ECON 340/ Zenginobuz Fall 2011 STUDY QUESTIONS FOR THE FINAL. x y z w u A u B

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1 ECON 340/ Zenginobuz Fall 2011 STUDY QUESTIONS FOR THE FINAL 1. There are two agents, A and B. Consider the set X of feasible allocations which contains w, x, y, z. The utility that the two agents receive in each allocation are given below: x y z w u A u B a) List all Pareto optimal allocations. b) What is the best allocation according to the utilitarian criterion? c) What is the best allocation according to the Rawlsian criterion? 2. Consider an economy with two consumers and two goods. One of these goods, Y, is a public good, and the other good, X, is a private good. The consumers preferences can be represented by u 1 (x 1, y) = x 1 y and u 2 (x 2, y) = x 2 y 2, where x i is the consumption level of good x by consumer i, and y is the consumption level of the public good. The public good can be produced with the production function f(x) = 2x. Consumer 1 has 10 units of X and consumer 2 has 20 units of X initially. a) Find the voluntary contribution equilibrium in this economy. b) Find the Lindahl taxes and the Lindahl equilibrium outcome. c) Show that the voluntary contribution equilibrium outcome is not Pareto efficient, while the Lindahl equilibrium outcome is efficient. 3. Consider an economy in which there are two types of individuals. They all care about a private good X and a public good Y. Each individual i starts with an income of M i and there is no public good initially. Let the price of the public good be 1. It takes one unit of the private good to produce one unit of the public good. The preferences of people of type A are U X, Y X Y, and there are N A of them in the economy. The preferences of people of A i i 2 type B are U B X i, Y X i. Their number is equal to N B. Let N = N A + N B denote the total number of individuals. You are given that N A > N B. a) Find the set of Pareto optimal allocations in this economy. b) Suppose the level of public good is determined democratically through a vote. Everyone is to pay an equal amount for the provision of the public good. The amount of public good that will be provided under equal contribution will be determined by majority voting (once chosen by the majorit, everyone has to pay their share of the cost). How much public good will be provided through this method? Is the associated allocation Pareto optimal? c) Instead of the majority rule, suppose they use the Lindahl mechanism. Determine the Lindahl equilibrium allocation. Is it going to be Pareto optimal? d) Who is better off under the Lindahl outcome compared to the voting outcome? Who is worse off? Assuming that the initial situation is as in part b), i.e. public budget is determined through a vote, can those who are better off under the Lindahl solution bribe those who are better of under taxation to move to the Lindahl outcome?

2 4. What is fair insurance? Why will a risk-averse consumer always buy full insurance when it is fair insurance? 5. Should the government allow insurance companies to use genetic testing to better assess the health status of their applicants? Would this genetic testing help or hurt those who are in bad health? Would it exacerbate or mitigate the problem of adverse selection in the health insurance market? Would it increase or decrease the number of people without health insurance? Would it be a good thing? 6. Are the following statements true or false? a) An insurance company must be concerned about the possibility that someone will buy fire insurance on a building and then set fire to it. This is an example of moral hazard. b) A life insurance company must be concerned about the possibility that the people who buy life insurance may tend to be less healthy than those who do not. This is an example of adverse selection. 7. Consider a hypothetical island with only ten people. Eight have income of $10,000, one has income of $50,000, and one had income of $100,000. a) (15 points) Draw a Lorenz curve for this income distribution. What is the approximiate value of the Gini coefficient? b) (15 points) Suppose a wealthy newcomer arrives on this island with an income of $500,000. How does this change the Lorenz curve? What is the impact on the Gini coefficient? 8. Consider an economy where individuals live for two periods only. Their utility function over consumption in periods 1 and 2 is given by U x x, where 1 2 x 1 and x 2 are period 1 and period 2 consumption levels, respectively. They have labor income of $100 in period 1 and labor income of $50 in period 2. They can save as much of their income in period 1 as they like in bank accounts, earning interest rate of 5% per period. They spend all their income before the end of period 2. a) What is each individual s lifetime budget constraint? If they choose consumption in each period so as to maximize their lifetime utility subject to their lifetime budget constraint, what is the optimal consumption in each period? How much do the consumers save in each period? b) Suppose the government introduces a social security system that will take $10 from each individual in period 1, put it in bank accounts, and transfer it back to them with intrest in period 2. What is the new lifetime budget constraint? What is the effect of this social security system on private savings? How does the system affect total savings in society? Now suppose that the introduction of social security induces individuals to retire in period 2, so they receive no labor income in period 2. c) What is the new optimal consumption in each period? How much do the consumers save? How does it compare with your answer to b) d) Based on what you found in c), should actual social security system lead to early retirement? Why or why not? 9. Daily demand for petroleum at a station is described by Q = p, where Q is liters of petroleum sold and p is the price in TL. The station s supply is Q = p. Suppose the government places a tax of 12 kuruş on every liter of petroleum sold. What will be the total revenue collected? What will be the deadweight loss resulting from this tax?

