Solution Manual for Public Finance, 10th Edition

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Part 1–Getting Started1-1Instructor’s Manual to accompanyPublic Finance,TenthEdition, by Harvey S. Rosenand Ted GayerChapter 1–IntroductionBriefOutline1.Public Finance and Ideologya.The Organic View of Governmentb.The Mechanistic View of Governmentc.TheViewpoint ofThisBook2.Government at aGlancea.Legal Frameworki.Federal Governmentii.State andLocalGovernmentsb.Size of Governmentc.Expendituresd.Revenuese.Our AgendaSuggested Answers to End-of-Chapter Discussion Questions1.a.McCain’sstatement is consistent with an organic conception of government.Individuals and their goals are less important than the state.b.Lockemakes a clear statement of the mechanistic view of the state in whichindividual liberty is of paramount importance.c.Chavez’s statement is consistent with an organic view of government.Theindividual has significance onlyas part ofsociety as a whole.2.Libertarians believe in a very limited government and are skeptical about the ability ofgovernmenttoimprovesocialwelfare.Socialdemocratsbelievethatsubstantialgovernment intervention is required for the good of individuals.Someone with anorganic conception of the state believes that the goals of society are set by the state andindividuals are valued only by their contribution to the realization of social goals.a.A law prohibiting receiving compensation for organ donation would be opposedby libertarians, as they would want the market to decide who buys and who sellsorgans and at what price the organs would be sold.Social democrats also mightoppose the law if they consider that such a law would prevent organ donationfrom happening as frequently. However, they are likely to support the law on thegrounds that paying for organ donation would coerce financially desperate peopleto sell their organs.The law would protect the individual from making a poor

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Chapter 1-Introduction1-2decision. The organic view might also oppose the law because the society mightbecome healthier if more individuals received transplants, although they wouldbelieve that individuals should donate for the good of society, rather than forcompensation.b.Libertarians oppose the law mandatinghelmet use for motorcyclists, arguing thatindividuals can best decide whether or not to usehelmetswithout governmentcoercion.Social democrats take the position that the mandate saves lives andultimatelybenefitsindividuals.Theorganicviewwouldprobablyleadtofavoring the mandate on the grounds that reduced health care costs caused byfewerinjuriesbenefit society.c.Libertarians oppose the law mandating child safety seats, arguing that individualscan best decide whether or not to use child safety seats without governmentcoercion.Social democrats take the position that the mandate saves lives andultimatelybenefitsindividuals.Theorganicviewwouldprobablyleadtofavoring the mandate on the grounds that reduced health care costs caused byfewer accidents benefit society.d.Libertarians would probably oppose a law prohibiting prostitution, while socialdemocrats would likely favor such a law.The organic view depends on the typeof society policymakers are attempting to achieve.The law would probably befavored on moral grounds.e.Libertarians would probably oppose a law prohibiting polygamy, while socialdemocrats would likely favor such a law.The organic view depends on the typeof society policymakers are attempting to achieve.The law would probably befavored on moral grounds.f.Libertarians would likely oppose theban on trans fats in restaurants, believingthatconsumers will demand restaurants remove trans fats if they believe that isimportant.Social democrats wouldprobably support the ban because consumersmight not understand how bad trans fats are for their health.Those with anorganic view would probably favor thebanbecause the scientific literaturesuggests that people who avoid trans fats are healthier, therefore the ban wouldreduce health care costs.3.The mechanistic view of government says that the government is a contrivance created byindividuals to better achieve their individual goals.Within the mechanistic tradition,people could disagree on the taxon saturated fats to reduce obesity.Libertarians wouldsay that people can decide what is best for themselves-whether to consumesaturatedfats-and do not need prodding from the government. In contrast, social democrats mightargue that people are too short sighted to know what is good for them, so thatgovernment-provided inducements are appropriate.

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Part 1–Getting Started1-34.a.If the size of government is measured by direct expenditures, the mandate doesnot directly increase it.Costs of compliance, however, may be high and wouldappear as an increase in a “regulatory budget.”b.Thisbanwould not increase government expenditures, but the high costs ofcompliance would increase the regulatory budget.c.It’s hard to say whether this represents an increase or decrease in the size ofgovernment.One possibility is that GDP stayed the same, and governmentpurchases of goods and services fell.Another is that government purchases ofgoods and services grew, but at a slower rate than the GDP.One must alsoconsider coincident federal credit and regulatory activities and state and localbudgets.d.The federal budget would decrease if grants-in-aid were reduced.However, ifstate and local governments offset this by increasing taxes, the size of thegovernment sector as a whole would not go down as much as one would haveguessed.5.The inflation erodes the real value of the debt by 0.036x £904billion or £32.54billion.The fact that inflation reduces the real debt obligation means that this figure should beincluded as revenue to the government.6.If you consider the size of government as the extent to which society’s resources aresubject to control by the government, the bothPolicy 1andPolicy 2 would increasethesize of government by the same amount. While it seems Policy 1 has no effect of the sizeof the government because it only mandates private spending, it causes resources to beunder the control of the government. Policy 2 seems to affect the size of the governmentbecause it changes revenues and transfers, but the cost to each household is the same asin Policy 1, a $5000 expenditure on health insurance or in additional taxes.7.Relative to GDP, defense spending grew from5.0percentof GDP in 1981 to6.0percentof GDP in 1985and then grew from 3.9 percent of GDP in 2007to4.7percent of GDPin20011.The increase from 2007 to 2011was proportionally larger, but both increaseswere the same in terms of the percentage point increase.8.a.For the years1997 to 2001, the absolute change in federal expenditures was$261.7billion[$1862.8-$1,601.2 billion],the change in federal expenditures in real terms (2001dollars) was $146.26billion[inflationrate=(90.727-84.628)/84.628=7.21%,$1,862billion–$1,601(1+0.0721)=$146.26billion],thechangeinrealgovernmentexpenditurespercapitawas$241.26[realgovernmentexpenditurespercapitain1997(2001dollars):$1,601.1*(1+1.0721)/0.227912= $6,289.72; real government expenditures per

