EXERCISES

TEXTBOOK Public Finance, 9th Edition (Harvey Rosen, Ted Gayer)

CHAPTER Tools of positive analysis
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Bài 3
Bài 6
CHAPTER Tools of normative analysis
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Bài 4
Bài 6
Bài 10
Bài 11
CHAPTER Public Goods
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Bài 2
Bài 11
Bài 13
CHAPTER Externalities
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Bài 6
Bài 8
Bài 10
Bài 11
CHAPTER 2 – Positive analysis
1. In 2008, presidential candidate John McCain proposed extending the cut in marginal
income tax rates passed during the Bush administration.
Explain why theory alone cannot predict how labor supply would be affected if this
proposal were implemented.
If there were no political or legal impediments to doing so, how could you design an
experimental study to estimate the impact of lower marginal tax rates on labor supply?

A change in the marginal tax rate changes the individual’s net wage. This generates both an
income effect and a substitution effect.

As long as leisure is a normal good, these effects work in opposite directions. Hence, one
cannot tell a priori whether labor supply increases or decreases.

Experiment: If there were no political or legal impediments, an experimental study could be

conducted in which a control group confronts the status quo, and an experimental group faces
the new tax regime. Other things that affect work effort would impact both the control group
and the experimental group, so any difference in work effort between the two groups could be
attributed to the change in marginal tax rates.

3. A researcher conducts a cross-sectional analysis of workers and finds a positive correlation

between time spent on a computer at work and wages.

The researcher concludes that computer use increases wages and advocates a policy of
computer training for all children.

What is a possible problem with this analysis?

There are three conditions to establish a cause-effect relationship: X happens before Y (OK), X
and Y move together (OK), other factors that affect the co-movement of X and Y have been
addressed (Not yet). To be more specific:

The workers who spend time on a computer probably have other skills and abilities that
contribute to higher wages, so training children to use computers would not necessarily cause
their earnings potential to improve => OMITTED VARIABLE ISSUE.
To summarize, this study illustrates the difficulty of determining cause and effect based on
correlations. The data do not reveal whether using a computer causes higher earnings, or
whether other factors cause workers to use computers and to earn higher wages.

6. Suppose that five states reduce income taxes in a given year. You are interested in
estimating whether the tax cut has increased saving, and you find that the saving rate for
residents of these five states increased by 2 percent in the year after it was introduced.

Can you reasonably conclude that the tax cut caused the increase in saving?

How would you conduct a difference-in-difference analysis to estimate the impact on saving?
What assumption must hold for the difference-in-difference analysis to be valid?

Since only five states reduced income taxes, we could examine what happened in a control
group of states (those with an income tax but with no change in the tax rates) and compare
savings rates between the two groups. This is important because other factors can affect
savings rates and we have controlled for this thanks to the inclusion of control group.

If, for example, the saving rate for the five states with lower taxes (the treatment group)
increased by two percent, while the savings rate for the other states (the control group)
increased by one percent, then we could conclude that lower taxes caused the saving rate to
increase by one percent—the difference between the two percent increase in the treatment
group and the one percent increase in the control group.

The assumption that must hold for this difference in difference approach to be valid is that in
the absence of the income tax cut, the savings rates of the treatment rates would have
increased by the same percentage as the savings rates of the control states.

Chapter Tools of normative analysis

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Bài 4
Bài 6
Bài 10
Bài 11

1. In which of the following markets do you expect efficient outcomes? Why?

a. Hurricane insurance for beach houses
b. Medical care
c. Stock market
d. MP3 players
e. Loans for students who wish to attend college
f. Housing
An efficient market: no barrier for exit/entry, every unit is a price-taking unit (not price maker),
no information asymmetry.
a. In this particular insurance market, one would not expect asymmetric information to be
much of a problem – the probability of a hurricane is common knowledge. One would
expect the market for hurricane insurance to operate fairly efficiently.

b. There is substantial asymmetric information in the markets for medical insurance for
consumers and also malpractice insurance for physicians. For efficient consumption, the
price must be equal to the marginal cost, and the effect of insurance may be to reduce the
perceived price of medical care consumption (this could make the insured feel that the cost
of the medical care < true cost). That would lead to consumption above the efficient level.
Because of the these issues, there is little reason to expect the market to be efficient.

c. In the stock market, there is good information and thousands of buyers and sellers. We
expect, in general, efficient outcomes.

d. From a national standpoint, there is a good deal of competition and information with regard
to MP3 players and music. The outcome will likely be efficient for MP3 players and music.
However, some firms might exercise some market power through high brand awareness and
proprietary downloading systems.

e. The private market allocation is likely inefficient without government intervention. Student
loan markets may suffer from asymmetric information – the student knows better than the
lender whether he will repay the loan or default on it, a form of adverse selection.

f. The market for housing is likely to be relatively efficient. Some inefficiencies may exist, such
as asymmetric information—the seller knows more about the house than the buyer—and
differentiated products. But, the market has developed to mitigate these inefficiencies. For
example, a buyer can employ a home inspector to help him understand more about the
quality of the home. Also, a large number of homes on the market increases competition.

