ECON 454, Summer Session II Midterm Exam Instructor: Melissa McInerney August 3, 2006

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1 ECON 454, Summer Session II Midterm Exam Instructor: Melissa McInerney August 3, 2006 You have two hours to complete this exam. Answer all questions in the blue books provided. Write your University ID number and NOT YOUR NAME on each book you use. You may put all answers in one book, but clearly label your answers. Make sure all cell phones, beepers, etc. are turned off. Remove all hats. No graphing calculators are allowed. The exam is worth 120 points. Point totals are indicated for each question. Answer each of the following questions. There are three sections: definitions/matching, true/false, and three short answer/problems. Make sure your exam has all three sections. DEFINITIONS/MATCHING For each phrase in the left hand column, mach it to the correct definition in the right hand column. There are more right hand column definitions than left hand column phrases. Each is worth 3 points. 1. (3 points) Efficiency condition for a public good (when there are two individuals in a production economy) 2. (3 points) Free rider problem b. MRS 1 =MRS 2 =MRT a. An activity of one entity affects the welfare of another entity in a way that is outside the market. 3. (3 points) In-kind transfer c. A good that is nonrival and excludable 4. (3 points) Adverse selection d. MRS 1 +MRS 2 =MRT 5. (3 points) Externality e. When an individual s behavior is affected by the fact that he is insured f. The fact that a commodity can satisfy one part of the definition of a public good and not the other. g. The incentive to let other individuals pay for a public good while you enjoy the benefits. h. A situation in which one side of an economic relationship has better information than the other i. The situation that occurs when the people who are most likely to receive benefits from a certain type of insurance are the ones who are most likely to purchase it. j. A spending program whose benefits only flow to those whose financial resources fall below a certain level k. Payments from the government to individuals in the form of commodities or services rather than cash. 1

2 TRUE/FALSE QUESTIONS Each of the following questions is worth five points. You will only receive credit if you justify your answer. If it is true, provide an example or other justification. If it is false, correct the statement so that it would be true and provide an example or other justification. 1. (5 points) When a good generates a positive externality, the private market produces too little of it relative to the socially efficient output. 2. (5 points) A public good cannot be provided privately. 3. (5 points) The disincentive to work was higher under Aid to Families with Dependent Children (AFDC) than under Temporary Assistance for Needy Families (TANF). PROBLEMS/SHORT ANSWER Each of the following questions is worth 30 points. You must show your work and follow instructions to receive credit. Question I (30 points) For this problem, assume that Christopher earns $700 per month. He allocates his income between food and all other goods. a. (1 point) Draw Christopher s budget constraint. Be sure to label the axes, the values where the budget constraint crosses the vertical and horizontal axes, and label this budget constraint BC1. b. (3 points) Christopher learns that he is eligible for $75 worth of food stamps and signs up for the program. Show how Christopher s budget constraint changes after he enrolls. Label his new constraint BC2 and show the values where the new budget constraint meets the horizontal and vertical axes. c. (1 point) Before food stamps, Christopher spent only $50 per month on food and the rest of his income on all other goods. Draw an indifference curve describing Christopher s consumption before enrolling in the Food Stamp program. Label this indifference curve IC1 and label his corresponding food and all other goods consumption on the horizontal and vertical axes. d. (3 points) Once Christopher receives Food Stamps, how does his utility change? Draw a second IC representing Christopher s optimal consumption given the food stamp benefit. Label the new IC IC2. e. (3 points) With food stamps, how much food does Christopher consume? Does he consume more, less, or the same amount of food as without food stamps? 2