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Chapter 1-Introduction1-4capita in2001(2001dollars):$1862.8/0.285225billion= $6,530.98;$6,530.98-$6,289.72=$241.26],and the change in expenditures per GDP is-$0.01106billion [$601.1/$8,332.4–$1,862.8/$10,286.2].For the years 2007to 2011, the absolute change in federal expenditures was$874.4billion[$3,603.1billion-$2,728.7billion],the change in federal expenditures in real terms (2011dollars) was $691.9billion[inflationrate=(113.338-106.231)/106.231=6.69%,$3,603.1billion–$2728.7(1+0.10669)=$691.9billion],the change in real government expenditures per capita was $1,899.78[realgovernmentexpenditurespercapitain2007(2011dollars):$2,728*(1+1.10669)/0.3017= $9,647.14;real government expenditures per capita in2011(2011dollars):[$3,603/0.3120billion = $11,546.92;$11,546.92$9,647.14=$1,899.78],and the change in expenditures per GDP is-$0.0442billion[$2,728.7/$14,028–$3,603.1/$15,094].b.The health spending and “other”categories had the largest relative increaseschanges from 1997 to 2001 and 2007 to 2011. Net interest had the only decreasein spending.19972001relativechange from1997 to 200120072011relativechange from2007 to 2011Defense285.7321.212.426%579.8751.329.579%Health123.8172.239.095%266.4372.539.827%Medicare190.0217.414.421%375.4485.729.382%Income secruity235.0269.814.809%366.0597.463.224%Social Security365.3433.018.533%586.2730.824.667%Net Interest244.0206.2-15.492%237.1230.0-2.995%Other157.3243.154.545%317.9435.536.993%9.a.The1997 to 2001absolute change in federal tax revenues was $411.9billion(=$1991.1-$1579.5), while from 2007to 2011the same change was-$264.5billion(=$2303.5-$2568.0).In real terms, the1997 to 2001change in federal tax revenues was $298.04(inflation over period 7.21%, real change =$1991.1-($1579.2*1.0721). For2007

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Part 1–Getting Started1-5to 2011, the change in federal tax revenues was $-436.30(inflation over period6.69%, real change = $2303.5-$2568.0*1.0669).The change in real tax revenues per capita for1997 to 2001was $778.16(=($1991.1/.285225-$1579.2*(1.0721)/0.272958))and for2007 to 2011was $-1699.26(=($2303.5/.312040-$2568.0*(1.0669)/0.301696)).ThechangeinthetaxrevenuesperGDPfrom1997to2001was0.004(=$1991.1/10286.2-$1579.5/8332.4)andfrom2007to2011was0.0530($2303.5/15094-$2568.0/14028).b.From1997 to 2001, social insurancetaxes had the largest relative increase.From2007 to 2011, the excise tax had the largest relative increase.From1997 to 2001and 2007 to 2011, socialcorporate taxesrevenue had the largest relative decrease.19972001relativechange from1997 to 200120072011relative changefrom 2007 to2011Individual Income Tax737.5994.334.820%1163.51091.5-6.188%Corporate Tax182.3151.1-17.115%370.2181.1-51.080%Social Insurance539.4694.028.661%869.6818.8-5.842%Excise Tax120.1151.726.311%164.7212.128.780%

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Part 1-Getting Started2-1Chapter 2–Tools of Positive AnalysisBrief Outline1.The Role of Theory2.Causation versus Correlation3.Experimental Studiesa.Conducting an Experimental Studyb.Pitfalls of Experimental Studies4.Observational Studiesa.Conducting an Observational Studyb.Pitfalls of Observational Studies5.Quasi-Experimental Studiesa.Conducting a Quasi-Experimental Studyb.Pitfalls of Quasi-Experimental Studies6.ConclusionsAnswers to End-of-Chapter Questions1.A change in the marginal tax rate changes the individual’s net wage. This generates bothan income effect and a substitution effect.As long as leisure is a normal good, theseeffects work in opposite directions. Hence, one cannot tella prioriwhether labor supplyincreases or decreases.If there were no political or legal impediments, an experimentalstudy could be conducted in whicha control group confrontsthe status quo, and anexperimental group facesthe new tax regime.Other things that affect work effort wouldimpact both the control group and the experimental group, so any difference in workeffort between the two groups could be attributed to the change in marginal tax rates.2.This is a valid criticism of thestudy of New York Homelessness. It reflects the problemof causality.Two things may be correlated, but it can be difficult to determine whichcauses the other. The remedy would be to set up a study in which individuals arerandomly assigned to groups.In an experimental study, the groupoffered job training,counseling services, and emergency money would not necessarily be more motivatedthan a group not signed up for those services, so if theydo not become homeless, it couldbe attributed tothe programs.3.The workers who spend time on a computer probably have other skills and abilities thatcontribute to higher wages, so training children to use computers would not necessarilycause their earnings potential to improve.This study illustrates the difficulty ofdetermining cause and effect based on correlations. The data do not reveal whether usinga computer causes higher earnings, or whether other factors cause workers to usecomputers and to earn higher wages.4.The text points out the pitfalls of social experiments: the problem of obtaining a randomsample and the problems of extending results beyond the scope of the experiment.Participants in the study had found it to their advantage to be a part of the experiment,which may have resulted in a self-selected population unrepresentative of the wider groupof health care consumers.In addition, the RAND Health Insurance Experiment was oflimited duration, after which the participants would move to some other health plan. This

