- (5pts) Utility Possibility Frontier: Each point in the diagram below shows Joe’s and Ed’s utility levels for different allocations of resources.
- (2pts) Define “Pareto-efficiency” (one sentence) and indicate which allocations in the above diagram are “Pareto efficient”.
- (1pt) (True or False) Allocation D is “Pareto Superior” to allocation E? Explain
- (1pt) (True or False) John Rawls would find allocation E to be unjust? Explain
- (1pts) (True or False) Robert Nozick (Libertarian) would find allocation B to be unjust? Explain
- (5pts) Edgeworth Box: Suppose Adam and Bob are stuck on an island. The island has only two resources: coconuts and pineapples. Suppose that there are only 30 coconuts and 40 pineapples on the island. Suppose they initially split the coconuts and pineapples equally between each other. However, Adam prefers pineapples over coconuts and is willing to exchange 10 of his coconuts for 2 pineapples. Such a trade will increase his utility from 60 to 80 utils. Bob likes coconuts and pineapples equally and therefore is happy to trade two of his pineapples for 10 of Adams coconuts. Bob’s utility also will increase from 100 to 140 utils. Use an Edgeworth Box showing Adam and Bob’s indifference curves and utility levels based on the initial allocation and then show their new indifference curves and utility levels after the trade. Assume that the trade takes Adam and Bob to a Pareto Efficient allocation.
- (7pts) More Edgeworth Box: Suppose that Adam’s utility function is UA = 3C0.25P0.75 and Bob’s utility function is UB=C0.2P0.8. Find an allocation of the 30 coconuts and the 40 pineapples that will be Pareto Efficient.
(8pts) Negative Production Externality:
- The steel industry emits one pound of sulfur dioxide into the air for every ton of steel it produces. Each pound of sulfur dioxide causes environmental damage equal to $40. The demand for steel is P= $5,000 – 0.1q. (q = amount of steel in tons) Marginal costs of production of each ton of steel is MC = 100 + 0.1q.
- (4 pts) What are the privately optimal (market) and socially optimal production levels of lumber and the amount that lumber production must be reduced to reach the socially optimal level?
- (2 pts) Calculate the amount of social loss that society would bear as a result of this externality.
- (2 pts) What would A.C. Pigou propose to resolve the problem? Be specific.
(6pts) Positive Consumption Externality:
- Using the letters below calculate social welfare for the market outcome and the socially optimal outcome. Identify the deadweight loss and describe in words what it represents.
Market Social Optimal
Externality => _________________ ___________________
Social Welfare =>
(8pts) Cap and Trade:
- Suppose the government wants to limit sulpher dioxide emissions which cause acid rain. Suppose PG&E and currently emits 13 units of sulpher dioxide and Con Edison currently emits 15 units of sulpher dioxide for at total of 28 units. Suppose the government wants to decrease the total units of sulpher dioxide to 22 units.
|MC of Eliminating||PG&E||Con Edison|
|1st Unit of Sulpher Dioxide||$100||$400|
|2nd Unit of Sulpher Dioxide||$200||$500|
|3rd Unit of Sulpher Dioxide||$300||$700|
|4th Unit of Sulpher Dioxide||$450||$900|
|5th Unit of Sulpher Dioxide||$600||$1,000|
|6th Unit of Sulpher Dioxide||$800||$1,100|
- (2 pts) Suppose the government requires each producer to reduce their pollution to 11 units each. What is the total cost of this regulation?
- (4 pts) Suppose each company is given 11 pollution rights and they are tradable. How many pollution rights will each have and what will be the cost under this system.
- (2pts) Explain how this example of tradable pollution rights is a Coase Theorem remedy to pollution.
- (5pts) Public Goods: There are 1000 people in the small town of Pohdunk, who want to have a fireworks display on the 4th of July. Willingness to pay for each of the 1000 individuals is P = 7.6 – 0.05Q, where Q is the number of colorful exploding rockets that shoot off during the display. The cost of each colorful exploding rocket is $100.
- (3pts) How many rockets should the town of Pohdunk purchase for its fireworks display?
- (1pt) How much should the town charge each individual in order to maximize consumer surplus while covering the costs of the show?
- (1pt) Explain why it is unlikely that the optimal amount of rockets will be purchased no matter what system of payment is used.
(8pts) Public Choice: Suppose you are a college student registered to vote in California.
The Republican gubernatorial candidate has made the following campaign pledge:
“My fellow Californians, if I am elected Governor I will make education my top priority. To show you that I mean business, I will support a bill that gives all college students a $10,000 credit towards tuition”
In response, the Democratic Candidate proposes the following:
“My fellow Californians, I will not be out done by my counterpart. I propose a $30,000 tuition credit for all college students.”
Assume for simplicity that the tuition credit bill will be passed into law immediately after the elections and students will receive the money soon thereafter. Also assume that you see no difference between Republican and the Democrat except for their tuition credit proposals. Finally, assume that you are a hard working student with a part-time job that pays $16/hr.
- (2 pts) If California has 1 million registered voters and in order to vote you will be forced to miss ½ hour of work, is it rational to vote? (show your work)
- (2 pts) What if the Democrat proposes a tuition credit of $120,000? Would that make it rational to vote? (show work)
- (2pts) Now imagine that the Republican and the Democrat were running for Mayor in a small town of only 100 voters including yourself. Instead of tuition credit, they are offering tax cuts. The Republican’s proposal will cut your taxes by $2,500 and Democrat’s proposal will reduce your taxes only by $500. Again assume that all you care about is your taxes and that you have to take ½ hour from your work to vote. Is it rational to vote?
- (2pts) Based upon the answers above, is it more rational to vote in statewide elections or local elections?
(8pts) Adverse Selection:
- Consider a state in which automobile drivers are divided equally into two types of drivers: careful and reckless. The average annual auto insurance claim is $400 for a careful driver and $1,200 for a reckless driver. Suppose the state adopts an insurance system under which all drivers are placed in a common pool and allocated to insurance companies randomly. An insurance company cannot refuse coverage to any driver. By law, each insurance company must charge the same price. Assume the price charged by the insurance companies is the break-even price. Predict the price of auto insurance if:
- (2pts) Auto insurance is mandatory for all drivers. (Show your work)
- (2pts) Auto insurance is voluntary for all drivers? (Show your work.)
- (2pts) Define adverse selection and explain how it applies to this situation.
- (2pts) Under a voluntary insurance system, how can the adverse selection problem be eliminated or reduced?