Public Economics: Advanced Topics

Tutorial 10 SOLUTIONS
Prepared by S. Grassi

Q1. Figure 1 shows that it is easier for a child born from poor parents to
become richer than his parents in the USA rather than in Denmark.
True/False? To justify your answer, refer to Figure 1 and describe the measure
of intergenerational income mobility used by Chetty et al (2014)

Figure 1

Sol: for the solutions you have to refer to lecture slides Inequality. You must
also look at the article by Chetty (in Keats: chetty-friedman-kline-
saezQJE14mobility.pdf) and learn what the Rank-Rank Slope is. See pages
1575-76-77 and earlier pages 1555.

Q2. Suppose you have to design an optimal transfer scheme for a specific
population with labor supply responses concentrated along the extensive

1
margin. The best way to transfer resources to those outside the labour force is
by means of a Negative Income Tax (give transfer to those with income=0)

SOL.False! Then the EITC or negative marginal tax rate program (subsidize
those with low earnings) is optimal. Explain: if labor supply responses are
concentrated along the extensive margin, then many people will decide to stay
out of the labor force with the negative income tax. See slides on optimal
income tax (part on optimal transfers)

Q3 Immigration and Redistribution

What type of misperception about immigrants are elicited in this paper? What is
the effect of immigration perception and support for redistribution?

SOL. See videos and paper

Q4. The excess burden of the tax is related to the

a) income effect.
b) tax revenue effect.
c) substitution effect.
d) price effect.

Q5. An EITC provides a cash subsidy for every $1 earned by those with
incomes below a given threshold per year. Which statement is correct?
a) The EITC increases the return to working and thus increases the cost of
leisure.
b) The EITC does not have an income effect for those recipients who are
already in the labor force and are eligible for the subsidy.
c) The EITC redistributes incomes to those who are unemployed.
d) The EITC only affects the incentives of those who were already
employed before the introduction of the EITC.

Q6
Show that with the following utility function for consumption and leisure,
there is no income effect.

u=c+ √ L
Assume that the budget is:
c=w(T −L).
SOL 6.
MRS=slope of budget.

2
 1
=w
2 √L
1
¿
L=
4 w2
¿ 1
c =wT −
4w

Note that the MRS is independent on c. For a given L, the slope of the
indifference curve remains constant. Indifference curves are parallel vertical
shifts of the same curve.

Find Income effect.

1
We change the wage to w’. Final choice of L is: L∗¿= 2
4w'
Now we find the level of L that gives the old utility at the new price.
'
MINc +w L
st :U∗¿ c + √ L
U* is U*=
1
4w
+ wT +
√ 1
4 w2
.
Use Lagrangean: L=c +w ' L+ λ {U ¿ −c−√ L}.
∂L
=0:1=λ
∂c
∂L 1
=0: w ' =λ
∂L 2√L
∂L
=0: U =c+ √ L
¿
∂λ
c 1
Find : L = 2
4w'
Substitution effect is: SE=Lc −L¿ ;
Income effect is: IE=L¿∗¿−L ¿.
c

1 1
SE= 2
− 2
4w' 4w
IE=0.

There are different ways of finding this result.

MORE Practice: find optimal labour supply for

1 /2 1/ 2
1) max
c,L
c L subject ¿ c=wT −wL

α 1−α
2) max
c,L
c L subject ¿ c=wT −wL

3
 3) max
c,L
lnc+lnL subject ¿ c=wT −wL