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Chapter 2-Tools of Positive Analysis2-2design could induce certain behavior in the short-run that would not necessarily bepresent if the health insurance coverage were permanent rather than transitory.Further,physicians’ “standard practices” are largely determined by the circumstances of thepopulation as a whole, not the relatively small experimental group.5.The scenario set up by the change in unemployment lends itself to a difference indifference approach, in which the first difference is across time and the second differenceis across income level. The researcher would measure the change in unemploymentduration for high earners between the period of lower benefits and the period of higherbenefits, and then compare this change to the change for the low earners. The treatmentgroup would be the high earners and the control group would be the low earners. Theassumption that must hold for unbiased estimates is that in the absence of the policychange, both the treatment and control groups would have experienced the same changein unemployment duration across the periods preceding and following the policy change.6.Since only five states reduced income taxes, we could examine what happened in acontrol group of states (those with an income tax but with no change in the tax rates) andcompare savings rates between the two.This is important because other factors affectsavings rates, but if other factors affected both the control group and the treatment group,then we can conclude that the treatment (lower taxes) caused the change in savings.If,for example, the saving rate for the five states with lower taxes (the treatment group)increased by two percent, while the savings rate for the other states (the control group)increased by one percent, then we could conclude that lower taxes caused the saving rateto increase by one percent—the difference between the two percent increase in thetreatment group and the one percent increase in the control group.The assumption thatmust hold for this difference in difference approach to be valid is that in the absence ofthe income tax cut, the savings rates of the treatment rates would have increased by thesame percentage as the savings rates of the control states.7.Correlation does not, in general, reveal anything about causation.Spitzer is assuming thatbecause there is no correlation between higher marginal tax rates and slowing economicactivity in the data, that marginal tax rates can be raised without harming economicgrowth.The assumption ignores that other factors could be playing in the economy thatwould mitigate the effect of higher marginal tax rates.Further, current higher marginaltax rates could imply lower future economic growth, which may not be reflected in thedata to which he was referring.8.There is a weak, positive relationship between deficits and interest rates, implying thatlarger deficits lead tolowerinterest rates.Inferences based on these data along would beproblematic because there are only a few data points and because it would be moreinformative tolook at deficits relative to some benchmark, such as GDP, andto expressboth interest rates and deficits in real terms, rather than nominal terms.It would also beusefulto control for other factors that can affect interest rates, such as monetary policyand the level of economic activity.Most importantly, the correlation found here does notnecessarily indicate a causal relationship.

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Part 1-Getting Started3-1Chapter 3–Tools of Normative AnalysisBrief Outline1.Welfare Economicsa.Pure Economy Exchangeb.Production Economy2.The First Fundamental Theorem of Welfare Economics3.Fairness and the Second Fundamental Theorem of Welfare Economics4.Market Failurea.Market Powerb.Nonexistence of Marketsc.Overview5.Buying into Welfare EconomicsAnswers to End-of-Chapter Questions1.a.In this particular insurance market, one would not expect asymmetric informationto be much of a problem–the probability of ahurricaneis common knowledge.Moral hazard could be an issue–people are more likely to build near a beach ifthey havehurricaneinsurance.Still, one would expect the market forhurricaneinsurance to operate fairly efficiently.b.There is substantial asymmetric information in the markets for medical insurancefor consumers and also malpractice insurance for physicians.For efficientconsumption, the price must be equal to the marginal cost, and the effect ofinsurance may be to reduce the perceived price of medical care consumption.That would lead to consumption above the efficient level. Because of the roles ofregulation, insurance, taxes, and the shifting of costs from the uninsured to theinsured, there is little reason to expect the market to be efficient.c.In the stock market, there is good information and thousands of buyers andsellers. We expect, in general, efficient outcomes.d.From a national standpoint, there is a good deal of competition and informationwith regards toMP3 players and music.The outcome will likely be efficient forMP3 players and music.However, some firms might exercise some marketpowerthrough high brand awareness and proprietary downloading systems.e.Theprivatemarketallocationislikelyinefficientwithoutgovernmentintervention. Student loan markets may suffer from asymmetric information–thestudent knows better than the lender whether he will repay the loan or default onit, a form of adverse selection.Government intervention does not “solve” theadverse selection problem in this case (because participation in the student loanprogram is not compulsory), but it may create a market that would not existwithout intervention.

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Chapter 3-Tools of Normative Analysis3-2f.The market for housing is likely to be relatively efficient.Some inefficienciesmay exist, such as asymmetric information—the seller knows more about thehouse than the buyer—and differentiated products. But, the market has developedto mitigate these inefficiencies.For example, a buyer can employ a homeinspector to help him understand more about the quality of the home.Also, alarge number of homes on the market increases competition.2.The social welfare function of W=f(Ua, Ub) implies that the welfare of society depends onthe utility of the individuals.It does not imply that the utility of the individual dependson the welfare of society as then-Senator Obama’s comment suggests.3.The First Theorem of Welfare Economics says that market transactions only occur whenthe transactions would be in the best interest of both parties.In contrast, the psychologistseems to view the kidney market as hurting one or both parties involved.4.If insurers in California could no longer use location to determine automobile insurancerates, some of the higher costs incurred by urban residents would be shifted to rural andsuburban residents. This change would reduce efficiency, but the purpose of the policy isto improve equity, based on an argument that it is unfair that urban residents should haveto pay more for insurance because they are more likely to be involved in accidents.Social welfare increases if the additional utility enjoyed by urban residents offsets theloss in utility to rural and suburban residents.5.a.Point A is the initial allocation.b.Giventhe initial allocation in the Edgeworth Boxabove, one can see that boththeseller and buyercan reach a higher indifference curveat point Bby trading ticketsOther goodsOther goodsTicketsTicketsBuyerSellerAB

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Part 1-Getting Started3-3and other goods without either person being worse off. Therefore, the currentallocation is inefficient.c.A situation in which the original allocation is efficient and the tradingdoes notaffect efficiencyis shown below at point A.6.a.Social indifference curves are straight lines with slope of–1. As far as society isconcerned, the “util” to Augustus is equivalent to the “util” to Livia.Other goodsOther goodsTicketsTicketsBuyerSellerA

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Chapter 3-Tools of Normative Analysis3-4b.Social indifference curves are straight lines with slope of–2. This reflects the factthat society values a “util” to Augustus twice as much as a “util” to Livia.c.

