280926745
1. Consider the "market failure" for a situation in which there is a negative consumption externality.
Assume a typically shaped demand curve and supply curve in the market that creates the externality.
Assume that the marginal social impact of the externality created in this market is constant. Assume
there is no externality present on the production side of the market.
a) Identify and explain ONE example of this type of externality in the real world.
b) IN A GRAPH THAT IS BIG ENOUGH Diagrammatically illustrate the market equilibrium if the
externality is ignored.
c) In your diagram identify and label the Pareto Efficient allocation and identify the dead-weight-loss to
society when the market allocates this good ignoring the impact of the externality.
d) Suppose demanders in this market have the property right to ignore the externality and consume at the
market equilibrium. Now assume trade in this property right is possible. On your diagram
geometrically indicate why (assuming trade can take place) there are gains from trade from an
incremental reduction in the number of units traded from the original market allocation.
e) INSTEAD of property rights and trade, suppose the government decides to use its ability to tax and/or
subsidize transactions in this market to alter the allocation. What would you have the government do?
As completely as you can, demonstrate the impact of your policy selection on the diagram you drew.
2. Suppose your BEST GUESS of the marginal cost of pollution reduction is MCBG = 2R where R is
pollution reduction. Suppose the marginal social benefit of pollution reduction is MSB = 100 1/2R.
Suppose you can use either a policy that sets R and then allows cap and trade on the pollution permits
consistent with R OR you can set a policy that charges people a fee to pollute based on R.
a) Based on this information, what is the value of R that would drive the cap on pollution?
b) Based on this information, what is the pollution fee you should set?
c) Now suppose the marginal cost of reduction turns out to actually be MCactual = 4.5R. After the fact,
which policy looks better? Show your analysis with equations and numbers and present a reasonably
accurate diagram of the situation.
3. You are preparing a benefit cost analysis for the mayor of Ithaca. The city wants to start a math-tutoring
program for all the 4th graders. The tutoring program will last a month. Labor is traded in an Ithaca
labor market where there is a local and preexisting per unit tax on labor. Here are all the important facts:
The local market demand curve for labor hours is typically shaped.
The local market supply curve for labor hours is completely elastic.
Current demand wage = $8.00/hr
Current supply wage = $6.00/hr
Current monthly level of employment in Ithaca = 1,500,000 hours.
The city of Ithaca will completely inelastically demand 30,000 hours of labor the month they tutor.
ANSWER SPACE:
4. Consider a project X that "lives" for 3 years from this day forward: 2012, 2013, 2014. The table below
gives information about the projects anticipated benefits and costs in each year.
$benefit
s
$costs
2012
2013
2014
$400
$200
$2,000
$1,500
$200
$570
a) Suppose the market interest rate is 0%. Should the project be undertaken?
b) Suppose I tell you that the project's internal rate of return is very near 14.5% (and that I am correct).
What exactly does that mean? (A formula or just well-chosen words or a picture are all equally
acceptable here.)
c) Given what I told you in part (b), if the market rate of interest is 10%, should the project be undertaken?
Briefly defend your position.
d) How about if the market rate of return is 19%? Briefly defend your position.
e) Suppose I tell you that there is an alternative project Y being considered with a Benefit/Cost Ratio that
is higher than that of project Xs. The two projects are mutually exclusive. Which project, X or Y, is
better? Briefly defend your position.
f) Assume there is uncertainty over the benefits of the project in the third year, and that, in fact, the
benefits could be $3,000 with probability and $1,000 with probability . How will this uncertainty
affect the benefit-cost calculations and the attractiveness of the project?
g) Suppose some of the benefits in the third year are due to a reduction in highway fatalities. What two
methodologies have been suggested for valuing a human life and which one would you recommend
using, assuming you want the project to get a thumbs up (that is a yes!)?
h) Suppose you realize that benefits and costs in the third year have been reported as anticipated nominal
amounts based on third year dollar values using an expectation of 3% inflation each year. How will
knowing this affect/inform your benefit-cost calculations?
5. Suppose there are two states of the world: good and bad.
In the good state of the world your income is $250,000.
In the bad state of the world your income is $40,000.
The good state occurs with probability good =0.25 and the bad state occurs with probably bad = 0.75.
Suppose your utility function is: u(M) = 50M1/2 where M = money income.
a) What would an income insurance contract look like if it took away all your income risk and left you
indifferent between buying the insurance and taking the income gamble? Show your work.
b) What is the insurance companys expected profit on this contract?
c) Graphically illustrate the values of expected utility, utility of the expected value, expected value and the
certainty equivalent.
d) How would your answers change if we changed the utility function to one where u(M) = 50M?
ANSWER SPACE:
10
ANSWER SPACE:
11