3 f. (3 points) With food stamps, how much of all other goods does Christopher consume? Does he consume more, less, or the same amount of all other goods as without food stamps? g. (3 points) Now, suppose Christopher received $75 in cash instead of food stamp vouchers. On a new graph, draw his old and new budget constraints. Label the values where the new and old budget constraints meet the horizontal and vertical axes, the axes, and label the original budget constraint BC1 and the new budget constraint BC3. Draw Christopher s initial utility (IC1) on BC1 (where Christopher consumes $50 worth of food per month) and label consumption at this point. h. (3 points) Once Christopher receives the $75 per month cash transfer, how does his utility change? Draw a second IC representing Christopher s optimal consumption given the cash transfer. Label the new IC IC3. i. (5 points) Given his initial preferences, does Christopher prefer the food stamps to the cash benefit, the cash benefit to the food stamps, or is he indifferent between the two? Justify your answer. j. (5 points) Describe one reason why society might choose to offer food stamps as a benefit, instead of cash transfers. 3

4 Question II (30 points) Pollution is a negative production externality. Assume Peter works at a plant which dumps its waste into a river that nobody owns. Peter s marginal benefit and marginal (private) cost curves are shown below. With each additional unit Peter produces, society is harmed by the distance between the marginal damage (MD) line and the horizontal axis. $ MB MPC MD 1. (2 points) Copy this graph into your blue book. In your blue book, show the point where Peter finds it optimal to produce in the absence of government intervention. Label this point Q1. 2. (2 points) At Q1, what is the marginal damage Peter inflicts on society? Label it on your graph and write your answer in a sentence. 3. (5 points) Where is the socially efficient level of production? Is this higher or lower than Peter s privately optimal level of production, Q1? Label this point on the graph and write a sentence telling me if the socially efficient level of production is higher or lower than the privately optimal level of production. 4. (5 points) Society decides to impose a Pigouvian tax on each unit. Define a Pigouvian tax in words. 5. (10 points) Using the graph, show the amount of the Pigouvian tax collected on each unit and the total tax revenue collected. Does the tax change the MPC curve? If so, how? (Draw it and describe it.) 6. (2 points) Now where will Peter produce? Label it on the graph. 7. (4 points) Instead of a Pigouvian tax, describe one other response the government could take to reduce pollution. How is this other alternative better or worse than a Pigouvian tax? Q 4

5 Question III Madeline, Alina, and Sarah each work at Target. They have the same job and earn $10 an hour. They can work a maximum of 160 hours per month. 1. (5 points) In this problem, we will be analyzing how much they choose to work and how much leisure they choose to consume. Draw the budget constraint we will use to examine the labor-leisure tradeoff for each of them. Be sure to label both the horizontal and vertical axes and provide the values where the budget constraint intersects the horizontal and vertical axis. 2. (10 points) Their state introduces a cash assistance/welfare program with the following parameters. If a recipient does not work, they receive a basic monthly grant of $500. For every hour that they work, their benefit is reduced by $0.50. Draw the budget constraint that Madeline, Alina, and Sarah now face with welfare. Be sure to clearly label: the slope of the budget constraint as well as hours of work and monthly income at each endpoint and kink point. 3. (4 points) Before welfare was introduced, Alina worked 20 hours per month. Draw an indifference curve, label it ICE1 showing Alina s work in the absence of welfare. After welfare, how much does Alina work? Draw a second indifference curve, label it ICE2 showing how much Alina works after welfare. In words, tell me if Alina works more, less, or the same amount after welfare is introduced. Why? 4. (5 points) Before welfare was introduced, Sarah worked 102 hours per month. Draw an indifference curve, label it ICS1 showing Sarah s work in the absence of welfare. Draw a second indifference curve, label it ICS2 showing how much Sarah works after welfare. In words, tell me if Sarah works more, less, or the same amount after welfare is introduced? Why? 5. (3 points) Before welfare was introduced, Madeline worked 150 hours per month. Draw an indifference curve, label it ICM1 showing Madeline s work in the absence of welfare. In words, tell me if Madeline works more, less, or the same amount after welfare is introduced? Why? 6. (3 points) In 1996, Aid to Families with Dependent Children (AFDC) was replaced with Temporary Assistance for Needy Families (TANF). In class, we discussed several of the major changes which were enacted as a result of this transition. Describe one of the major changes. 5