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Part 1-Getting Started3-57.Musgrave (1959) developed the concept of merit goods to describe commodities thatought to be provided even if the members of society do not demand them.“Sin taxes”work the opposite way and apply tocommodities that members of society might demand,but ought not to have.8.a.There is no obvious reason why there is a market failure with burglar alarm calls;the Los Angeles police could set a response fee equal to the marginal cost.b.There is no obvious reason that the production of a documentary film about rockmusic and the fall of the Soviet Union would improve welfare in the UnitedStates.c.There is no economic reason why cherry pies should be regulated, especiallysince there are no such regulations for apple, blueberry, or peach frozen pies.d.It is hard to imagine a basis in welfare economics for this guarantee to thedomestic sugar producers, unless the utilities of sugar producers are given greatweight in the social welfare function.e.This is not an efficient policy.If the problem is that too much water is beingconsumed, then the answer is to increase the price of water. On that basis, peoplecan decide whether or not they want to buy toilets that require less water. Water,like most other resources, is a private good.f.There is no obvious reason that the preservation of video game history wouldimprove welfare.9.In this case, the “Edgeworth Box” is actually a line because there is only one good on theisland. The set of possible allocations is a straight line, 100 units long. Every allocationis Pareto efficient, because the only way to make one person better off is to make anotherperson worse off. There is no theory in the text to help us decide whether an allocation isfair.Although splitting the peanuts even between the people may be fair, it may not befair if the calorie “needs” of the people are different.With a social welfare function, wecan make assessments on whether redistribution for society as a whole is a good thing.10.Social welfare is maximized when Mark’s marginal utility of income is equal to Judy’smarginal utility of income.Taking the derivative of Mark’s utility function to find hismarginal utility function yields MUM= 50/(IM1/2) and taking the derivative of Judy’sutility function yields MUJ= 100/(IJ1/2).If we set MUMequal to MUJ, the condition formaximization becomes IJ= 4IMand, since the fixed amount of income is $300, thismeans that Mark should have $60 and Judy should have $240 if the goal is to maximizesocial welfare = UM+ UJ.

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Chapter 3-Tools of Normative Analysis3-611.a.If the food is evenly distributed between Tang and Wilson, Tang will have 14.14units of utility and Wilson will have 7.07 units of utility.b.If the social welfare function is UT+UW, then the marginal utilities of both shouldbe equal to maximize social welfare.EquateMUT=1/(2FT1/2)toMUW=1/(4FW1/2)and substitute FT=400-FW. Therefore, FT=320 and FW=80.c.If the utility of both Tang and Wilson must be equal, then set UT=UWandsubstitute FT=400-FWand solve. Therefore, FT=80 and FW=320.12.Although Victoria’s marginal rate of substitution is equal to Albert’s, these are not equalto the marginal rate of transformation and the allocation is, therefore, Pareto inefficient.Both people would give up 2 cups of tea for 1 crumpet but, according to the productionfunction, could actually get 6 crumpets by giving up 2 cups of tea. By giving up tea andgetting crumpets through the production function, both utilities are raised.13.a.The marginal rates of substitution for coffee and for tea are constant for bothHannah and Jose. Hannah would trade ¼ pound of coffee for 1/3 pound of tea toremain equally satisfied.Similarly, Jose would trade ¼ pound of tea for 1/3pound of coffee to remain equally satisfied.The constant MRS means linearindifference curvesb.Green indifference curves are Jose’s and red indifference curves are Hannah’s.CoffeeTeaTeaHannahJoseCoffee15131110

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Part 1-Getting Started3-7c.The contract curve follows the bottom and right borders of the Edgeworth Box. Atany interior point in the box, the parties will find it in their interest to trade untilthey reach these borders. This is because Hannah would only choose to consumetea once she has consumed all the coffee in the economy. Likewise, Jose wouldonly choose to consume coffee once he has consumed all the tea in the economy.d.The initial allocation is not Pareto efficient.It is possible to make one better offwithout making the other worse off.14.a.False.As showninthe text, equality of the marginal rates of substitution is anecessary, but not sufficient, condition.The MRS for each individual must alsoequal the MRT.b.Uncertain. As long as the allocation is an interior solution in the Edgeworth box,the marginal rates of substitution must be equal across individuals. This need notbe true, however, at the corners where one consumer has all the goods in theeconomy.c.False.A policy that leads to a Pareto improvement results in greater efficiency,but social welfare depends on equity as well as efficiency. A policy that improvesefficiency but creates a loss in equity might reduce social welfare.d.False. Moving to a point on the utility possibilities curve may not result in aPareto improvement because one party may receive less utility on the curve thanthey received at the interior point.

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Part 2–Public Expenditure: Public Goods and Externalities4-1Chapter 4–Public GoodsBrief Outline1.Public Goods Defined2.Efficient Provision of Public Goodsa.Deriving the Efficiency Conditionb.Problems in Achieving Efficiencyc.The Free Rider Problem3.Privatizationa.Public versus Private Provisionb.Public versus Private Production4.Public Goods and Public ChoiceAnswers to End-of-Chapter Questions1.a.Wilderness area is an impure public good–at some point, consumption becomesnonrival; it is, however, nonexcludable.b.Satellite television is nonrival in consumption, although it is excludable;thereforeit is an impure public good.c.Medical school education is a private good.d.Televisionsignalsarenonrivalinconsumptionandnotexcludable(whenbroadcast over the air).Therefore, they are a public good.e.Anautomatic teller machine isrival in consumption, at least at peak times.It isalso excludable as only those patrons with ATM cards that are accepted by themachine can use the machine. Therefore the ATM is a private good.2.a.False.Efficient provision of a public good occurs at the level where totalwillingness to pay for an additional unit equals themarginal cost of producing theadditional unit.b.False.Due to the free rider problem, it is unlikely that a private business firmcould profitably sell a product that is non-excludable.However, recent researchrevealsthat the free rider problem is an empirical question and that we should nottake the answer for granted.Public goods maybe privately supported throughvolunteerism, such as when people who attend afireworks display voluntarilycontribute enough to pay for the show.c.Uncertain.This statement is true if the road is notcongested, but when there isheavy traffic, adding another vehicle can interfere with the drivers already usingthe road.d.False.There will be more users in larger communities, but all users haveaccessto the quantity that has been provided since the goodis nonrival, so there is no

