ECON4320

Chapter 1

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.

Chapter 3

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.
Tickets
Seller

Other
Other
goods
goods
B

Buyer Tickets

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
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.

Tickets
Seller

Other Other
A
goods goods

Buyer Tickets

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.
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.
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.

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 13 Jose
Tea

10 11

Tea
Hannah 15 Coffee

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.
Chapter 4

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
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.

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.

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.
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 both three and four shepherds, where the net social
benefits equals 12 sheep:

𝑛=3 ⇒ net benefit = 𝑛(10 – (𝑛 − 1) − 4𝑛 = 12

𝑛=4 ⇒ net benefit = 𝑛(10 – (𝑛 − 1) − 4𝑛 = 12

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 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.

MBBritne
MBParis y

Chapter 5

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.

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.
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 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.

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

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.