ECON 2255 Assignment Package 1

DEPARTMENT OF ECONOMICS, JUSTICE AND POLICY STUDIES

ECON 2255
Assignment Package 1

1. Answer each of the following statements True/False/Uncertain. Give a full explanation of your
answer.

A) Government intervention requires the application of normative economics.

B) Public goods are vertically aggregated (ie. marginal rates of substitution are added
together, rather than equated to one another at the efficient level of provision) because
public goods are non-excludable.

C) Every point along a contract curve in an Edgeworth box is Pareto efficient.

D) The First Fundamental Welfare Theorem of Economics implies a large amount of

government intervention is necessary to maximize social welfare.

E) If all voters in a majority voting election have single peaked preferences, a consistent
decision will be reached, regardless of the order of voting.

F) In the presence of a positive externality, a government could achieve the socially

optimal equilibrium through the use of a Pigouvian subsidy.

G) The economic incidence of a tax is the same whether it is levied on buyers or sellers.

2. A provincial government is providing a public good to 5 citizens:

The marginal cost of producing the public good can be given as: MC  10  2Q .
The citizens’ marginal benefits from the public good are:
Matt: MB  20   0.5  Q Chris: MB  20  3Q
Kim: MB  20   0.5  Q Nicola: MB  20  2Q
Anthony: MB  20  Q
a) Explain why a private firm would fail to produce an efficient output of this good.
b) What is the optimal quantity of the public good? What is total cost to supply this quantity?
c) If Chris is forced to pay for half (50%) of the public good, what is his preferred quantity of
the public good? What is the total cost to supply this quantity? Why is this different from
the answer in part b?

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d) If Chris is forced to pay for all (100%) of the public good, what is his preferred quantity of
the public good? What is the total cost to supply this quantity? Why is this different from
the answer in part c?
e) Now assume that the good is rivalrous (but still non-excludable) and that the government
decides to provide it anyway. What is the optimal quantity of the rivalrous (but non-
excludable) good in this case?

3. Consider the market for Widgets:

The demand for widgets is given by: QD  1300 10P
Supply of widgets is given by: QS  2P  20
Production of widgets causes an externality with marginal damage given by: MD   0.6  Q
(Hint: Convert the demand and supply functions into PMB and PMC functions. Include a graph to
show the intuition behind your equations.)
a) Calculate the free market equilibrium price and quantity for widgets.
b) Graphically illustrate total surplus. Calculate the total surplus and total welfare (total
surplus less negative externality) at the free market equilibrium price and output.
c) Calculate the socially quantity for widgets.
d) Calculate the per-unit Pigouvian tax which leads to the socially optimal quantity.
e) Calculate the total revenue generated by the Pigouvian tax.
f) Calculate the deadweight loss associated with the Pigouvian tax. Also calculate the new
Social Welfare (do this with and without the tax revenue included).
g) Explain how the Pigouvian tax can increase social welfare while reducing total surplus.

4. Consider a two person (1 and 2), two good (A and B) exchange economy. Social welfare for
the economy is: W=U1+U2.

a) Draw social indifference curves for the economy in question. What is the rate at which
society is willing to trade one person’s welfare for another?
b) Suppose that person 1’s utility function is U1=A+2B and person 2’s utility function is
U2=3A+B. Suppose that each person is endowed with 15 units of goods A and B (making
a total of 30 units in the economy). Determine the optimal allocation in the economy,
under the condition that both individuals receive at least as much utility as their endowed
consumption bundle.
NOTE: The marginal utilities for person 1 are: MUA=1, MUB=2. The marginal utilities
for person 2 are: MUA=3, MUB=1.
c) Suppose social welfare is now characterized as: W=min(U1,U2), re-do part B. Describe
how the optimal allocations change and why.

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5. Edward and Emma have utility functions as follows:

 UED = F0.5O0.5
MUFED = 0.5 F-0.5O0.5 ; MUOED = 0.5 F0.5O-0.5

 UEM = F0.25O0.75
MUFEM = 0.25 F-0.75O0.75 ; MUOEM = 0.75 F0.25O-0.25

Where F is consumption of fireworks F (a public good) and other goods O. Assume all good
comprising O are private goods.

a) Suppose the price of fireworks is 3 and the price of other goods is 1. Further suppose both
Edward and Emma have an identical endowment of O equal to 10 (that cannot be traded
between one another).
Determine the optimal amount of fireworks that should be provided.
b) Describe factors that may impact the amount of fireworks provided. Do you think there
will be under or overprovision of fireworks?
c) Determine Edward and Emma’s Lindahl prices from a). Does Edward or Emma pay more
for fireworks? What is causing the change in price?

6. Consider the case where the federal government is willing to spend $X in the form of a grant
to provinces. Prove graphically that the increase in welfare is greater if a non-matching grant is
used (rather than a matching grant).

7. The federal government drastically cut transfers to provinces and replaced some conditional
grants for social assistance with unconditional ones. Discuss the effects of these changes on the
following:

a) The level of spending by provincial governments.

b) The composition of spending by provincial governments.
c) The quality of social assistance programs.

8. Why is the demand for health care services different from the demand for other kinds of
services?

9. Can you think of reasons why the problem of adverse selection in the market for health care
insure might become more severe among the older cohorts in the population?

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