A01 325: #1 VERSION 2 SOLUTIONS

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1 Economics 325: Public Economics Section A01 University of Victoria Midterm Examination #1 VERSION 2 SOLUTIONS Fall 2012 Instructor: Martin Farnham Midterm Exam #1 Section 1: Multiple Choice Each question worth 2 points. Select the most appropriate answer, and fill in the matching letter on your NCS bubble form. Questions 1-3 refer to the following diagram of a perfectly competitive market. No externality is present. 1

2 1) What is the deadweight loss associated with producing zero units of the good? A) $2,000 B) $5,000 C) $20,000 D) $40,000 E) None of the above 2) What is the variable cost of producing 200 units of this good? A) $5,000 B) $2,500 C) $200 D) $50 E) None of the above 3) What is the change in social welfare (aggregate net benefits) going from the equilibrium quantity to Q=600? A) It rises by $5,000 B) It falls by $5,000 C) It rises by $10,000 D) It falls by $10,000 E) None of the above 2

3 Questions 4-7 refer to the diagram below of a market with an externality present. 4) What type of externality is illustrated in the above diagram? A) A negative production externality B) A negative consumption externality C) A positive production externality D) A positive consumption externality E) None of the above. 5) Which of the following areas represents social welfare at the equilibrium level of production? A) Area A+C B) Area A+B+C C) Area A+B+C-D D) Area A E) Area C-D 3

4 6) Which of the following areas represents total social welfare at the efficient level of output? A) Area A B) Area A+C C) Area A+B+C D) Area C E) Area A+B+C-D 7) Which of the following areas represents total external benefits at the efficient level of output. A) Area A B) Area A+B C) Area A+B+C+D D) Area A+B+D E) Area E+F+D END SECTION 1. Answer each question as clearly and concisely as possible on the exam paper. Use of carefully labeled diagrams, where appropriate, is strongly encouraged. Section 2: True, False, or Uncertain (5 points each). Respond to each of the following statements by labeling the statement true, false, or uncertain. Then justify your claim. Answers that do not provide justification will receive zero points. 4

5 1) Adorable cat videos on YouTube are public goods. In order to be a public good, a good must be non-rival and non-excludable. Here s a short, correct answer: False. Cat videos are not public goods because while they are basically non-rival (my watching doesn t deprive you of watching), they are excludable. If YouTube wanted to, they could charge you per view. You could get full credit for saying uncertain, and discussing rivalness and excludability, like above. You could even get full credit for saying true, as long as you made the point that they weren t pure public goods (for reasons like those above). You could also argue they were rival because the server where the video is stored is congestible if enough people use it, access speed will slow down or access will be cut off. You could also point out that even if YouTube doesn t exclude people from watching the videos, they force people to watch ads and get paid ad revenues per view hence the videos are excludable (someone can be forced to pay for a consumer viewing them). Many people said such videos were non-excludable because people aren t charged for viewing them. But non-excludability isn t about whether people are or are not charged. It s about whether they can or cannot be charged. Or in fact, whether someone (like, in this case, an advertiser) can or cannot be charged when the good is consumed. The term non-excludable means one cannot be kept from consuming the good if the supplier isn t paid. So plenty of goods that are free to consumers are technically excludable including these videos. If you said, Cat videos are public goods because they re nonrival and people aren t charged for watching them that s not applying the definition of non-excludability correctly. People lost points for this sort of reasoning. One answer that was totally wrong was, The government doesn t provide cat videos, so they re not public goods. Government provides lots of private goods and fails to provide lots of public goods. A good is only a public good if it fits the definition above. 2) In the face of imperfect information about firms abatement costs, economists prefer a market for tradable pollution permits to a system where firms are charged a per unit amount (set by the government) for polluting. Here s a short, correct answer: Economists prefer permits to charges because permits provide the same advantages of charges (they re cost-minimizing and generate government revenue) but they also guarantee that the government will hit its pollution target. Recall from the introduction to tradable permits that pollution standards (forcing firms to pollute at a certain level) are great at hitting a pollution target but aren t cost minimizing (recall why). Pollution charges (per unit of pollution) are cost minimizing and generate government revenue which allows us to lower taxes in other markets, but unless the government has a lot of information about marginal abatement costs of firms, it s 5

6 unlikely to correctly pick a charge that hits its pollution target (say, as delineated in some international treaty). Permits provide the best of both worlds. The government sets its pollution target with the number of permits it issues. Firms then trade permits according to their own marginal abatement cost schedules (so firms facing high MAC buy more permits; firms facing low MAC buy fewer). This way, permits are cost minimizing AND the government hits its target. People talked a lot about efficiency here. I actually started the discussion of permits by saying Let s set aside the issue of efficiency and just assume the government has some target it needs to meet. If the government happens to know the efficient level of pollution, that s great. But if it knows the efficient level of pollution, it must know what MAC curves look like, so then it shouldn t have any trouble picking the correct charge and hence there s no advantage to permits. So talking about efficiency didn t tend to lend a lot useful to your answer. A quick note on waffling on. I don t mind long answers to questions. They take longer to grade but I know sometimes you just want to get your thoughts down on paper. However, there is an advantage to a good short answer. You re less likely to say something wrong if you say state your answer concisely. If you give basically the right answer, and then go on to say some things that are logically incorrect, I take off points. Sometimes I just give full points once I see the correct answer and don t read further. But if I happen to notice something wrong mixed in with an otherwise correct answer, I do mark points off. So keep in mind that while the risk of a short answer is that you don t say enough, the risk of a long an answer is that you say too much! END SECTION 2 Section 3: Short Answers 6