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Chapter 4–Public Goods4-2reasons larger communities would necessarily have toprovide a larger quantity ofthe nonrival good.3.We assume that Cheetah’s utility does not enter the social welfare function; hence, herallocation of labor supply across activities does not matter.a.The public good is patrol; the private good is fruit.b.Recall that efficiency requires MRSTARZAN+ MRSJANE=MRT. MRSTARZAN=MRSJANE=2. But MRT=3.Therefore, MRSTARZAN+ MRSJANEMRT.Toachieve an efficient allocation, Cheetah should patrol more.4.The Search for Extra-Terrestrial Intelligence is a public goodbecause it is nonrival andpresumably non-excludable.The government should pay for the research only if theSMB is greater than theSMC.5.Wine and liquorare both rival and excludable goods, so public sector production is notjustified on the basis of public goods.Therefore, it makes no economic sense to havepublicproduction.6.It is unlikely that if Pemex were privatized that the situation would lead to a monopolysituation. Comparing oil production to telephone service is not a correct comparison. Inthe case of the telephone company, there was only one provider of telephone service. Inthe case of oil production, there would be only one producer in Mexico, but manycompetitors providing oil from whichMexico could buy. The newly privatized companywould have to compete to sell its goods.It would likely become more efficient than thestate run company because of this competition.7.Theseamenitiesbeingpresentinprivateairportsalonewouldnotbeenoughtorecommend that airports be privately run.If fliers desire such amenities, it is not clearthat they cannot be provided in public airports via renting space. One would also needinformation on the cost of running the airports and distributional issues that might existfor publicly run airports versus privately run airports before recommending that airportsbe privately run.8.The experimental results on free-riding suggest that members of the community mightvoluntarily contribute about half of the required amount.The reason these citizenswanted to use private fundraising was because the state government redistributed taxdollars from wealthy districts to poor districts (the so-called Robin Hood plan), so usingprivate donations was a way to avoid losing tax dollars to other districts.9.Books are not a public good.They are both rival (two people cannot read a book at thesame time) and excludable (you can keep a person from reading a book).But if the goodslibraries provide are a sense of community or a better educated populace, thesewouldqualify as public goods. If the public good aspect of the library is to produce a bettereducated populace, then perhaps the classic books are a better choice.

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Part 2–Public Expenditure: Public Goods and Externalities4-310.Hiring private military firmsto provide military support in Afghanistan, Iraq, or Darfurwould be similar to the example of airport security in the text.One might argue that aprivate firm would not provide adequate training, use unethical or especially aggressivemethods to shorten the conflict, thus lowering costs to increase profits.Proponentswould argue that such things could be stipulated in a well-written contract. However, nocontract can specify every possible contingency.In high conflict situations this may beespecially true as the opposing side will not be predictable.11.a.Zach’s marginal benefit schedule shows that the marginal benefit of a lighthousestarts at $90 and declines, and Jacob’s marginal benefit starts at $40 and declines.Neither person values the first lighthouse at its marginal cost of $100, so neitherperson would be willing to pay for a lighthouse acting alone.b.Zach’s marginal benefit is MBZACH=90-Q, andJacob’s is MBJACOB=40-Q.Themarginal benefit for society as a whole is the sum of the two marginal benefits, orMB=130-2Q(forQ≤40), and is equal toZach’s marginal benefit scheduleafterwards (forQ>40).The marginalcost is constant at MC=100, so theintersection of aggregate marginal benefit and marginal cost occurs at a quantityless than 40.Setting MB=MC gives130-2Q=100, orQ=15.Net benefit can bemeasured as the area between the demand curve andthe marginal benefit of the15thunit. The net benefit is $112.5 for each person, for a total of $225.12.Each day the private decision of eachshepherdwould equate private cost with privatebenefit.Therefore,7 would show up because theneachshepherdwouldgraze foursheep.If theshepherdsgrazeless than foursheep, then they will stay home.The netbenefits to society are 0sheep(the benefit to the sevenshepherdsis 4sheep(7x4=28) andthe cost to society is 4sheep per shepherd(7x4=28)). The efficient number ofshepherdsto show up at themeadowis the number that will maximize social net benefits, whichhappens where the social marginal benefit equals the social marginal cost. This occurs atfourshepherds, where the net social benefits equal 12sheep(4x7–4x4).Access to themeadowis an impure public good. It is rival–if oneshepherdhas access to themeadow,the others have less access. It is, however, non-excludable because it is difficult to keepshepherd from grazing the meadow.13.Britney’s marginal benefit is MBBRITNEY=12-Z, andParis’s is MBPARIS=8-2Z.Themarginal benefit for society as a whole is the sum of the two marginal benefits, orMB=20-3Z (forZ≤4), and is equal toBritney’s marginal benefit schedule afterwards (forZ>4). The marginal cost is constant at MC=16. Setting MB=MC along the first segmentgives 20-3Z=16, or Z=4/3, which is the efficient level of snowplowing.Note that ifeitherBritneyorParishad to pay for the entire cost herself, no snowplowing would occursince the marginal cost of $16 exceeds either of their individual marginal benefits fromthe first unit ($12 or $8).Thus, this is clearly a situation when the private market doesnot work very well. Also note, however, that if the marginal cost were somewhat lower,(e.g., MC≤8), then it is possible thatPariscould credibly free ride, andBritneywouldprovide the efficient allocation.This occurs because ifBritneybelieves thatPariswillfree ride,Britneyprovides her optimal allocation, which occurs on the second segment ofsociety’s MB curve, which is identical toBritney’s MB curve (note thatParisgets zero

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Chapter 4–Public Goods4-4marginal benefit for Z>4).SinceParisis completely satiated with this good at Z=4, herthreat to free ride is credit ifBritneyprovides Z>4.See the graph below.MBBritneyMBParis

