California State University, Fullerton Department Of Economics Dr.

Morteza Rahmatian

Economics 590 Fall 2008 First Exam

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Part I:

Please answer the following 10 questions. Use graphs where they aid the discussion but remember that an unlabelled graph is useless. (6 Points each) Why the market demand for a private good is obtained by summing individual demands horizontally, but the market demand for a public good is obtained by summing them vertically? What is the free rider problem in the case of public goods? The smaller the group of payers or beneficiaries, the smaller the problem is likely to be. Why?
List and discuss three problems that might arise when using the Coase theorem. Ans: Bargaining costs are generally not zero. Identifying damages is difficult. There is generally some amount of asymmetric information.

1.

2.

3.

4.

The US government spends about $1.5 billion for research on alternative medicine, such as herb and energy field therapy. Is such research a public good? Is it sensible for the government to pay for such research? Research on alternative medicine is a public good if the research leads to treatments or cures that are non-excludable, meaning that others besides those who discovered the treatment may profit from the treatments. This would happen if discoveries cannot be patented. Whether or not it is sensible for government to pay for such research depends on the potential benefits of the research, which could be substantial if alternative medicine provides effective treatments, and whether or not the treatments can be patented.

5.

What are the primary reasons that explains an increase in federal expenditures for Social Security since 1965. Ans: Federal expenditures for Social Security have increased since 1965 for several reasons, including increases in the number of persons entitled to benefits and the introduction of Medicare and other programs.

6.

Why do/should we care that federal expenditures are becoming an increasingly larger portion of GDP? Ans: We should care that federal expenditures are becoming an increasingly larger portion of GDP because of public sector crowding out.

7.

It is possible that two different economists can examine the same situation, such as school funding, and reach entirely different conclusions. Why is this so? Ans: Reasoning resulting in differing results includes the time period under examination, the data sources and proxies used, the econometric tools employed, and many other reasons. This is not to say that because different researchers come to different conclusions the analysis is confused. It just means further investigation is needed.

8. 9.

What is market failure? What are the cases of market failure and how they are corrected. Social welfare functions can be formed in many ways. They can be additive, meaning that the all utilities curves are added together. They incorporate the idea of least-best, meaning that the utility of the person with the least is maximized. If you were a central planner for an economy, what type of social welfare function would you create? Ans: Answers will vary, but generally you need a social welfare function that incorporates some collectively agreed upon notion of fairness. It must also be function that can be implemented without causing undue stress on citizens or the economy.

10.

In recent years, a number of states have instituted taxes on patrons of nude and topless dance bars. Such taxes are known as sin taxes, because they target behavior that is believed to be sinful. How do sin taxes relate to the notion of merit goods? Musgrave (1959) developed the concept of merit goods to describe commodities that ought to be provided even if the members of society do not demand them. Sin taxes work the opposite way and apply to commodities that members of society might demand, but ought not to have.

Part II:

Please answer the following 4 of the following 5 questions. Use graphs where they aid the discussion but remember that an unlabelled graph is useless. (10 Points each)

1.

What is externality? Please explain positive and negative externality. With use of a graph please show the analysis of Pigouvian tax solution for internalizing the externality. Please read page 83, figure 5.4

2.

Explain how you would expect a libertarian, a social democrat, and someone with an organic conception of the state to react to the following laws: a. A law prohibiting gambling b. A law mandating seat belt use c. A law mandating child safety seats d. A law prohibiting prostitution e. A law prohibiting polygamy f. A law requiring all commercial signs be written in the countrys native language. Libertarians believe in a very limited government and are skeptical about the ability of government to improve social welfare. Social democrats believe that substantial government intervention is required for the good of individuals. Someone with an organic conception of the state believes that the goals of society are set by the state and individuals are valued only by their contribution to the realization of social goals.

a.

A law prohibiting gambling would probably be opposed by a libertarian and advocated by a social democrat. Someone with an organic conception of the state would first decide whether gambling would help to achieve the states goals before taking a position on this issue. If the
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view is that gambling keeps individuals from being productive, then someone with an organic view would probably be in favor of prohibiting it, but if gambling is considered a good way to raise more revenue for the state, then they might oppose the prohibition. b. Libertarians oppose the law mandating seat belt use, arguing that individuals can best decide whether or not to use seat belts without government coercion. Social democrats take the position that the mandate saves lives and ultimately benefits individuals. The organic view would probably lead to favoring the mandate on the grounds that reduced health care costs caused by fewer accidents benefit society. Libertarians oppose the law mandating child safety seats, arguing that individuals can best decide whether or not to use child safety seats without government coercion. Social democrats take the position that the mandate saves lives and ultimately benefits individuals. The organic view would probably lead to favoring the mandate on the grounds that reduced health care costs caused by fewer accidents benefit society.

c.

d.