4. Many controversial issues in public finance concern when a central authority should allow
markets to work and when it should intervene. Generally we think of the government as the
central authority, but it could be a university as well. For example, according to Princeton
University’s student newspaper, the Daily Princetonian (April 16, 2007), there was “a flourishing
market of graduation ticket buyers and sellers on [the Internet].” However, the dean of students
shut down the market, arguing that “[s]elling tickets undermines that spirit of community, and
undermines the sense of class unity that seniors have worked hard to create.”
To analyze this policy, assume that a typical senior’s utility depends only on two commodities,
graduation tickets and a composite of all other goods. Assume there are two students, Angelo
and Bahn, each of whom starts out with three tickets. However, Angelo is “rich” and has twice
the amount of all other goods as Bahn. For simplicity, you may assume that graduation tickets
are infinitely divisible.
a. Draw an Edgeworth Box showing the initial allocation, assuming conventionally shaped
indifference curves for both students.
b. Using the Edgeworth Box, explain how the ban on selling tickets can lead to an inefficient
outcome.
c. Using the Edgeworth Box, represent a situation in which the ban on selling tickets does not
reduce efficiency for these two students.

(as in the box above, the initial allocation could be adjusted from A to B => both Angelo
and Bahn get higher utility. So the initial allocation is not efficient, and only by allowing
ticket trading can we obtain more efficient allocation)
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.
Imagine a simple economy with only two people, Augustus and Livia.
a. Let the social welfare function be W= UL+UA where UL and UA are the utilities of Livia and
Augustus, respectively. Graph the social indifference curves. How would you describe the
relative importance assigned to their respective well-being?
b. Repeat part a when W= UL + 2UA
c. Assume that the utility possibilities curve is as follows:

Graphically show how the optimal solution differs between the welfare functions given in parts a
and b.
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.
W= UL + UA
4=2+2
4=1+3
4=3+1

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.

W= UL + 2UA
4 = 2 + 2.1
4 = 1 + 2*1.5
4 = 0 + 2.2
To increase util of Augustus, society is willing to reduce 2 util of Livia.
Social welfare is maximized when Mark’s marginal utility of income is equal to Judy’s marginal
utility of income. Taking the derivative of Mark’s utility function to find his marginal utility
function yields MUM = 50/(IM1/2) and taking the derivative of Judy’s utility function yields MU J =
100/(IJ1/2). If we set MUM equal to MUJ, the condition for maximization becomes IJ = 4IM and,
since the fixed amount of income is $300, this means that Mark should have $60 and Judy
should have $240 if the goal is to maximize social welfare = UM + UJ.

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 MU T=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 U T=UW and substitute
FT=400-FW and solve. Therefore, FT=80 and FW=320.

Chương Public Goods

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Bài 13
1. Which of the following do you consider pure public goods? Private goods? Why?
a. Wilderness areas
b. Satellite television
c. Medical school education
d. Public television programs
e. Automated teller machine (ATM)

a. Wilderness area is an impure public good: at some point, consumption becomes rival (when
the area becomes crowded; it is, however, nonexcludable.
b. Satellite television is nonrival in consumption, although it is excludable; therefore it is an
impure public good.
c. Medical school education is a private good (both rival and excludable).
d. Television signals are nonrival in consumption and not excludable (when broadcast over the
air). Therefore, they are a public good.
e. An automatic teller machine is rival in consumption, at least at peak times. It is also
excludable as only those patrons with ATM cards that are accepted by the machine can use
the machine. Therefore the ATM is a private good.

2. Indicate whether each of the following statements is true, false, or uncertain, and justify
your answer.
a. Efficient provision of a public good occurs at the level at which each member of society
places the same value on the last unit.
b. If a good is nonrival and excludable, it will never be produced by the private sector.
c. A road is nonrival because one person’s use of it does not reduce another person’s use of it.
d. Larger communities tend to consume greater quantities of a nonrival good than smaller
communities

Solutions:
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. For excludable goods, it is required that we need to
 know the individual preferences (so it is hard for private sector to provide public goods
efficiently) Đối với excludable goods, vẫn cần phải biết preferences của cá nhân, nên vẫn khó
để khu vực tư có thể cung cấp một cách hiệu quả. However, 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 (maybe true/false depending on the context - có thể đúng/sai tùy hoàn cảnh). 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.