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Part 2–Public Expenditure: Public Goods and Externalities5-1Chapter 5–ExternalitiesBrief Outline1.The Nature of Externalities2.Graphical Analysisa.Implicationsb.Conclusion3.Private Responsesa.Bargaining and the Coase Theoremb.Mergersc.Social Conventions4.Public Responses to Externalities: Taxes and Subsidiesa.Taxesb.Subsidies5.Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programsa.Emissions Feeb.Cap-and-Tradec.Emissions Fee versus Cap-and-Traded.Command-and-Control Regulation6.The US Responsea.Progress with Incentive-Based Approaches7.Implications for Income Distributionsa.Who Benefits?b.Who Bears the Cost?8.Positive Externalitiesa.A Cautionary NoteAnswers to End-of-Chapter Questions1.Before passengers were charged for checked bags, they would choose whether to checkbags or carry them on based on whether they were willing to trade time for the hassle ofdealing with carry-on bags. That is, passengers who valued saving time by not having todeal with baggage claim more than the cost of dealing with carry-on baggage will chooseto carry on.The fact that passengersare nowcharged for checked baggage but not forbaggage carried onto the plane will inefficiently allocate overhead space.Passengers willcarry on more and bigger bagsto save the fee charged, resulting in full overhead luggagecontainers. Overhead space will go to the first passengers on the plane, rather than beingdistributed more evenly.Bags checked (without a charge) at the gate forces some whowould choose to carry on even without the fee to have to check, which is a loss inefficiency.Those who elect to carry on to avoid the fee, but would rather check theirbags, alsoresult in an inefficiency.2.The Coase theorem suggests that the church and the comedy club could negotiate. If thechurch possessed the right to the “noise” in the building, the comedy club could pay thechurch to be quiet.If the comedy club possessed the right to quiet in the building, thechurch could compensate the club for the noise.

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Chapter 5-Externalities5-23.It is the case that a carbon tax would be passed on to the consumer. The tax raises coststo the producer for producing the final good.These increased costs would decreasesupply, which will increase the price of that final good.In a cap and trade system,businesses must purchase permits in order to emit carbon.If the cost of purchasing andusing abatement equipment is less than the cost of buying a permit, the business willuseabatement equipment.In either case (buying a permit or using abatement equipment)costsfor the producer increase, decreasing supply and increasing the price of the finalgood.If the carbon tax and the number of permits issued in the cap and trade systemwere set appropriately, the outlays for both programs would be the same.4.a.ThenumberofpartiespermonththatwouldbeprovidedprivatelyisP.b.See schedule MSBp.c.P*.Give a per-unit subsidy of $b per partyto induce the correct number ofparties.d.The optimal subsidy is $b.The total subsidy=abcd. “Society” comes out ahead byghc,assumingthesubsidycanberaisedwithoutanyefficiencycosts.(Cassanova’s friends gaingchd; Cassanova loseschdbut gainsabcd, which is asubsidy cost to government.)5.The payment for signing a waiver is a negotiation as suggested by the Coase Theorem.Ifresidents accept the payment and sign the waiver, they are signaling that the noise cost tothem is less than the payment. If the residents choose not to accept the payment and signthe waiver, the payment is not great enough to cover the cost of the noise.The CoaseTheorem suggest in this case that further negotiation could occur.6.On the surface, the tax on saturated fat seems like a Pigouvian tax, if you assume that the$3 isequivalent to the level of the damage from the saturated fats.The commentator isnot correct in his criticism that the tax is levied on an input rather an outcome. If the taxis properly set and is the direct cause of unhealthy consumers, the efficient level ofsaturated fat will be consumed. However, this tax suffers from the problem of assumingthat the saturated fat leads directly to poor health outcomes and is the only source ofunhealthy outcomes. Some consumers are healthy no matter the level of consumption of

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Part 2–Public Expenditure: Public Goods and Externalities5-3saturated fats. Others are unhealthy even with no consumption of the saturated fats. Andmany consumers will simply reallocate their consumption to nontaxed unhealthy foods.7.a.It is very likely that the farmer could negotiate with the neighbors, providedproperty rights are clearly defined. The Coase Theorem is therefore applicable.b.It is unlikely that negotiation could result in an efficient outcome in this case. It islikely that there are a great number of farmers involved in both harvesting antsand growing trees, making negotiation very difficult.c.Property rights are not being enforced, making negotiation through the CoaseTheorem impossible.d.There are too many people involved for private negotiation.8.a.Thepriceofimportedoildoes notreflecttheincreasedpoliticalriskbyeffectively subsidizing authoritarian regimes like those in Saudi Arabia.b.The tax would estimate the marginal damage (e.g., the increased instability in theMiddle East, etc.) by importing oil from Saudi Arabia.c.The supply ofTGRsis vertical at 104.5billionif government seeks to reduceconsumption of gasoline to 104.5 billion.Consumers must have one TGR inorder to buy one gallon of gasoline, plus they must pay the price at the pump.Limiting TGRs effectively limits the demand for gasoline, so the price per gallonwill fall, but consumers must have TGRs in order to purchase gasoline.If themarket price of one TGR is $0.75, this means that supply and demand intersect at$0.75, as shown in the graph.This kind of program curbs consumption withoutgiving government more revenue because consumers are purchasing the TGRsfrom each other.However, the total amount of TGRs is limited by government.Those consumers seeking to purchase more gasoline than allowed by the initialallocation of TGRs can purchase additional TGRs from other consumers at themarket price of $0.75.By choosing to use a TGR to purchase gasoline, aconsumer incurs an opportunity cost equal to $0.75 since they cannot sell theTGR once it has been used.