3 10. Consider an economy with two goods x 1 and x 2. The demand for good 1 is given by x 1 (p 1 )=16- p 1, while the demand for good 2 is x 2 (p 2 ) = 16 - p 2. Good 1 is produced in a competitive industry with a supply function S(p 1 ) = p 1. Good 2, on the other hand, is produced by a monopoly whose cost function is C(x 2 ) = 1/2(x 2 ) 2. Market for each good is initially at their respective equilibrium. Government gets approval from the parliament to impose a unit tax in the amount of 4 units in either (but not both) industry. a) Calculate the tax revenue collected, change in consumer surplus, change in the producer surplus and the excess burden due to this tax for each industry. b) Which industry should the government put this tax on? 11. Consider a monopolist who faces the following demand function for his product Q=70 - P. The total cost of producing Q units of output is given by TC=25Q 2-5Q+300 a) Find the equilibrium price and quantity. b) The government considers levying a unit tax. The statuary incidence of the tax is on the buyers. For every unit purchased buyers are paying $5 tax. Find the new equilibrium quantity, the price paid by the buyers, the price received by the seller. c) What is the economic incidence of this tax? How much is the tax revenue collected? 12. Consider the utility function and the budget constraint, where and are after-tax prices of goods X and Y, and x and y are the respective consumption levels of these goods. a) Find the price elasticity of demand for both commodities. b) Suppose the producer prices are set at. Apply the inverse elasticity rule to find how the (specific) tax rates and should be set for an optimal consumption tax design. c) Let and. Calculate the tax rates required to achieve revenue of. REVIEW QUESTIONS FOR THE VERBAL PART OF THE FINAL 1) In Adam Smith' s work, the invisible hand is a metaphor for a) self-interest. b) the profit motive. c) government enforcement of contracts. d) coordination through market prices. 2) The first fundamental theorem of welfare economics states: a) Pareto improvements lead to increased competition. b) Competitive markets lead to a Pareto efficient allocation. c) No one can be made better off without someone's being made worse off. d) Competitive markets lead to externalities and information problems. 3) The second theorem of welfare economics states that any particular point on the utilities possibility frontier can be reached if the government will a) redistribute income properly to begin with. b) leave the competitive system alone. c) equalize people's marginal rates of substitution. d) adopt a utilitarian social welfare function.

4 4) Which is not a true comparison between the concepts of Pareto improvement and Pareto efficiency? a) Pareto improvement refers to a reallocation while Pareto efficiency refers to an allocation itself. b) The existence of a potential Pareto improvement implies that the economy is Pareto inefficient. c) A Pareto improvement must lead to a Pareto efficient allocation. d) A movement from one Pareto efficient point to another is never a Pareto improvement. 5) Charging a toll on a crowded bridge can a) help to correct a negative externality. b) be a positive externality, because people don't wait so long once there is a toll. c) interfere with competitive efficiency. d) be a public good, since my paying the toll does not keep you from paying the toll as well. 6) The market failure referred to as incomplete markets is the failure of a) all people to demand all goods. b) some goods to be demanded because their competitive prices are too high. c) some goods to be provided because their prices are too low. d) some goods to be provided even though benefits would exceed costs. 7) TRUE or FALSE: The only type of externality that causes a market failure is a negative externality. 8) TRUE or FALSE: Examples of incomplete markets include insurance against flood damage or health insurance for the elderly. 9) Which of the following occurrences is never associated with a Pareto improvement? a) A middle-class person becomes worse off. b) Inequality increases. c) The poorest person's situation remains unchanged. d) Everyone benefits. 10) There is a basic trade-off between efficiency and equity because a) income redistribution tends to reduce incentives for efficient behavior. b) people who are efficient dislike equity. c) Pareto improvements can only be made by sacrificing efficiency. d) the economy can only achieve a Pareto efficient allocation by starting from an unequal allocation of resources. 11) Which is not true of Rawlsian social welfare functions? a) They have right-angled social indifference curves. b) They are derived from a concept of justice. c) They treat everyone equally. d) They focus attention on the least advantaged individual. 12) Which is not true of utilitarianism? a) It was espoused by Jeremy Bentham. b) It implies that a dollar given to one person is as important as a dollar given to anyone else. c) It implies linear social indifference curves. d) It encourages redistribution when there is diminishing marginal utility of income.