11. Suppose that there are only two fishermen, Zach and Jacob, who fish along a certain
coast. They would each benefit if lighthouses were built along the coast where they fish. The
marginal cost of building each additional lighthouse is $100. The marginal benefit to Zach of
each additional lighthouse is 90 - Q, and the marginal benefit to Jacob is 40 - Q, where Q
equals the number of lighthouses.
a. Explain why we might not expect to find the efficient number of lighthouses along this
coast.
b. What is the efficient number of lighthouses? What would be the net benefits to Zach and
Jacob if the efficient number were provided?
MB và MC
MB z = 90 – Q
MB J = 40 – Q
b. Lighthouse => public goods
SMB = 130 – 2Q = MC = 100
=> Q = 15

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.

Britney and Paris are neighbors. During the winter, it is impossible for a snowplow to clear the
street in front of Britney’s house without clearing the front of Paris’s. Britney’s marginal benefit
from snowplowing services is 12 - Z, where Z is the number of times the street is plowed.
Paris’s marginal benefit is 8 - 2Z. The marginal cost of getting the street plowed is $16.

Sketch the two marginal benefit schedules and the aggregate marginal benefit schedule.
Draw in the marginal cost schedule, and find the efficient level of provision for snowplowing
services.
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.

MBParis
MBBritney

Chapter Externalities
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Bài 6
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Bài 11
 a. The number of parties per month that would be provided privately is P.

b. See schedule MSBp.

c. P*. Give a per-unit subsidy of $b per party to induce the correct number of parties.

d. The optimal subsidy is $b. The total subsidy=abcd. “Society” comes out ahead by ghc,
assuming the subsidy can be raised without any efficiency costs. (Cassanova’s friends gain
gchd; Cassanova loses chd but gains abcd, which is a subsidy cost to government.)

6. For each of the following situations, is the Coase Theorem applicable? Why or why not?
a. A farmer who grows organic corn is at risk of having his crop contaminated by genetically
modified corn grown by his neighbors.
b. In Brazil it is illegal to catch and sell certain tropical fish. Nevertheless, in some remote
parts of the Amazon River, hundreds of divers come to capture exotic fish for sale on the
international black market. The presence of so many divers is depleting the stock of exotic fish.
c. In the state of Washington, many farmers burn their fields to clear the wheat stubble and
prepare for the next planting season. Nearby city dwellers complain about the pollution.
d. Users of the Internet generally incur a zero incremental cost for transmitting information. As a
consequence, congestion occurs, and users are frustrated by delays.
a. It is very likely that the farmer could negotiate with the neighbors, provided property rights
are clearly defined. The Coase Theorem is therefore applicable.
b. It is unlikely that negotiation could result in an efficient outcome in this case. It is likely that
there are a great number of divers involved + property rights unclear, making negotiation very
difficult.
c. Property rights are not being enforced + two many people involved, making negotiation
through the Coase Theorem impossible.
d. There are too many people involved for private negotiation.

8. In India, a drug used to treat sick cows is leading to the death of many vultures that feed off of dead
cattle. Before the decrease in the number of vultures, they sometimes used to smash into
the engines of jets taking off from New Delhi’s airports, posing a serious threat to air travelers.
However, the decline of the vulture population has led to a sharp increase in the populations
of rats and feral dogs, which are now the main scavengers of rotting meat [Gentleman, 2006,
p. A4]. There have been calls for a ban on the drug used to treat the cows.
Identify the externalities that are present in this situation. Comment on the efficiency of banning the drug.
How would you design an incentive-based regulation to attain an efficient outcome?

The use of the drug to treat sick cows leads to a positive externality (the benefit enjoyed by air travelers)
as well as a negative externality (the costs created by a larger number of rats and feral dogs). Banning the
drug might raise or lower efficiency, depending on whether the positive externality is larger or whether
the negative externality is larger.
There are many ways to design incentive-based regulations. Policymakers could determine the efficient
level of drug usage and then either allocate or sell the right to use the drug for sick cows.

10. American suburbs are expanding to more rural areas at the same time as pig farms are
expanding in size [Economist, 2007d, p. 36]. The smells emanating from the massive amounts of
pig manure adversely affect property values.
Imagine that the Little Pigs (LP) hog farm is situated near 100 houses. The following table
shows, for each level of LP’s output, the marginal cost (MC) of a hog, the marginal benefit
(MB) to LP, and the marginal damage (MD) done to property values:

a. How many hogs does LP produce?

b. What is the efficient number of hogs?
c. Suppose the owner of LP can reduce the marginal damages of hog smells by twothirds by
modifying the hogs’ diet. The modified diet increases the marginal cost of each hog by $100.
What is the efficient number of hogs?
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.

11. The private marginal benefit for commodity X is given by 10 - X, where X is the number of
units consumed. The private marginal cost of producing X is constant at $5. For each unit of X
produced, an external cost of $2 is imposed on members of society. In the absence of any
government intervention, how much X is produced? What is the efficient level of production of
X? What is the gain to society involved in moving from the inefficient to the efficient level of
production? Suggest a Pigouvian tax that would lead to the efficient level. How much revenue
would the tax raise?

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.