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Chapter 5-Externalities5-49.The use of the drug to treat sick cows leads to a positive externality (the benefit enjoyedby air travelers) as well as a negative externality (the costs created by a larger number ofrats and feral dogs).Banning the drug might raise or lower efficiency, depending onwhether the positive externality is larger or whether the negative externality is larger.Therearemanywaystodesignincentive-basedregulations.Policymakerscoulddetermine the efficient level of drug usage and then either allocate or sell the right to usethe drug for sick cows.10.The program matches prices to changes in demand, fluctuating as demand changes.Thisresults in higher efficiency. Drivers will respond efficiently by choosing to park based ontheir willingness to pay.11.a.When the Little Pigs hog farm produces on its own, it sets marginalbenefit equalto marginal cost. This occurs at 4 units.b.The efficient number of hogs sets marginal benefit equal to marginal social cost,which is the sum of MC and MD. At 2 units, MB=MSC=1600.c.The efficient number of hogs sets marginal benefit equal to marginal social costs.At 3 hogs, MB=MSC=1600.12.Private Marginal Benefit = 10-XPrivate Marginal Cost = $5TGRs$104.5 billionSupply of TGRsDemand for TGRs$0.75

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Part 2–Public Expenditure: Public Goods and Externalities5-5External Cost = $2Without government intervention, PMB = PMC; X = 5 units.Social efficiency implies PMB = Social Marginal Costs = $5 + $2 = $7; X = 3 units.Gain to society is the area of the triangle whose base is the distance between the efficientand actual output levels, and whose height is the difference between private and socialmarginal cost. Hence, the efficiency gain is ½ (5-3)(7-5) = 2A Pigouvian tax adds to the private marginal cost the amount of the external cost at thesocially optimal level of production.Here a simple tax of $2 per unit will lead toefficient production. This tax would raise ($2) (3 units) = $6 in revenue.13.a.The total cost of emissions reduction is minimizedonly when the marginal costsare equal across all polluters, therefore a cost-effective solution requires that MC1= MC2or that 300e1= 100e2.Substituting 3e1for e2in the formula e1+ e2= 40(since the policy goal is to reduce emissions by 40 units)yields the solution. It iscost-effective for Firm 1 to reduce emissions by 10 units and for Firm 2 to reduceemissions by 30 units.b.In order to achieve cost-effective emission reductions, the emissions fee shouldbeset equal to $3,000. With this emissions fee, Firm 1reduces 10 units and Firm2reduces 30 units, but Firm 1 has to pay $3,000 for each unit of pollution theycontinue to produce, which gives them a tax burden of $3,000 x 90 (Firm 1generated 100 units in the absence of government intervention) or $270,000.Firm 2 has a lower tax burden because it is reducing emissions from 80 units to50units.Firm 2 pays $3,000 x 50 =$150,000.As the text concludes, the firmthatcuts back pollution less isn’t really getting away with anything because it hasalarger tax liability than if it were to cut back more.c.From an efficiency standpoint, the initial allocation ofpermits does not matter. Ifthe two firms could not trade permits, then Firm 2 would have to undertake all ofthe emissions reduction.Initially, Firm 1’s MC is zero, while Firm 2’s MC is$4,000, so there is a strong incentive for Firm 2 to purchase permits from Firm 1.Trading should continue until MC1= MC2, which is the cost-effective solution.This means that the market price for permits will equal $3,000, the same as theemissions fee.At this price, Firm 2 will purchase 10 permits from Firm 2,allowing Firm 2 to reduce emissions by 30 rather than40 and requiring Firm 1 toreduce emissions by 10.This solution is the same as the solution achieved withthe emissions fee. However, Firm 1 is better off because instead of having to paytaxes, it will receive a payment of $30,000 for its permits.Firm 2 must pay$30,000 for the extra permits, but it also avoids the payment of taxes.Thegovernment lost $420,000 in tax revenue.The firms must still pay the cost ofemissions reduction, plus Firm 2 must pay for the permits purchased from Firm 1.

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Chapter 5-Externalities5-614.If marginal costs turn out to be lower than anticipated, cap-and-trade achieves too littlepollution reduction and an emissions fee achieves too much pollution reduction. With aninelastic marginal social benefit function, cap-and-trade is not too bad from an efficiencystandpoint, while an emissions fee causes pollution reduction to be much greater than theefficient level when marginal cost is lower than anticipated.When marginal socialbenefits are elastic, the opposite is true.

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Part 2–Public Expenditure: Public Goods and Externalities6-1Chapter 6–Political EconomyBrief Outline1.Direct democracya.Unanimity Rulesb.Majority Voting Rulesc.Logrollingd.Arrow’s Impossibility Theorem2.Representative Democracya.Elected Politiciansb.Public Employeesc.Special Interestsd.Other Actors3.Explaining Government Growtha.ConclusionAnswers to End-of-Chapter Questions1.a.Below, the preferences foreach person.b.C wins in everypair wisevote. Thus, there is a stable majority outcome, despitethefactthatpersons1,2,and3havedouble-peakedpreferences.Thisdemonstratesthatalthoughmulti-peakedpreferencesmayleadtovotinginconsistencies, this is not necessarily the case.2.Thepassage of the agriculture bill in 2007isconsistent with the logrolling model.Because the members of rural areas were able to trade votes with those in urban areas3.a.Neither issue would pass with majority voting as in both cases, two voters of thethree would vote against the each issue because they receive negative net benefits.1234ABCDPerson 1Person2Person3Person4Person5

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Chapter 6–Political Economy6-2This is not efficient because issue X has a positive total net benefit and should befunded.b.With logrolling, voters A and B can trade votes. A will vote for issue Y if B votesfor issue X, but C will not vote for either project.Both issues will pass with twovotes for and one against.This is not efficient because issue Y has a negativetotal net benefit.c.If side payments were allowed A could pay B to vote for issue X (A would notpay C because C would require a higher payment than B), and B could pay A or Cto vote for issue Y. This would result in the same inefficient outcome as in b.d.If side payments were allowed A would have to pay B at least 1 to vote for issueX.A would only be willing to pay less than 6.B would have to pay A or C atleast 3, but no more than 4 to entice him to vote for issue Y.4.Yes, it is consistent, because the theory says that when unanimity is required, nodecisions are likely to be made. A majority system might be more suitable, although it issubject to cycling and other problems.5.When the policy changed to allow and encourage female voting, female voters becamethe majority, so it is sensible that the median voter is now a woman.Given this, themedian voter theorem suggests that politicians should shift their positions to more closelyalign with the views of women.6.When there is a vote over five options, there is the chance that a potential majority vote issplit between four relatively preferred options, and the fifth option wins.The winningoption may have been voted down if it had been a two-way vote with any of the otheroptions.Further, if preferences are not single-peaked, cycling and inconsistent publicdecisions may emerge.

