Economics 325: Public Finance Section A01 University of Victoria Midterm Examination #1 VERSION 1

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1 Economics 325: Public Finance Section A01 University of Victoria Midterm Examination #1 VERSION 1 Fall 2010 Instructor: Martin Farnham Midterm Exam #1 Page 1 Section 1: Multiple Choice (3 points each) Select the most appropriate answer, and circle the corresponding letter on your exam paper. Questions 1-8 refer to the diagram below. 1) What type of externality is illustrated by the above diagram? A) Positive consumption externality. B) Positive production externality. 1

2 C) Negative consumption externality. D) Negative production externality. E) Negative consumption and production externality. 2) Which area represents deadweight loss at the equilibrium? A) H B) C+F C) F+H D) E E) F 3) Which area represents total consumer benefit at the equilibrium? A) A+B+D+E B) A+B+D+E+G+I C) A+B+C+D+E+F+G+H+I+J D) B+D+G+I E) A+B+C Note: In error I previously listed the correct answer as B. B tells us total social benefit, which is consumer benefit plus external benefit. The correct answer is D. Students who had B as their answer will see an adjustment of -3 to their score on the gradesheet. This reflects the fact that they were originally given 3 points for an incorrect answer. Students who had D as their answer will see an adjustment of +3 to their score. Students who answered A, C, or E will see an adjustment of 0 (i.e. no adjustment) to their score. 4) Which area represents consumer surplus at the equilibrium? A) B+D B) A+B+D+E C) A+B+C D) B+D+G+I E) A+B+D+E+F 5) Which area represents the total external cost or total external benefit at the efficient quantity? A) A B) A+E C) A+C+E+F D) A+C+E+F+H E) C+F+H 2

3 6) How much does variable cost decrease as we move from Q2 to Q1? A) J B) H C) I D) H+I+J E) H+J 3

4 7) What would be an appropriate policy for correcting the market failure in this situation? A) a tax B) a subsidy C) a price floor D) a binding quota E) a nonbinding quota 8) Which of the following best describes the shape of the marginal externality curve (either marginal external benefit or marginal external cost) in the above diagram? A) It is upward sloping. B) It is downward sloping. C) It is flat. D) It slopes down and then up. E) It slopes up and then down. END SECTION 1. Answer each question as clearly and concisely as possible. 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. 1) (5 points) Bluefin Tuna (which are generally hunted by fishing fleets in international waters) are threatened with extinction, due to overfishing. The reason there are too few Bluefin Tuna in the world is that Bluefin Tuna are a public good. False. To be a public good, a good must be non-rival and non-excludable. Bluefin Tuna are not a public good because although they are non-excludable (and this is why they are overfished) they are a rival good. Technically Bluefin Tuna are a commons good. 4

5 2) (5 points) Unless there is a pre-existing market failure, government policy interventions generally cause a reduction in social welfare. True. When markets function well (i.e. there is no market failure), social welfare is already maximized (this is how we define a well-functioning market). In these cases, government policy interventions that change quantities in the market will always cause a reduction in social welfare. END SECTION 2 Section 3: Short Answers 1) (9 points total) Consider the market for boxes of paper. Assume that the market is otherwise competitive, but that a negative production externality (water pollution) is present. Demand and supply for paper are given in the diagram below (see next page). a) 2 points What is the equilibrium quantity of paper in the market? What is the efficient quantity of paper in the market? Equilibrium: 200 Efficient: 150 b) 3 points Clearly illustrate and label in the diagram the deadweight loss in equilibrium in this market. You don t need to provide a number. Deadweight loss is the area bounded by the equilibrium quantity, the efficient quantity, the MSB curve, and the MSC curve. See black triangle in diagram below. c) 4 points Clearly illustrate and label in the diagram the per unit tax which would bring about the efficient quantity of production. You don t need to provide a number. The optimal per unit tax is illustrated with the vertical arrow in the diagram below. It is equal to the Marginal External Cost at the efficient quantity. This is the vertical distance between the MSC curve and the MPC (supply) curve at Q=150. This appears to be about 5

6 $2.50 per box of paper. Some people got partial credit for showing a taxed supply curve. But when I ask for you to clearly illustrate and label the optimal tax, I want you to explicitly show me a distance that represents that tax, for full credit. Diagram for Question 1 (Market for Boxes of Paper) 6

7 Question 2 (public good) refers to the diagram below: 2. (7 points total) The diagram above gives two different individual demand curves for a public good. Assume there are only three consumers in this market. One has the individual demand curve D1, the other two each have the individual demand curve D2. a) 4 points Carefully draw the marginal social benefit curve for the public good on the diagram above. See the kinked solid purple line above. We get this by vertically aggregating the demand curves, keeping in mind that there is 1 D1 curve and 2 D2 curves. 7

8 b) 3 points If the marginal cost of providing the public good is $10 per unit, what is the efficient quantity of the good? You must show your work to receive credit. Graphically, we see the efficient quantity as where MC=MSB. We need to find an equation for MSB. The problem is that the MSB curve is kinked, so there is an equation describing the upper part and a different equation describing the lower part. The MC curve crosses MSB in the lower part, so that s the equation we want. Equations for MSB curve: Upper: MSB=125-(3/4)Q Lower: MSB=100-(1/2)Q To see how we get the equation for the lower part of MSB, first note the slope of the lower part of the MSB curve is -1/2. Note also the dotted line extending back to the y- axis. This gives us the y-intercept of 100. MC=MSB 10=100-(1/2)Q -90=-(1/2)Q Q=180 Note: if you ve forgotten your algebra of lines (going from equations to graphs and vice versa) now s the time to relearn it (it will pay dividends later in this course and in other economics courses). It s very easy, except if you haven t learned it! Come for help. END SECTION 3. END OF EXAM. 8