Public Economics: Advanced Topics

Tutorial 9 SOLUTIONS
Prepared by S. Grassi

Q1
The following graph refers to the model by R Bénabou and J. Tirole on beliefs in
a just world. Explain why the red dots indicate equilibria.

SOL.
The figures describe two curves: 𝜆(𝜏) and τ(λ). The first, indicates the choice of
memory recollection effort (or how much one wants to suppress bad news from
their children) in response to the tax rate. If the tax rate is expected to be very
low, one’s income will depend on one own’s effort and return to effort is high
because not taxed. Then, it is important to believe that effort pays off to motivate
oneself or one own’s children to exert effort. The reverse is true if tax is
expected to be high. The function τ(λ) describes the choice of the tax rate as a
function of the beliefs of the majority. If the recollection of bad news is highly
distorted, then the pivotal voter is the optimistic poor and tax will be chosen to
be low.
The red dots indicate the intersection of these “best response” function.

Q2
“When agents have a high recall rate (𝜆 = 𝜆̅ > 𝜆∗ ), enough of the poor end up
with pessimistic beliefs (𝜇 i=0) to constitute a majority and impose a high tax rate
𝜏̅ > 𝜏 ∗ . The expectation of substantial redistribution (𝜏̅ > 𝜏 ∗ ) and therefore a low

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net return to effort, in turn, generates only weak incentives to deny that 𝜃 is low.
So agents indeed make no effort at dissonance reduction, choosing the natural
awareness rate, 𝜆̅.”
Which equilibrium of the world is this statement describing? Can you describe
the alternative equilibrium found in the model?

SOL: Realistic Pessimism/ Welfare State.

The alternative equilibrium is the Belief in a Just World/ Laissez Faire: “When
agents try hard to ignore discouraging news about the efficacy of individual
effort (𝜆 = 𝜆 < 𝜆∗ ), enough people end up with relatively optimistic beliefs
(𝜇 i=𝑟̅ ) to make the poor among them the pivotal group: 1- 𝜆 >1⁄2 .16 The
expectation of a relatively low tax rate (𝑡 < 𝜏 ∗ ) , in turn, generates strong
incentives to believe that 𝜃 is high. So people indeed make significant efforts at
maintaining such a worldview, forgetting (or minimizing to their children) any
dissonant information at a high rate 1-𝜆.

Q3 “Intergenerational Mobility and Preferences for Redistribution”

What is the main take-away from the table below? How does it relate to the
paper by Bénabou and Tirole (Beliefs in a Just World) studied in class?

SOL
See section II. Mobility (Mis)Perceptions A. Actual and Perceived Mobility in
the paper. The misperceptions of mobility found in this article are perfectly in
line with Bénabou and Tirole’s (2006) model of “ideology,” where people need
and demand “just world” beliefs to summon willpower and effort. In their
“Belief in a Just World Equilibrium,’’ there is overestimation of mobility and
rewards for effort and low redistribution; the opposite holds true for the
“European or Realistic Pessimism equilibrium.’’

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Q4
You graduate from KCL and take a job as a research assistant with a wage of
$25 per hour. Your job is extremely flexible: you can choose any number of
hours from 0 to 2000 per year. Suppose that the government introduces a
negative income tax: you receive $5,000 from the government and pay a tax of
25% on all income you earn. Discuss this tax change on equity and efficiency
grounds. Explain the likely effects in terms of the empirical evidence on labor
supply responses. Draw a graph in [hours, consumption] space as part of your
answer.

SOL
The BudgetConstraint has a slope of -.75×25; the income at 2000 hours is
$42,500 ($5,000 plus 2000 × .75×25) and the income at 0 hours is $5,000. This
tax distorts labor supply and generate DWL, since workers keep only 75 cents of
every dollar they earn and because of the income effect of the $5,000 guarantee.
This tax provides a safety net for the very needy. Overall the tax is progressive,
and it redistributes to the poor. It does introduce a distortion at the intensive
margin because of the substitution effect. It does introduce a distortion at the
extensive margin, because it pushes people to stay out of the labour force. If
labour supply is concentrated at the extensive margin, it discourages people from
working. It also discourages people to work at the intensive margin because of
the high marginal tax rate. It is a good tax in terms of equity as it helps the very
poor.

C
50,000

42500

5000

2,000 Leisure