HE3001 Tutorial 8

1) Consider the fishing industry. Access to the ocean is rival and non-exclusive: Every fisher can go fishing,
but once fish is caught, it is the fisher’s private property.

Suppose the total value of fish is f (b)=−b2 +100 b, where is b is the total number of fishing boats.
Assume that each fishing boat gets an equal split of the total value of fish. The cost of sending a boat is
c=10 .
(a) Suppose each potential fisher decides whether to send a boat independently. What is the equilibrium
number of boats?

(b) What is the socially optimal number of boats?

(c) Now suppose the ocean is privatized. Its owner can charge each fishing boat an entry fee of p (on top
of the costs incurred for sending the boat). What is the profit-maximizing level of entry fee? Under this
fee, is the equilibrium number of boats socially optimal?

2) A city has 1,000 people. Citizens of this city consume only one private good, Labatt’s ale. There is one
public good, the town skating rink. Although they may differ in other respects, inhabitants have the same
100 100
utility function, U ( X i , G )= X i− U ( Xi ,G ) =Xi− , where X i is the number of bottles of
G G
Labatt’s consumed by citizeni and G is the size of the town skating rink, measured in square meters.

The price of Labatt’s ale is $1 per bottle and the price of the skating rink is $10 per square meter.
Everyone who lives in the city has an income of $1,000 per year.

(a) Write down an expression for the absolute value of the marginal rate of substitution between skating
M UG
rink and Labatt’s ale for a typical citizen, .
MUX i

(b) What is the marginal cost of an extra square meter of skating rink (measured in terms of Labatt’s ale)?

(c) Since there are 1,000 people in town, all with the same marginal rate of substitution, you should now
be able to write an equation that states the condition that the sum of absolute values of marginal rates of
substitution equals marginal cost. Write this equation and solve it for the socially efficient amount of G .

(d) Suppose that everyone in town pays an equal share of the cost of the skating rink in taxes. Write out
each citizen’s (expected) budget constraint for a given size of skating rink G .

(e) Given the situation in part d), every year the citizens vote on how big the skating rink should be. What
size of the skating rink would each citizen most prefer? (Hint: solve for the optimal G given the above
budget constraint.) How does this compare to the socially optimal rink size?
3) Homeowners 1, 2, and 3 live at the end of a badly deteriorated road. Fixing the road would cost $C.
The individual values of road repair for Homeowner 1,2, and 3 are $3000, $5000, and $8000 respectively.

To address reluctance from each homeowner to cover the cost, the local government has decided to use
the VCG mechanism to determine whether to fix the road:

Each homeowner is asked to report his value for fixing the road.

If the sum of the reported values is greater than C, the road will be fixed and each homeowner will have
to pay $C/3. Furthermore, each homeowner also has to pay an additional tax as calculated by the VCG
mechanism (as specified in your lecture notes).

Suppose that C = $13, 500, so that each homeowner has to pay $4,500 as his share of the cost.

i) Will the road be fixed?

ii) What will be the additional tax paid by each homeowner?

iii) How does each homeowner’s welfare change as a result of the VCG mechanism?
How does total welfare change?

Ans: -$1500, $500, $2500

4) Bob and Ray are sharing an apartment for the year. In a flea market they spot a 25-year-old sofa that
would look great in their living room.

Bob’s utility function is u B (S , M B )=(1+ S) M B , and Ray’s utility function is u R (S , M R )=(2+S )M R .

In these expressions M B and M R are the amounts of money that Bob and Ray have to spend on other
goods, S=1 if they get the sofa, and S=0 if they don’t get the sofa. Bob has W B dollars to spend, and
Ray has W R dollars.

(a) What is Bob’s reservation price for the sofa?

Reservation price= max price individual is willing to pay for the good, individual should be
indifferent between buying and not buying
Price incurring for public good is rB, wB-rB is for private good you can buy

(b) What is Ray’s reservation price for the sofa?

(c) If Bob has a total of W B=100 and Ray has a total of W R=75 to spend on sofas and other stuff, what
is the maximum cost of the sofa that they could buy the sofa and have a Pareto improvement over not
buying it?
5) Trump and Biden share a rental apartment with a very old bathroom. They have approached the
apartment owner for help in deciding on upgrading the bathroom, which would cost $400. If the
bathroom is upgraded, they will both enjoy the benefits from its use. The value to Trump of upgrading
the bathroom is $180 and the value to Biden of upgrading the bathroom is $370.

The apartment owner decided to use the VCG mechanism to determine whether to upgrade the
bathroom.

Assume that Trump and Biden can either choose to report their own true value or report a value of 0.

(a) In each of the 4 combinations of reports, will the bathroom be provided and what will be the
additional VCG tax paid by each of Trump and Biden? Use this to fill up the payoff matrix below.

Biden

Report $370 Report $0

Trump Report -20,150 0,0
$180
Report $0 -170,0 0,0

First consider good provided in each outcome (for each of the 4 reports)

Then consider if they are pivotal and the tax (tax put on people to induce them to tell the truth, then
based on their true values, decide if want to provide the public good)

Public good only provided when sum of mi>0. Under VCG, provided when vi>0, pareto efficient.

This qn was a past year paper (gives level of difficulty)-> specifically go through slides with VCG eqns and
then try to solve it bc this qn is just numerical application

(b) Suppose we iteratively eliminate weakly dominated strategies for each player. Is this game
dominance solvable? Discuss the role of the VCG mechanism in implementing socially efficient
outcomes.

Conceptual Questions

6) If a public good can be provided in a variable amount, state and explain the condition for a given
amount to be Pareto efficient.

7) Explain how the VCG mechanism encourages truth-telling among participants.