2016

[ECONOMICS 350]

Concordia University
College of Alberta

Assignment
October 18
Gonzalo
Marinadue
Ruiz
de Loizaga

Gonzalo Marina Ruiz de Loizaga

CONCORDIA UNIVERSITY COLLEGE OF ALBERTA

ECONOMICS 350
ECONOMICS OF PUBLIC EXPENDITURES
ASSIGNMENT 1
Due: October 16, 2016
1.

Consider a simple economy with two individuals, John and Marsha. The
economy is endowed with 30 kilograms of cheese and 30 loaves of bread each
month. John and Marshas preferences for bread and cheese are given by their
marginal rates of substitution of bread for cheese:
MRSJbc = 10
xJb
MRSMbc = 5
xMb
where xJb is the quantity of bread consumed by John and xMb
is the quantity of bread consumed by Marsha.
a.
b.
c.

If each individual only had one loaf of bread, how much cheese would
each individual be willing to give up in order to have another loaf of
bread.
In the initial allocation, each individual has 15 kilograms of cheese and 15
loaves of bread. Draw the Edgeworth Box diagram for this economy and
explain whether the initial allocation of cheese is Pareto efficient.
Draw the contract curve for this economy where the MRSs are equal.

a)

b)

Since MRSjbc is not equal to MRSmbc, it does not fulfill the necessary condition to be
pareto efficient, which would be

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c)

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2.

Thelma and Louise are neighbors. During the winter, it is impossible for a
snowplow to clear the street in front of Thelmas house without clearing in
front of Louises house. Thelmas marginal benefit from snowplowing is 12
Z, where Z is the number of times the street is plowed. Louises marginal
benefit is 8 2Z. The marginal cost of getting the street plowed is $16.
Suppose the snowplowing service is financed by distortionary taxation. The
marginal cost of public funds varies with the amount of tax revenue, R, that is
raised:
MCF = 1 + 0.0002441R2
If the tax revenue is only raised to finance the snowplowing of Themas and
Louises street, what is the optimal provision of the snowplowing service.
(Assume that snowplowing does not affect the amount of revenue generated
by the tax system and that the average cost of snowplowing is equal to the
marginal cost, $16.)

First, by using the equation:

Now, substituting for their values (MR is 0 since the revenue is not affected by this
system)

And the revenue from such taxes is raised only to finance the snowplowing (R=16Z,
which is money value of a snowplow)
Now, solving:

This can be rearranged the following way

This is a second degree equation that can be solved with the following formula

Thus:

Which has the following results, Z=1 and Z=-4. Since Z in this case cannot be negative,
the only plausible solution would be Z=1, Z being the number of snow plowings.
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3.

Arnold consumes two goods x and y. His preferences over alternative

consumption bundles can be expressed by the utility function:
U(x,y) = xy
Such that MUx = Y and MUy = x
Given his income I = 200 and prices (px, py) = (4, 2), Arnold maximizes his
utility from consumption of goods x and y.
a. Determine Arnolds utility maximizing consumption bundle (x*, y*).
Remember that MRS = Px/Py.
b. The government considers subsidizing Arnolds consumption of good x.
In particular, the government considers a subsidy s that halves the price
paid by Arnold per unit if x consumed. Determine Arnolds optimal
consumption bundle (xs, ys) conditional on the subsidy having been
implemented.

a)
The utility function that is to be maximized, U(x,y)=x*y results in the following two
marginal Utilities, MUx = y and MUy = x. Which are the components for the slope of the
indifference curve, also called MRS. So, combining it with the prices:
Substituting for its values
Which leads us to 2x=y
Now, using the income available and the prices for each good:
And using the previously found relation
Which has a result for x. x=25
Thus y=50
b)
Following the steps of a) with the new given prices:

Which gives the relation x=y

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Now, using the available income to buy the products

Which, substituting ends up as
Having a result of x=50
Thus, y=50

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4.

Are the concepts of fairness and equality in the distribution of income

synonymous? To what extent is income inequality consistent with fairness?
What are the implications of your answer for government expenditure policy?

No, they are not, even though those words may be related to each other, they have
different meanings in economic terms. Equality would mean that everyone, even those
who are not in need of it, would be entitled to receive the same government help as those
who really need it. In opposition of equality is fairness, the latter meaning that people
should have should have the same opportunities at hand. To deepen in its meaning, one
must take into account that the possibilities a subject can achieve by himself (no
government help) are also counted, which ultimately will help those who are more
stretched. Income inequality is fair in the sense that there are jobs that are more
demanding than others (need more qualification, experience) and it would be unfair to
reward the same way a cashier and a manager, both of them having to do very different
jobs with very different needs. The implications of these concepts for government
expenditure policy are that the government should look for those who are more hardpressed and focus their efforts and limited resources where they are needed instead of
using those resources on people who do not need such help. This way, the government
takes a support role in the economy which may lead to a more flourishing population, yet
the government has to be wary when taking such courses of action for they can obtain
secondary results that may not be desired.

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5.

A popular measure of the extent of the poverty problem is the poverty gap,
which measures how much income would have to be transferred to the
poverty population to lift every households income to the poverty line. What
are the conceptual difficulties in such a measure of poverty?

Poverty line is used to state who is able to live above certain minimum standards and who
is not able to do so. By helping those below the line to rise, those minimum standards
would be easier to reach. But, how can those standards be determined? What should be
considered necessary or not? (a car and gas to be able to work, is it considered essential?)
In addition, the inflation varies every year, what makes money have different values at
different points of time and what was an acceptable income years ago, nowadays may be
considered minimal, in addition, the price index and the state of the economy (crisis
specially) may have significant impact on such statements. Being all of the factors
considered percentage rates, it would be too risky making the poverty line an absolute
value for extended periods of time.

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6.

State the First and Second Theorems of Welfare Economics and discuss their
significance. Some would argue that there is no need for government if
markets allocate resources efficiently. Why is this so? Do you agree with this
statement given our current globalized economy?

The First Theorem states that a market will tend toward a competitive equilibrium that is
weakly pareto optimal when the market maintains the following three attributes:
1. Complete markets - No transaction costs and because of this each actor also has perfect
information, and
2. Price-taking behavior - No monopolists and easy entry and exit from a market.
Furthermore, the First Theorem states that the equilibrium will be fully pareto optimal
with the additional condition of:
3. Local nonsatiation of preferences - No two market allocations give any market actor
equal satisfaction.
The Second Theorem states that, out of all possible Pareto optimal outcomes, one can
achieve any particular one by enacting lump-sum wealth redistribution and then letting
the market take over.
The First Theorem is often taken to be an analytical confirmation of Adam Smith's
"invisible hand" hypothesis, which competitive markets tend toward an efficient
allocation of resources. The theorem supports a case for non-intervention in ideal
conditions: let the markets do the work and the outcome will be Pareto efficient. Yet, it
may not be the one pursued by the government or society.
The second theorem means that redistributions can allow us to select from all efficient
outcomes for one that has desired features, such as distributional equity. The shortcoming
is that for the theorem to hold, the transfers have to be lump-sum and the government
needs to have perfect information on individual consumers' tastes as well as the
production possibilities of firms.
Both theorems follow the assumption that private sector, once set up and running, will do
it by itself without any further government intervention. Yet, that would not be applied
nowadays, because of the power some large firms possess and certain laws/regulations.
For example, patents prevent the efficient allocation of certain medicines because the
firms having exclusivity will pursue maximum profit, not maximum efficiency. Another
reason to oppose these theorems are the so called public goods. Public goods are
provided by the government precisely because the private sector would not be able to
provide them efficiently. For example, healthcare provided by the private sector is much
more expensive than the one provided by the government, which in turn leads to people
not being able to use efficiently, only those who could pay the high prices set by the firms
would be able to use them.
Another way to opposite this is the effect globalization has. Countries around the world
are not a single market with multiple offers, they are heterogeneous, differentiated
markets, which in turn leads to price differences both for producing and for selling. The
exploitation of such differences may lead to hurt the economy of the producing/buying
country by a significant amount. If all the firms in Canada would take their production
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plants and processes to China, yes, Canada would be able to keep up for a time, but those
jobs that were created by the production plants would hurt both Canadians income and
Canadas taxing capabilities, which would eventually lead Canada to a crisis. For an
efficient globalized maket, plenty of interventions would be needed and not only from
governments, but from banks, organizations and Continental level organizations
(European Union, UN) to ensure the private sector is playing with the same rules all
over the globe.

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7.

Many would group the functions of the public sector under 3 headings:
allocation, distribution and stabilization. According to Robin Boadway, in his
article, Economic Theory Dictates a Rethinking of Policy, what is the most
important function of government and discuss his rationale for choosing this
function.

According to the article, the most important role of the government will be
(re)distribution. For it is the instrument that will be most important in the toolkit the
government possesses when it comes to have an impact to curve a certain situation or
effect. Yet, while the (re)distribution function is the most significant, the distribution
itself should not be the final reason for using it, for monetary changes with such a reason
are based on economic welfare, which is just talking about cash, not welfare as a whole.
Now, should those changes be done with a greater purpose in mind, they can be used to
stimulate certain aspects of the way of life people has. For example, just handling money
to those in need may be helpful, but it will most likely not be so, since having the cash in
hand does not guarantee it will be used for the desired purpose. On the other hand, paying
part of the rental, helping people find a job, creating some attractive attractions (an arena
for example, or an ice palace) could lead to achieving the goal that was in mind at the
beginning more efficiently than just a monetary measure.
So, while the most important heading of the government is the redistribution, in order to
maintain welfare, stability, efficient allocation and citizen quality of life should be taken
into account above all else, by thinking ahead the objective that is to be achieved and the
effects the taken measures may have.

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