7 Question 1 refers to the diagram below points total Consider the market illustrated above, where an externality is present. a) 3 points On the diagram above, shade in the area representing deadweight loss in equilibrium. Clearly label the equilibrium and efficient quantities in this market. See above. People often formulaically shade in DWL without thinking about it. Note that there is a positive production externality in this case (make sure you understand why). So in equilibrium, production is lower than is socially optimal. The DWL can be thought of as the extra social benefits we could have had, less the extra social costs we would have had, had we produced at Q eff. Social welfare would have been higher, by the amount of the shaded triangle. An alternative way to think of it is that by being at the bad equilibrium, social welfare is reduced (relative to what it would have been at the efficient 7

8 quantity) by the amount of the triangle. Note that with externalities, the DWL triangle is always bounded by MSC and MSB. b) 3 points Consider the optimal (social welfare maximizing) per unit tax or subsidy to correct the market failure. Which would you choose a tax or a subsidy? Clearly illustrate and label the amount of the optimal per unit tax or subsidy in the diagram above (obviously you can t give a number, so just illustrate the amount). We want a subsidy, because that will increase production. A subsidy paid to producers drives down the marginal cost curve of producers. By choosing a subsidy equal to MEB at the efficient quantity (I label this s* above), the government can induce production to rise to the efficient quantity. 8

9 c) 3 points Clearly illustrate (on the diagram above) total government expenditure (in the case of a subsidy) or revenue (in the case of a tax) under this optimal policy. See above. The government spends s* per unit of the good produced and there are Q eff units produced when the subsidy is imposed. So government expenditure is Q eff *(s*). This is represented by the shaded rectangle above. You didn t need to note consumer and producer price in this case, but I show it above anyway. Price to consumers falls to P c while price to producers (who get the consumer price plus the subsidy, s*) rises to P s. Note that this is the opposite of what happens with a tax, but a subsidy is the opposite of a tax so that should make some intuitive sense. Now consider a different situation, illustrated in the diagram below. Note that the curves have changed, so the situation is different than before. 9

10 d) 3 point On this new diagram, shade in the area representing deadweight loss in equilibrium. Clearly label the equilibrium and efficient quantities in this market. Here, there s overproduction occurring, relative to the social optimum (due to a negative production externality). The waste resulting from that is the extra social cost, in excess of the extra social benefit, that results from being at the equilibrium instead of the efficient quantity. This suggests (as usual) that the DWL should be an area between the MSB and MSC curves. If you re not sure why DWL is the area shaded, ask yourself, How much higher is total social cost as a result of producing at Q eq instead of Q eff? and How much higher is total social benefit as a result of producing at Q eq instead of Q eff? The difference between those two areas (find them!) is DWL. Try to think about the intuition of deadweight loss, rather than just flipping a coin over which triangle to shade. e) 3 points 10

11 Consider the optimal (social welfare maximizing) per unit tax or subsidy to correct the market failure in this new scenario. Would you choose a tax or a subsidy? Clearly illustrate and label the amount of the optimal per unit tax or subsidy in the diagram above (obviously you can t give a number, so illustrate the amount). Here the MSC curve lies above the MPC curve. This tells us there s a negative production externality (make sure you understand why). So, in equilibrium, too much of this good is produced relative to the social optimum (the efficient quantity). We want to reduce production, and a tax will do this. To choose the optimal tax, we need to find the MEC at the efficient quantity. This is marked t* in the diagram above. It s just the difference between MSC and MPC at the efficient quantity. We ll set our per unit tax equal to t*, and that will generate the desired reduction in equilibrium quantity. Note the dotted line is the private marginal cost curve plus the amount of the per unit tax. This reflects the costs of producers when the tax is in place. 11

12 Note that a per unit tax is denoted as a distance not an area. And it s a vertical distance. Some people drew arrows that were diagonal, but those describe changes in both price and quantity, so they don t describe taxes. Similarly, per unit subsidies are denoted as distances, not areas (see above). f) 3 points Clearly illustrate (on the diagram above) consumer and producer price under the optimal policy in this new scenario. The tax pushes up the price that consumers pay and pushes down the price that producers receive, as noted above. Study this very carefully. Many people seemed to think the price remained the same for suppliers before and after the tax, but that will only ever happen under fairly unusual circumstances, and it certainly won t happen in this case, given that the demand curve slopes down and the supply curve slopes up. While you didn t need to show it, the shaded rectangle above shows government revenue. Notice the height of this rectangle is t*, and Q eff is the width. The government collects revenue of Q eff *(t*). Question 2 refers to the diagram below 12

13 2. 8 points total Assume there are three consumers in the market for a public good. Two of them have the individual demand curve D2 and one has the individual demand curve D1. Assume that provision of the public good costs $75 per unit. a) 4 points Draw the marginal social benefit curve for this market on the diagram above. To get this, just add up vertically the individual marginal benefit curves. Note that a number of people drew the MSB curve that was correct for the other version of the exam. This means that either people were being careless about reading directions, or they were carelessly copying off the wrong version of the exam. Either way, I noticed and I wasn t particularly impressed. Make sure this doesn t happen in the future. 13

14 b) 4 points Find the efficient quantity of provision. You must show your work to get credit. You can get partial credit for illustrating the efficient quantity on the diagram. Note that the answer won t necessarily be an integer. I ve drawn the efficient quantity above. It s always useful to draw pictures and support your math with a picture. Often you catch mistakes this way. We need to stare at that MSB curve and write an equation for it. There are two equations for it, because it s composed of two distinct segments. The upper segment has the equation (using the slope-intercept formula) MSB=125-(3/4)Q The lower segment has the equation MSB=100-(1/2)Q. To find the efficient quantity, we set MSB=MSC. This intersection happens in the upper part of the MSB curve so we set 125-(3/4)Q=75 -(3/4)Q=-50 Q=50*(4/3)=200/3 This is the efficient quantity END SECTION 3. END OF EXAM. 14