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Part 2–Public Expenditure: Public Goods and Externalities6-37.On the graph below, the price of taxi rides would increase from PCto PMedand thenumber of taxi rides would decline from QCto QMed. This would result in adeadweightloss to society of triangledce.8.a.With the demand curve of Q=100-10P and a perfectly elastic supply curve at P=2,the milk is sold at a price of $2, and a quantity of 80 units is sold.b.The marginal revenue curve associated with the inverse demand curve P=10-(1/10)Q is MR=10-(1/5)Q, while the marginal cost curve is MC=2.The cartelwould ideally produce a quantity where MR=MC, or 10-(1/5)Q=2, or Q=40. Theprice associated with a cartel quantity of 40 units is P=10-(1/10)*40, or P=6.c.The rent associated with the cartel is the product of the marginal profit per unitand the number of units produced. The marginal profit per unit of milk is $4 (=$6price-$2 marginal cost), while 40 units are produced.Thus, the rents equal$160.d.The most the cartel would be willing to contribute to politicians is the fulleconomic rent of $160.The cartel situation, the quantity of milk produced is toolow from society’s point of view. The deadweight loss triangle is computed usingthe difference between the cartel output and competitive output as the “base” ofthe triangle, and the difference between the cartel price and competitive price asthe “height.” Thus, the triangle is equal to (1/2)*(80-40)*($6-$2)=$40.e.As Figure 6.5 in the textbook shows, the deadweight loss could now go as high asthe sum of the conventional deadweight loss and the rents, or $160 rents + $80DWL = $240.This is because, as notedin the text, “rent-seeking can use upQmedS=MCNumber of taxi rides$DMRQCPCPMedfcbade

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Chapter 6–Political Economy6-4resources–lobbyists spend their time influencing legislators, consultants testifybefore regulatory panels, and advertisers conduct public relations campaigns.Such resources, which could have been used to produce new goods and services,are instead consumed in a struggle over the distribution of existing goods andservices.Hence, the rents do not represent a mere lump-sum transfer; it is ameasure of real resources used up to maintain a position of market power.”9.This is an example of possible rent-seeking.If Philip Morris supports limited cigaretteadvertising, it is unlikely that there will be new entrants in the cigarette market becauseestablishing business would be more difficult with reduced advertising.Philip Morriswill maintain or develop market power.10.a.The outcome of the first election (M vs. H) is M.The outcome of the secondelection (H vs. L) is L.The outcome of the third election (L vs. M) is M.Majority rule leads to a stable outcome since M defeats both H and L. Giving oneperson the ability to set the agenda would not affect the outcome in this case.b.With the change inEleanor’s preference ordering, majority rule no longergenerates a stable outcome.In a vote between M and H, the outcome is H.In avote between H and L, the outcome is L. In a vote between L and M, the outcomeis M. So, giving one person the ability to set the agenda affects the outcome. Forexample, Abigail prefers H, so she might pit L against M first in order toeliminate L and avoid having L defeat H.

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Part 2–Public Expenditure: Public Goods and Externalities7-1Chapter7–EducationBrief Outline1.Justifying Government Intervention in Educationa.Is Education a Public Good?b.Does Education Generate Positive Externalities?c.Is the Education Market Inequitable?2.What Can Government Intervention in Education Accomplish?a.Does Government intervention Crowd Out Private Education?b.Does Government Spending Improve Educational Outcomes?c.Public Spending and the Quality of Educationd.Does Education Increase Earnings?3.New Directions for Public Educationa.Charter Schoolsb.Vouchersc.School AccountabilityAnswers to End-of-Chapter Questions1.There are numerous rationales given for government provision of education.Eventhough education is primarily a private good, many argue that educating a child providesexternalbenefits.However,theexistenceofapositiveexternalityimpliesthatgovernment should subsidize education rather than making it free and mandatory. Otherrationales are based on equity, including a belief in commodity egalitarianism.Therationales do imply a lower level of provision of higher education versus primary andsecondary.Highereducationhashigherprivatebenefitsandfewerexternalities,therefore requires a lower level of provision.2.It may be that national income is increased purely though private returns to educationsummed up across the economy. If this is the case, one could not use an externality-basedargument to justify subsidization. However, if education quality increases the growth rateof national incomeoutside ofthe returns that accrue toindividuals who consume theeducation, then private decisionswill yield a lower than efficient level of educationquality. This reasoning would allow for government subsidization that would improve thequality of education.3.If students are required to pay “a lifelong tithe on all earnings” there might be a distortionin choices of careers among students.Under the tithe system, some students wouldchoose a lower paid (and less productive) career path, compared to the situation in whichthey faced a standard bank loan. The tithe system would create inefficiencies by partiallyremoving incentives for students to pursue the highest-paying jobs.4.If households are allowed to supplement public education with private lessons, then thebudget constraint in Figure7.1of the textbook is modified by drawing a line starting atpoint x (consuming only public education) that runs to the southeast and is parallel to AB.The figure below is then similar to the analysis of in-kind benefits like food stamps.

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Chapter 7–Education7-2If parents pay for the public schooling (rather than perceiving it as being free), and theschooling was paid for with a lump sum tax, then the budget constraint shifts in by anamount that depends on the household’s share of the tax burden.If the household’s taxburden exactly equals the cost of public school, the budget constraint is no longer the linesegmentABbut rather the segmentCDB, where the segmentDBruns along the originalbudget constraint, except that the minimum amount of schooling consumed is eP.5.Making wealthy students pay more tuition only increases efficiency if it is reasonable toassume that wealthy students will be paid more than less wealthy students at the end ofthe education. If there are few externalities, then the demand for education should comefrom the private benefits of the education, which is the present value of future earnings.If wealthy students are paid better after college, their demand would be higher and theywould be willing to pay more for the education.In terms of equity, this policy seems tobe fair in that it gives less wealthy students a better chance at an education.DCepBAAOther GoodsEducationPublic School is financed by taxes leviedon parentsepBAAOther GoodsEducationParents can supplement publiceducation with private lessons

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