Libertarians would probably oppose a law prohibiting prostitution, while social democrats would likely favor such a law. The organic view depends on the type of society policymakers are attempting to achieve. The law would probably be favored on moral grounds. Libertarians would probably oppose a law prohibiting polygamy, while social democrats would likely favor such a law. The organic view depends on the type of society policymakers are attempting to achieve. The law would probably be favored on moral grounds. Libertarians would likely oppose the law, believing that individual business owners should make the decision about which language is used for their signs. Social democrats would also probably oppose the law in order to foster a more inclusive society. Those with an organic view would probably favor the law if they hold the view that every member of the society should speak the native language.

e.

f.

3.

Which of the following do you consider pure public goods? Private goods? Why? a. b. c. d. e. a. b. c. d. e. Wilderness areas Satellite television Medical school education Public television programs An Internet site providing information on airplane schedules Wilderness area is an impure public good at some point, consumption becomes nonrival; it is, however, nonexcludable. Satellite television is nonrival in consumption (although it is excludable). Medical school education is a private good. Television signals are nonrival in consumption. An Internet site is nonrival in consumption (although it is excludable).

4.

In each case listed below, can you rationalize the government policy on the basis of welfare economics? a. In Los Angeles, the police respond to 127,000 burglar alarm calls per year. There is no charge. (97 percent of the alarms are false.) b. Honey production is subsidized by the federal government. c. The Federal Government regulates cherry frozen fruit pies, requiring at that at least 25 percent of each pie by weight contains Cherries and that no more than 15 percent of the cherries be blemished. There are no such regulations for apple, blueberry or peach frozen pies. d. In Washington, DC, you cannot become a hairdresser unless you have a license from the city government. e. The National Energy Policy Act requires that all new toilets flush with only 1.6 gallons of water. Most American homes have toilets the consume 5.5 to 7 gallons per flush. f. The federal government subsidizes the production of electricity from chicken manure. [Note: I am not making this up.]

a.

There is no obvious reason why there is a market failure with burglar alarm calls; the Los Angeles police could set a response fee equal to the marginal cost. Welfare economics provides little basis for such a subsidy of honey production. There is no economic reason why cherry pies should be regulated, especially since there are no such regulations for apple, blueberry, or peach frozen pies. It is hard to imagine a basis in welfare economics for this regulation for hairdressers.

b. c.

d. e.

This is not an efficient policy. If the problem is that too much water is being consumed, then the answer is to increase the price of water. On that basis, people can decide whether or not they want to buy toilets that require less water. Water, like most other resources, is a private good. There is no economic reason why the federal government should subsidize the production of electricity, whether the electricity comes from coal, nuclear power, or chicken manure. One can assume the question that the R&D process of creating electricity from chicken manure is already developed, so there is not a positive externality argument. Since the production of electricity is a private good, with no obvious violations of the fundamental welfare theorem, there is no justification

f.

5.

The private marginal benefit for commodity X is given by 10 X, where X is the number of units consumed. The private marginal cost of producing X is constant a $5. For each unit of X produced, an external cost of $2 is imposed on members of society. In the absence of any government intervention, how much X is produced? What is the efficient level of production of X? What is the gain to society involved in moving from the inefficient to the efficient level of production? Suggest a Pigouvian tax that would lead to the efficient level. How much revenue would the tax raise. Private Marginal Benefit = 10 - X Private Marginal Cost = $5 External Cost = $2 Without government intervention, PMB = PMC; X = 5 units. Social efficiency implies PMB = Social Marginal Costs = $5 + $2 = $7; X = 3 units. Gain to society is the area of the triangle whose base is the distance between the efficient and actual output levels, and whose height is the difference between private and social marginal cost. Hence, the efficiency gain is (5 - 3)(7 - 5) = 2. A Pigouvian tax adds to the private marginal cost the amount of the external cost at the socially optimal level of production. Here a simple tax of $2 per unit will lead to efficient production. This tax would raise ($2) (3 units) = $6 in revenue.