Public Economics Exam

Public Economics – Designing Government Policy Final Examination (10 points each, explain your answers) 1 . True / False / Uncertain: It is always better to use monetary policy for output stabilization than to use fiscal policy. False. Monetary policy becomes ineffective once real interest rates come close to zero. Also: different lag lengths. 2. True / False / Uncertain: Requiring employers to make accommodations for disabled workers and to pay disabled and non-disabled workers the same wages will raise the unemployment of the disabled.

Uncertain. The demand for their labor will be reduced, as they are now effectively more expensive to firm. (5) That said, their labor supply will increase if they value the accommodations more than they cost, or if their was a market failure of some kind in the provision of accommodations before. (5) Empirically, this appears to be true (Guacamole & Angst, JEEP 2001). (5) 3. True / False / Uncertain: Demand-side health insurance that deals optimally with the tradeoff between moral hazard and protection does not lead to overcompensation of health care, I. E. The social cost of the marginal unit of health care consumed will to exceed the social benefit of that unit. False. Insurance always creates some level of overcompensation; and asymmetric information may lead to oversupply (5 for this second point). 4. Suppose Jim has an 80% chance of being employed, and a 20% chance of being unemployed. When employed, Jims income is $10,000, and when unemployed, Jims income is $100. Jims utility function is given by U = In dollar terms, how much more would it be worth to Jim if he made his expected income with certainty, than if he faced the uncertain income stream Just described? 1 ,296 (5) – His expected income equals $8,020 (2), while the certainty equivalent of is risky income is $6,724 (3). 5. True / False / Uncertain: The invention of a new local public good makes it more likely that the efficient allocation predicated by the Output model materializes. False. It’s the other way around, as an additional local public good makes it necessary for there to be even more differentiated localities. 6. Identify two reasons why the current Social Security system is not as redistributive as the manner in which Average Indexed Monthly Earnings are transformed into Primary Insurance Amounts would suggest.

The rich live longer than the poor. Many spouses of formerly high-earning retirees infinite from being allowed to choose to receive 50% of their spouse’s PIP. You must have contributed for at least 10 years. Income above a certain threshold is not taxed. Richer people start working later in life. EXTERNALITIES In Karri, Kansas, population 1,001, the only source of entertainment available is driving around in your car. The 1,001 Karaoke’s are all identical.

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They all like to drive, but hate congestion and pollution, resulting in the following utility function: = f + add – d 2 – 6th/1000, where f is consumption of all goods but driving, d is the number of hours of driving Karaoke I does per day, and t is the total number of hours of driving all other Karaoke’s do per day. Assume that driving is free, that the unit price of food is $1, and that daily income is $40. 1. If an individual believes that the amount of driving he does won’t affect the amount that others drive, how many hours per day will he choose to drive? 8) Eight hours – he would simply maximize add -do. 2. If everybody chooses this number of hours, then what is the total amount t of driving by other persons? (4) 8,000. 3. What will the utility of each resident be? (4) 56. 4. If everybody drives 6 hours a day, what will the utility level of each Karaoke be? (4) 64. 5. Suppose that the residents decided to pass a law restricting the total number of hours that anyone is allowed to drive. How much driving be allowed if the objective is to maximize the utility of the typical resident? 8) Five hours (maximize over d after setting t/1000 = d). 6. The same objective could be achieved with a tax on driving. How much would the tax have to be per hour of driving? (8) $6. WORK INCENTIVES (24 points, explain your answers) Anna is endowed with 1000 hours, which can be taken either as leisure or as labor. For each hour spent on labor, Anna earns a wage of $20/hour. Consider the following two situations, and draw the indicated graph (see the file 2011 Final Graphs): 1.

The welfare guarantee in this society is $5,000, but a recipient loses $1 for every $2 she earns. Anna’s money is spent on feeding herself and her kids; one unit of food costs $1 . Draw the budget set facing Anna, with leisure on the horizontal axis and how many hours of work) the welfare benefits run out. (7) 2. There is no welfare guarantee in this society, but someone earning less than $20,000 receives an extra $1 for each $1 she earns. Anna’s money is spent on feeding herself and her kids; one unit of food costs $1 .

Draw the budget set facing Anna, with leisure on the horizontal axis and consumption of food on the vertical axis. (7) II. True/False/Uncertain: Redistributing income to the poor always reduces someone’s work incentives, even if the money you use for it has fallen out of the sky miraculously. (10) True. Even in this extreme scenario, and even if we disregard inflationary pressure, there will be some at the poverty margin who will be tempted to reduce their labor supply to benefit from redistribution. ESSAY (60 points) All taxes are bad… But some are worse than others.

Discuss. See the file “2011 Final Essay’ for an example of an essay that received full credit. What we expected is a treatment of the equity and efficiency Justifications for some taxes (redistribution, externalities, public goods), of the dead-weight loss created by taxes that drive a wedge between private and social benefits and costs, of the differences in dead- weight loss created by different taxes (exponential increase with increasing rate, different elasticity, international distortions and why they become large quickly), and of some specific examples.