk into a bar and talk about social justice. On what points may
they find agreement about maximizing social welfare? One what points would they disagree?

Let’s suppose a government wants to encourage higher education take-up rates for students from
lower socio-economic backgrounds, and is considering two policies to increase access: lump-
sum transfers to high school leavers whose household income is less than a stated threshold, and
subsidies for tuition. Assume a prospective low-income college student intends to consume two
goods; higher education and food. Holding everything else equal, how would these two policies
influence this student’s optimal consumption bundle (hint – you should explain both separately)?
Assume graduate student Sally consumes only two goods, drip coffee (a normal good) and
ramen noodle soup (an inferior good). Sally only buys her coffee at Starbucks, so coffee costs
her $2 per cup while ramen noodle soup costs her $1 per package. She has a total income to
spend on these goods of $50 per week. In order to promote a new house blend, Starbucks lowers
its price of drip coffee to $1 per cup. Demonstrate on a graphic how the drop in price will
impact Sally’s new optimum consumption bundle (put coffee on the X axis, and ramen noodle
on the Y axis). Make sure you outline the specific income, substitution, and total effects on your
graphic.

How would a behaviorist respond to the comment that healthcare can be efficiently provided by
the market?

Consider two goods, cigarettes and sporting equipment. Which one would you consider more
demand elastic and why? Which would you consider more demand inelastic and why? Draw
two hypothetical demand curves for the two goods. If you were government and had the sole
objective of raising money, which good would you tax?

The market demand curve for bushels of wheat (in thousands) is QD = 40 – (4/5)P and the market
supply curve for bushels of wheat (in thousands) is QS = 2P – 2, where P is the (per bushel)
market price. What is the equilibrium quantity and price? Suppose in order to help farmers,
government introduces a price floor of $25 per bushel – in other words, the price of wheat is not
allowed to fall below this value. What is the new equilibrium quantity demanded, and what is
the deadweight loss?