EC320 : Economics of Public Policy

In Class Problem Set

Seminar 4

Weeks 9 & 10

Department of Economics

University of Warwick

2022-23

1
Question 1
Assume that all individuals have the same utility function over consumption and labour
given by:
U (c, l) = c + θln(16 − l)
where c represents consumption, l represents hours of labour, and θ is a constant parameter
that reflects an individual’s distaste for labour hours. Also, ln( ) denotes the natural
logarithm. Suppose the only income that individuals have is from labour income, and
that they work at an hourly wage w.

1. Assuming the government imposes a tax on labour income at rate t, write down the
budget constraint faced by the individual. Solve for the individual’s optimal labour
supply.

2. For this part i.e. part (2) only, assume that

• There are 100 individuals in this society with the utility function given above.
• All individuals have θ = 24
• There are 50 low wage individuals and 50 high wage individuals. The low wage
individuals earn wage w = 4, while the high wage individuals earn wage w = 8.

Calculate how much revenue the government will raise if it imposes a 25% labour
income tax (t=0.25) on all 100 individuals.

3. The government creates a universal basic income (UBI) program to support individuals
with low or zero labour income, where the UBI phases out after a certain threshold
of income. The programme is financed by imposing a labour tax on higher earners.
More specifically:

• The UBI program provides all individuals a lumpsum grant of £20.

• The grant does not phase out for the first £24 of labour income.
• After the first £24 of labour income, the grant is phased out at a 50% rate.
• After the grant phases out entirely, labour income from that point up to £120
is taxed at a 25% rate.
• After £120, any additional labour income is taxed at a 50% rate.

Explain and graph the budget constraint. For each bracket in your budget constraint,
indicate the sign (direction) of the substitution and income effects on an individual’s
choice of labour supply.

4. For this part i.e. part (4) only, consider an individual with θ = 24 and w =
8. Calculate this individual’s optimal choice of hours of labour under the UBI
programme you graphed in part (3).

2
Question 2

Consider the utility function U = αlog(x1 ) + βlog(x2 ) − L where L is the total labour
hours. The budget constraint is represented by wL = q1 x1 + q2 x2 .

1. Show that the price elasticity of demand for both commodities is equal to -1.

2. Setting producer prices p1 = p2 = 1, show that the inverse elasticity rule implies
t1
t2
= qq12 .

3. Setting w = 100 and α + β = 1, calculate the tax rates required to achieve a revenue
of R = 10.

Question 3
Consider an economy with two consumers of skill levels s1 and s2 , s2 > s1 . Denote the
allocation to the low skill consumer by (x1 , z1 ) and that to the high skill consumer by
(x2 , z2 ).

√
1. For the utility function U = x− zs , write down and explain the incentive compatibility
constraints for the consumers. Which constraint binds at the optimum?

2. For the utilitarian social welfare function

√ z1 √ z2
W = x1 − + x2 −
s1 s2
set up the optimisation problem of the government and express W as a function of
x1 and x2 only. For s1 = 15 and s2 = 20, derive the optimal values of x1 and x2
and hence, z1 and z2 .

3. Contrast the above outcome to the case when skills are publicly observable.