5 13) The free-rider problem refers to people who a) will only consume a public good if it is free. b) for efficiency's sake, should be allowed to consume public goods (such as mass transit) even if they do not pay. c) will not voluntarily pay for a public good even though they would benefit from its provision. d) are not willing to pay for a public good because they lack information about its potential benefits. 14) Which is not true of a public good? a) Excluding people from consuming it is not generally desirable. b) Public provision will assure an efficient quantity is produced. c) Private provision will lead to too low a level of provision. d) Excluding people from consuming it is not generally feasible. 15) Efficient private provision of pure public goods is difficult because a) too much will be demanded as each consumer is forced to buy her or his own units of the public good. b) too little will be demanded because private provision leads to higher marginal costs than public provision. c) too much will be produced as firms compete with each other for the public's dollars. d) too little will be demanded as, individually, consumers choose not to pay the full cost of units of the good. 16) A decentralized economy has trouble providing an efficient level of public goods because a) the government must produce all goods that are not private goods. b) the market can add up individuals' marginal rates of substitution but cannot set this sum equal to marginal cost. c) a decentralized market cannot lake into account the benefits accruing to other consumers once someone buys a unit of the public good. d) only a king or dictator cares enough to provide public goods. 17) At the efficient level of public goods provision, which of the following is not generally true? a) An individual's marginal benefit is less than the cost of the last unit. b) Pareto efficiency is achieved. c) The margina1 consumer's benefit is just equal to his or her cost of consuming. d) Marginal rates of substitution add up to equa1 marginal cost. 18) The median voter is powerful because a) median preferences are also the most common preferences. b) politicians naturally prefer middle positions. c) median preferences please half the people more than any other choice. d) a middle position makes lobbying efforts more credible. 19) The median voter model could explain excessive public expenditure in an economy where a) marginal benefits were constant across income groups, taxes were proportional to income, and the income distribution was skewed with many poor and few rich. b) marginal benefits were proportional to income, taxes were uniform, and the income distribution was skewed with many poor and few rich. c) marginal benefits were constant across income groups, taxes were uniform, and the income distribution was skewed with many poor and few rich. d) marginal benefits were constant across income group s, taxes were uniform, and the income distribution was skewed with many rich and few poor.

6 20) Lindahl equilibrium a) sets supply equal to demand. b) equates each individual' s marginal benefit to the marginal cost of production. c) tricks people into telling the truth by imposing penalties for lying. d) assigns tax prices proportional to average benefits. 21) TRUE or FALSE: You like vanilla ice cream. I move to your town and demand so much vanilla ice cream that its price rises. This is an example of a negative externality from consumption. 22) Which of the following is a lump sum tax? a) A sales tax b) A payroll tax c) A head tax d) An income tax 23) The idea that people should be taxed according to the benefits t receive from government expenditures is called a) benefit taxation. b) corrective taxation. c) horizontal equity. d) vertical equity. 24) A Pareto efficient tax structure a) would raise no revenue since being taxed makes you worse off b) would use only lump-sum taxes if there are extemalities in economy. c) would use only indirect taxes since direct taxes are always distortionary. d) could be consistent with either a Rawlsian or a utilitarian social welfare function. 25) If a tax is imposed on an industry's output and the tax is shifted backward, a) output demand is probably very inelastic. b) input demand is probably very inelastic. c) input supply is probably very inelastic. d) output supply is probably very elastic. 26) A tax system is called progressive if a) tax liabilities increase with income. b) marginal tax rates increase with income. c) after-tax incomes are less unequal than before-tax incomes, d) average tax rates increase with income. 27) If the indifference curves between two goods are linear, then a tax on one good will lead to a substitution effect that is a) zero. b) very large. c) greater than zero but very small. d) either zero or very large, but you cannot generally tell which without further information. 28) Another term sometimes used for deadweight loss is a) specific egalitarianism. b) excess burden. c) distortionary taxation. d) compensated demand.

7 29) A lump-sum tax causes a) income and substitution effects that reinforce each other. b) income and substitution effects that offset each other. c) no income effect. d) no substitution effect. 30) Producer surplus is a measure of a) unintended inventories that build up when consumers cut back demand in response to the imposition of a tax. b) extra profits to a firm whose output price has been increased by the imposition of a commodity tax. c) profits from selling inframarginal units at a price equal to the cost of the marginal unit. d) amount of revenue raised by a lump sum tax on producers (on either their output or their input). 31) Ramsey taxation deals with a) income taxes. b) differential lump.-sum taxes (for example, taxes based on ability). c) commodity taxes. d) purely distributional taxation. 32) When supply curves are perfectly elastic, Ramsey rules dictate that commodity tax rates should be proportional to the a) sum of the price elasticity and the income elasticity of demand. b) sum of the inverses of the price elasticity and income elasticity of demand. c) price elasticity of demand. d) inverse of the price elasticity of demand. 33) The country with the lowest level of tax revenues in relation to GDP among OECD countries is a) Turkey b) USA c) Austria d) Mexico 34) A simple Ramsey tax system would tend to tax a) high wages more heavily than low wages. b) food more heavily than perfume. c) trips to Europe more heavily than commuting to work. d) all goods equally.