Exercises on Microeconomics for Public Policy Problem Set IV - Answer Keys 1. Let mi ; M (a) mi be the investment of consumer i.

Then, xi = mi + mj ; xi = M 1 2 is one, the good is a pure public good. mi .

represents the degree of spillover (positive externality) of good 1. If

is zero, the good

is a local good, and if

(b) Consumer i maximization problem is: s max log xi + xi = max log mi + mj + M 1 2 mi (xi ;xi ) 1 2 FOC gives mi + mj = 1: Therefore, consumer i chooses mi = 1 for consumer j. The unique Nash equilibrium is mi = mj = consumption are x = 1; M
i 1 1+ 1 1+

mi : mj ; given mj . Same . Then, the levels of

for both i = 1; 2. !

(c) The utilitarian welfare maximization problem is: max U 1 + U 2 = max2 (m1 ;m ) (xi ;xi ) 1 2 FOC for mi requires
i j 1 1+ 1 mi + mj

log m1 + m2 + M + log m2 + m1 + M

m1 m2

mj + mi

= 1: The solution is m1 = m2 = 1. This is the same

as the solution in (b) i (d) m = m =

= 0.

is both the unique Nash equilibrium and the utilitarian optimal for 8 . G=n.

2. (a) For given G and n, the consumption of the private good of each consumer is x = M Hence the maximization problem is:
(G;n)

max M

G + 5 log G n

n :

FOCs require:

G n2 The solution is (G ; n ) = (25; 5).

1 = 0;

1 5 + = 0: n G 5 + 5 log (5n) n. Remember that

(b) Given n, the optimal G is Gn = 5n. Hence, Un = M

the optimal club size is n = 5. For population of 18, the closest club size is obtained when ^ there are 4 clubs. The club size is n = 4:5; and public good provision is G = 22:5. The price ^ ^ n for the membership is G=^ = 5: (c) Let p be the willingness to pay for the club with (G; n) at the utility level obtained in the ^ n ^ ^ solution of (b). Then, U (M p; G; n) = U M G=^ ; G; n . Hence p = 9:5 5 log (22:5) + 5 log G (G; n) = np n. G: By denition, ^ ^ G; n = 0.

The prot of this (monopolistic) club is then Hence at the optimal level, competition is perfect between club owners.

(G; n) > 0. E cient zero-prot equilibrium is obtained if the

3. (a) Without any correction for externality, the inverse demand is equal to MPC in the equilibrium: 20 q = 2 + q: Hence, q N = 9; pN = 11: q = 2 + q + 0:5q. Hence,

(b) At the social optimum, the inverse demand is equal to MSC: 20 q = 7:2; p = 12:8.

(c) The deadweight loss is the triangle area formed by (p ; q ) ; pN ; q N and M SC q N ; q N ; where M SC q N is the marginal social cost at q N : M SC q N = 15:5. Hence, DW L =
1 2

(9

7:2) (15:5

11) = 4:05.

(d) The optimal tax would be equal to MEC at the e cient level of emission: T = 0:5q = 3:6: