EXAMINATION QUESTIONS

1. a. Explain why non-price rationing of jobs must occur if a legal minimum wage is set
above the competitive equilibrium wage in a labor market.
b. Explain why non-price rationing is likely to produce an inefficient allocation of
resources

2. Only a small percentage of people who watch public television programs voluntarily
contribute to public television stations. Nevertheless, politicians support using tax
dollars to finance their operations. Presumably, politicians do so because they believe
that a majority of their constituents are willing to have their tax dollars finance such
programs. Why might an individual be willing to pay taxes to finance public television,
but not be willing to voluntarily contribute to a public television station?
3. A monopolist has a patent for producing a product. The monopolist faces the following
market demand for its product:

Qd(P) = 1000 - P.

Its cost of production is 10Q, so its marginal cost is 10/unit.

The monopolist knows that the market demand is made up of the demands of 1,000
individuals, each of whom will buy at most one unit of the good. That is, there is one
person who is willing to pay as much as $1,000 for a unit one person who is willing to
pay as much as $999 for one unit, one person who is willing to pay as much as $998 for
one unit, etc. No one is willing to buy more than one unit.

a. Suppose that the monopolist could charge each customer exactly what that
customer is willing to pay. If the monopolist does this will the resulting allocation
be Pareto Optimal? Define the term, ‘Pareto Optimality’ and explain why the
resulting allocation is or is not Pareto Optimal.

b. Suppose the monopolist knows the market demand, but does not know what any
particular individual is willing to pay. If the monopolist simply sets a single price at
which s/he will sell to anyone willing to buy at that price, what price will maximize
the monopolist’s profits and what will be the size of the social surplus associated
with the volume of goods purchased at this price?

4. A baker and a doctor own and occupy spaces that are separated by a common wall.
The baker can organize his space in either of two ways, A or B.
If the baker chooses A he can produce a profit of $1000/month.
If the baker chooses B he can only produce a profit from his operations of $900/month.
 The doctor also has two ways, C or D of using the space she rents.
If she chooses C she earns $2000/month, regardless of how the choice of the baker.
However, if she chooses D her profits depend upon the baker’s choice as follows:

If the doctor chooses D and the baker chooses A then the doctor earns $1,800/month.
If the doctor chooses D and the baker chooses B then the doctor earns $2,300/month.

a. What is the Nash equilibrium pattern of use of the spaces?

b. Suppose the doctor sues the baker, arguing that the baker is causing her harm. The
baker argues that he should be allowed to do whatever he wishes in his own property
and would be harmed if he were forced to choose option B rather than option A.
According to the Coase Theorem, will the pattern of use of these two properties after
the judge rules in this case be different from the way these properties are currently
being used? Explain your answer.

b. According to the Coase theorem, will the pattern of use of these two properties
after the judge rules be different if the doctor wins the case than what it will be if
the baker wins the case? Explain your answer.
5. Explain the difference between an externality that is Pareto Relevant and an externality
that is Pareto irrelevant. Give examples of each type of externality.
6. Merchants typically prefer to operate in close proximity to other merchants who sell
different goods. Why would a merchant prefer to operate in leased space in a mall
owned by a single owner than to operate in a space that the merchant owns, but is in a
shopping district in which other property is occupied by merchants who sell different
goods?
7. a. Suppose that the cost to an individual person or firm of reducing its pollution is the
same regardless of the density of population in the area in which that person or firm is
located. Suppose that pollution generated in a region only affected the people who lived
in that region.
Explain why it would not be socially efficient to have the same pollution tax levied on
polluters located in a densely populated region as in a sparsely populated region.

c. Some potentially renewable resources are so extensively harvested that they are
driven toward extinction, while the harvesting of other renewable resources is
controlled in a way that allows stocks of these resources to replenish themselves.
Explain what role the structure of property rights plays in determining whether or
not a renewable resource will be systematically overharvested.
8. Why do economists generally prefer to control pollution by tax/subsidy schemes rather
than by direct regulation of production processes? When might direct regulation be
preferable to a pollution tax?
9. Suppose that firm A's profit depends upon both its own output, Qa, and the output of
firm B, Qb, as follows:
 πA = Qa - .001Qa2 - .001QbQa.

That is, the operation of firm B imposes an external cost on firm A where the level of
that cost is an increasing function of the levels at which both firms B and firm A operate.
Firm B’s profit depends only on its own output as follows:
πB = Qb - .001Qb2.
Suppose that B were required to pay A an amount equal to {.001QaQb}, or {.001Qa} for
each unit B chooses to produce. Explain why this would lead to a pattern of production
that is not Pareto Optimal.

10. (i)Suppose that good x has the technical properties of a public good and that it has been
determined that enough of this good will be produced to allow each individual in a
community to consume X units of this good. If the population of the community were to
decrease would the community be able to devote fewer resources to the production of
good x if it wished to get the same consumption/capita as before?

(ii) ‘Pay’ television programs may be broadcast via a scrambled, or encoded, signal. An
individual can only receive the signal in an intelligible format if s/he makes a cash
payment to the broadcaster. Exclusion of non-payers allows the producer of the
program to make a profit. Why is such exclusion not compatible with the conditions for
allocative efficiency?

11. Consider the following data with respect to a public good: Its social marginal cost of
production is $55/unit; There are three individuals in the community, A, B and C. Individual
A's marginal valuation function is: MVA(q) = 250 -15q; Individual B's marginal valuation
function is:MVB(q) = 110 -7q; Individual C's marginal valuation function is: MVC(q) = 40 -q,
where q is the quantity of public good produced and MV i(q) is the amount that individual I is
willing to pay for another unit given that q units are already produced.
a. Compute the Pareto Optimal quantity of the good for this community.
b. Prove that the Lindahl equilibrium tax prices are: ta=$25; tb= $5; tc= 25.
c. Suppose that it has already been agreed that the cost of production will be split
evenly. Find the value of q which will be chosen by majority rule.

12. The governor of Pennsylvania has proposed that private companies be leased some
highways to operate some highways as private enterprises. These firms must charge
tolls to users of the roads in order to raise the revenues required to cover the cost of
building and maintaining these roads.

a. When is it socially efficient to use tolls to finance these costs? Explain your answer.

b. Is it ever socially efficient to build a road whose costs could not be covered by tolls?
Explain your answer.
13. Consider the following data with respect to a public good: Its social marginal cost of
production is $55/unit; There are three individuals in the community, A, B and C.
Individual A's marginal valuation function is: MVA(q) = 250 -15q; Individual B's marginal
valuation function is:MVB(q) = 110 -7q; Individual C's marginal valuation function is:
MVC(q) = 40 -q, where q is the quantity of public good produced and MV i(q) is the
amount that individual I is willing to pay for another unit given that q units are already
produced.

a. Compute the Pareto Optimal quantity of the good for this community.
b. Prove that the Lindahl equilibrium tax prices are: ta=$25; tb= $5; tc= 25.

c. Suppose that it has already been agreed that the cost of production will be
split evenly. Find the value of q which will be chosen by majority rule.

14. Individuals 1,2 and 3 live in a community that provides public schooling that is financed
by income taxation. Each individual has a child that must be educated. There is a
private school to which any person may send their child. It costs $10,000/child/year at
the private school. Individual 1 has an annual income of $25,000. Individual 2 has an
annual income of $50,000. Individual 3 has an annual income of $150,000. These three
individuals must decide how much the community must spend/child, S, in the public
school. Individual tax bills are dependent upon the amount/child attending the public
school that the community chooses to spend, S, and the number of children(n=1,2, or 3)
who attend the public school. The income tax rate is t. Therefore, individual 3 will pay
taxes of $.667n/dollar/child in public school; Individual 2 will pay taxes of
$.222n/dollar/child in public school; Individual 1 will pay $.111n/dollar/child in public
school. Only Individual 3 is considering sending his child to private school.

Given these tax prices, if all three children are in the public school Individual 1’s most
preferred level of S is $3,000/child in school. However, if there are only 2 children in the
public school, Individual 1 would most prefer $4,500/child in attendance. If all three
children attend the public school,Individual 2’s most preferred level of
expenditure/child is $5,000/child. If only 2 children attend the public school individual
2’s most preferred level of expenditure/child is $7,500/child. Individual 3 is willing to
spend $10,000/year on a private school education for his own child, if his tax bill for
public education is less than $7,000. However, if he sends his child to public school he
most prefers that the expenditure/child be $8,500. All preferences are singled peaked.

The community wishes to choose the expenditure/child in attendance at public school

by majority rule. Does Black’s theorem apply? Explain your answer.

15. a.What are the nature of the externalites that justify mandatory schooling laws and state
regulation of the curriculum?
 b.Describe the arguments for and against replacing the operation of public schools at which
no tuition is charged with public financing of vouchers that can be used to pay a portion (or
all) of the tuition that might be charged by private schools.
c. What are the nature of externalities that justify public funding of education?
16. (i)How are adverse selection and moral hazard related to information asymmetries?
(ii) How do insurance companies mitigate the effects of adverse selection?
(iii) How do insurance companies reduce the effect of moral hazard?
(iv) Why are individuals unlikely to be willing to pay a substantial risk premium for
unemployment insurance?
17. The administrative cost per policy holder of a health insurance pool increases with the
number of claims per policy holder that must be processed. There are many more claims
per policy holder filed by policy holders who have low deductible, comprehensive insurance
policies than by policy holders who have policies with high deductible, catastrophic
insurance policies. Therefore, comprehensive policies are much more expensive/dollar of
actual insurance than are catastrophic policies. However, the amount of risk premium
people are generally willing to pay for insurance is smaller for coverage against small, highly
predictable risks than the risk premium they are willing to pay for insurance against large
possible losses than have the same expected dollar loss as the set of small, highly
predictable risks. Nevertheless, in the United States, most people with health insurance
have low deductible, comprehensive policies that are more expensive/dollar of expected
loss than available, catastrophic health insurance coverage. Why?
18. (a)What is the Prospective Payment system and why was it introduced?
(b) How do first party insurers limit moral hazard?
(c)What are the principal factors that account for the rate of increase of medical care
expenditures?

19. a. Why does the social security system have a ‘legacy’ debt?
b. In a ‘pay-as-you’ go system for financing social security what factors determine the steady
state rate of return the average individual can expect to earn on the taxes that individual pays
into the system?
c. Why has the social security system been associated with a reduction in the percentage of
the elderly population that lives in poverty?

d. What is a person’s Social Security Wealth. Why is the Social Security Wealth of your
parents smaller than that of your grandparents?
e. Do provisions of the social security system in the United States penalize people who
choose to delay retirement beyond the age at which they first become eligible for benefits?
f. The average person in the United States accumulates insufficient private assets during their
working lives to sustain during their retirement years the same level of annual expenditures
as they had during their working years. To what extent is this because social security has
reduced the incentives of individuals to save for retirement?
g. President Bush proposed dividing payments made into the social security system into two
pots. One pot would be used to continue to finance a guaranteed benefits program on a pay-
as-you go basis. This pot would be augmented by borrowing to cover the legacy debt, so as to
continued to pay to current retirees the same level of benefits as written into the current law.
However, for future retirees the monies put into this pot would only be sufficient to fund at a
reduced level of guaranteed benefits. The remaining portion of taxes paid by current workers
 would be placed into individual retirement savings accounts with the deposits in each
individual’s account being proportional to the tax that individual paid.
h.The argument that has been made in favor of this proposal is that monies invested in
these private accounts could be expected to earn more in interest than the implicit rate of
return on taxes the individual who is currently working would pay into social security under
the pay-as-you-go system. Once one accounts for the burden of the extra taxes that must be
paid to cover the borrowing costs of the legacy debt, would the average member of your
generation still have a higher social security wealth under this proposal than under a
proposal that simply raised your tax rate sufficiently to continue the existing system with
the existing benefit rules?

20. Suppose that the demand for good X is represented by the equation:
Qd(Pb) = 1000 - 5Pb
where Qd is the quantity demanded by buyers and Pb is the price paid by buyers.

Suppose that the supply for good X is represented by the equation:

Qs(Ps) = 50Ps
where Ps is the price sellers receive and Qs(Ps) is the quantity they are willing to supply at
the price Ps.
If there is a tax/unit of t, then Pb- t = Ps

In equilibrium, Qs must equal Qd.

a. Suppose that t = 0. Then Ps=Pb. What is the equilibrium quantity sold and market
clearing price?
b. Suppose that a tax is levied on each unit sold by the seller and that tax is calculated to
be 10% of the selling price. This tax is to be added to the selling price and collected from
the buyer. Then Pb = 1.1Ps. Find the new equilibrium quantity and the new equilibrium
price received by the seller Ps.
c. How much tax revenue is raised by the tax? What fraction of the tax is paid by buyers?
d. What is the magnitude of the excess burden created by the tax?
21. Suppose that good X is produced by a monopolist. Let the market demand for good X be
Qd(Pb) = 1000 - 5Pb, where Pb is the price the buyers must pay for each unit of the good
they buy. Let the monopolist’s cost of production be 10/unit produced. The monopolist
sets the price at the level that maximizes its profit.

a. What price will the monopolist charge if it wishes to make its profit as large as possible?
b. Suppose that a tax is imposed on each unit the monopolist sells and that this tax is
$10/unit sold. Let your answer to part a be P*. Prove that when this tax is imposed the
monopolist will increase Pb from P* to P* + $5. Explain why the monopolist does not
pass all of the tax forward to the buyers.

22. Suppose that a government wishes to raise $100,000 in tax revenue and is restricted to
levying taxes on the purchase of good x and of good y.
The demand for goods x and y are as follows:
Qx = 105(1 - .1Px)
Qy = 105 (1.1 - .2Py)
Where Pi is the price of good i measured in dollars per unit of good i.
Before any tax is imposed the equilibrium selling price of both x and y is $1. If a tax is imposed
on good i the price of that good will increase by the full amount of the tax per unit.
 Prove that if the government wishes to minimize the excess burden of raising $100,000 in
tax revenue the tax/unit on good x must be twice the tax/unit on good y.

23. The City raises tax revenue by imposing two taxes. The first tax is levied on the value of
real estate in the city. The second tax is levied on wages earned by city residents.
Currently, the city levies a property tax at the rate of $10.82tax/$1,000property value. It
levies a wage tax at the rate of 1% of gross wages earned. Last year the city raised
$121,000,000 from the property tax and $47,000,000 from the wage tax.

Suppose that the demand for labor in the city labor market is
Qd(Pb) = 450,000 – 9.575Pb where Pb = annual wage paid before taxes; the supply of
labor is Qs(Ps) = 4.8356Ps, where Ps = Pb(1-ι) where ι is the rate of tax on gross wages
paid. There are currently 150,000 people paying the wage tax, with average annual gross
earnings of $31,333/year/worker.

a. The city wishes to raise $215 million dollars in tax revenue from these two taxes this
year. It currently expects to raise the same amount of property tax revenue this year
as it did last year. Therefore, it wishes to raise an additional $47 million dollars in tax
revenue from the wage tax. Will it be able to raise this additional revenue by simply
doubling the rate of tax from 1% to 2 %. Explain your answer.
b. Given the demand and supply functions, if the city raises the tax by 1 percentage
point what is the implied reduction in the number of people who will pay the city’s
wage tax if it increases the tax and if nothing were to happen to the cost of property in
the city?
c. If nothing were to happen to the cost of property in the city, given the demand and
supply functions, what percentage of the increase in wage tax would be borne by
workers?
Explain why the cost of real estate and revenue from the real estate tax in the city
will fall if the wage tax is raised.
24. a .Under what conditions would a tax have no excess burden? Describe such a tax.
b. Under what conditions would a tax have a negative excess burden? Describe such a
tax.
c. Some proposals for reform of the income tax system include provisions for
eliminating some tax expenditures and reducing the income tax rate.
(i) What is a ‘tax expenditure’?
(ii) Provide an example of a tax expenditure.
(iii) The elimination of tax expenditures would expand the base upon which
taxable income was calculated. Therefore, if some tax expenditures were
eliminated it would be possible to reduce the income tax rates without reducing
total tax revenue. What objective(s) of a good tax system would be promoted by
such changes in the tax system?
25. a. The social security system in the United States is financed by two wage taxes. The
first tax is the legal responsibility of the employee. The employer must withhold this tax
from the employee’s pay check and forward the money directly to the U.S. treasury. The
second tax is the legal responsibility of the employer. For each dollar that the employee
must pay, the employer must also pay a dollar in wage tax. Explain why employers
would not be any better off if the law were changed, eliminating the tax that is the legal
 responsibility of the employer and doubling the tax that is the legal responsibility of the
employee.

c. Explain why economists believe that the economic burden of the social security tax is
borne by workers.

26. The Pittsburgh Penguins play at Mellon Arena. The Arena has a total seating capacity of
12,000 people. All of the costs to the Penguins of playing at the arena are fixed costs.
Fixed costs are costs that are independent of the number of people who attend the games.
Suppose that the demand for tickets to a Penguins game is: Q(Pb) = 20,000 -400Pb,
where Pb is the price of a ticket to a buyer.

Since all costs are fixed, the Penguins will maximize their profits by choosing a price, Pb,
that maximizes their revenues, net of tax.

a. If there is no tax, what ticket price will the Penguins charge?

b. Suppose that the City were to impose a tax on each ticket the Penguins sold at a rate of
t% of the price received by the Penguins, Ps. Then Pb =(1+t)Ps. Prove that if the
Penguins wish to maximize their after-tax profits they will charge the same price to
buyers, Pb, regardless of the rate of tax, t.
c. Who bears the burden of this tax?

27. Explain why the short-run incidence of a tax is likely to be different from the long-run
incidence of the same tax.
28. Mr. Jones buys a house which prior to his purchase was assessed for tax purposes as
being worth $50,000. The property tax due on this assessment was $1,000. That is, the
tax rate is equal to 2% of the assessed value. Mr. Jones purchased the house for
$100,000, expecting that it would continue to be assessed at $50,000 for tax purposes
since it was commonly known that assessed values bore no relation to the selling price of
homes in this community. However, after Mr. Jones made his purchase the assessment
practices changed and his property was reassessed for tax purposes as being worth the
price he paid for the house. The tax on the property therefore went up to $2,000/year. Mr.
Jones feels that he cannot afford to live in the house if he has to pay $2,000/year in
property taxes.

Explain why Mr. Jones will not be able to avoid the burden of the additional
$1,000/year in tax simply by selling his property to someone else.
29. Suppose that in the short run the supply of capital to the economy is fixed, but that it can
move freely from sector to sector. Prove that under these assumptions a tax on capital
used by corporations must shift capital out of the corporate sector and that generally this
will change the after-tax return to the owners of the capital stock regardless of where
their capital is used.

Suppose that in the long run the supply of capital to the economy were perfectly elastic.
Prove that under this assumption the long run burden of a corporate income tax must be
borne by wage earners.
30. According to Charles Murray, in his book , Losing Ground: American Social Policy:
1950-1980, changes in welfare policy in the 1960's had the unintended consequence of
increasing the percentage of people in the U.S. who were receiving welfare.
(i) What welfare policy changes took place in the 1960's?
(ii) Why might those changes have increased the percentage of the population receiving
welfare?
(iii) What other changes in the economy and society would be expected to increase the
welfare rolls, independently of any change in welfare programs?
(iv) What change in welfare policy took place in 1996?
(v) What has happened to the percentage of the population on welfare since 1996?
(vi) What factors other than the change in welfare policy in 1996 could have been
expected to reduce welfare rolls since 1996?

31. "It is sometimes argued that when the government borrows money to meet its
current expenses rather than collecting taxes from current tax payers to finance those
expenses it is imposing a burden on future generations who have to pay the principal and
interest on the debt. However, this is confusing purely financial transactions with the use
of resources. No matter how government finances its current use of resources, when the
government uses resources today those resources are not available for use by the private
sector of the economy today. It is the current generation that is deprived of productive
opportunities by today's government activities, not the future generation even if all of the
government's current expenses were financed by new debt issue."

Comment upon the above quote. In your comment discuss how the way resources are
used today can impact upon the income of future generations and how the method of
financing today's government spending can influence the way resources are used today.

32. “The government decides whether to fund its current expenditures with taxes or by the
sale of bonds. But regardless of the method of financing chosen by the government, it is
households who decide how much of the economic burden of the government’s current
expenditures are borne by future taxpayers.” Explain how the current reactions of
households to government’s current financing decisions can affect the consumption
possibilities of future taxpayers.