Practice Midterm 2 (with solutions)

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B EHAVIORAL E CONOMICS , M ARKETS , AND P UBLIC P OLICY Practice Midterm #2 (with solutions) NAME PENN I.D. NUMBER Please Read And Follow These Instructions Carefully: • You have 75 minutes to complete this exam. • If required, show your work for each problem in the space provided. • Write your answers neatly. Illegible writing will not be graded. • Do not remove the staples that hold the exam pages together. • Good luck! DO NOT TURN THE PAGE UNTIL INSTRUCTED TO DO SO SOLUTIONS

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Multiple Choice (2 points each; 22 points total) Write the letter of the correct answer in the blank space. No partial credit will be given. 1) True or false: Starbucks coffee is rivalrous because the company has a way of preventing people from consuming it. a. True b. False Response: B 2) True or false: The principal-agent problem arises when an agent makes decisions on behalf of a principal that the principal cannot observe or prove. a. True b. False Response: A 3) True or false: To minimize deadweight loss, the government should tax when consumers are fully salient. a. True b. False Response: B 4) Standard economics assumes that agents are selfish and optimizers. An optimizer: a. Always chooses the best option for themselves b. Never makes mistakes c. Is internally consistent d. All of the above Response: D

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5) The following are attempts to solve the adverse selection problem, EXCEPT: a. “Sin taxes , ” such as the soda tax , which make socially costly goods more expensive b. Third-party ratings of products or firms such as Carfax or the Better Business Bureau c. Regulatory guidelines such as FDA standards for minimum quality d. Screening practices, such as offering a variable pay scheme that gives more productive workers higher expected earnings Response: A 6) Which of the following could lead to a positive externality from production? a. A worker contributing to a retirement savings plan b. A patient getting a vaccination c. An inventor filing a patent d. A firm reducing its pollution Response: C 7) Suppose we live in a world with two goods. Society currently demands 20 units of Good A, and 50 units of Good B. The government wants to raise revenue via taxing one or both of these goods. According to the Ramsey Rule, an example of an optimal tax in this world would: a. Depend on the current market prices of Good A and Good B. b. Reduce the quantity demanded of Good A by 10 units (to 10) and reduce the quantity demanded of good B by 10 units (to 40). c. Increase the quantity demanded of good A by 15 units (to 35) and decrease the quantity demanded of good B by 15 units (to 35). d. Reduce the quantity demanded of Good A by 4 units (to 16), and reduce the quantity demanded of Good B by 10 units (to 40). Response: D

8) Which is an example of tax aversion: a. Jeanna brags about the great deals she got shopping at the outlets, telling her friends “I bought my sweater for only $20,” when she really got the sweater for $21.20 after taxes. b. After gasoline taxes increase, Professor Kessler decides it is better for him to start taking the train to campus rather than drive, because he’d rather not pay the higher price for gas. c. Though Margaret realized the price of a Diet Coke was higher after the institution of the sweetened beverage tax, she ignored it and continued purchasing it each day at lunch. d. Elizabeth takes an Uber to Delaware, where there is no sales tax, to go shopping, rather than run her errands in Pennsylvania. Response: D 9) Free trials often allow people to have something before committing to buying and paying for it. This is an example of companies taking advantage of: a. Altruism b. Asymmetric information c. Endowment effects d. Tax aversion Response: C 10) Beyoncé has $60 to split between her three children, Blue Ivy, Sir, and Rumi. A Pareto Optimal allocation of the money: a. can only occur if each child gets $20 b. must give the most money to Blue, the oldest, because she will spend it most wisely c. will make sure all $60 gets distributed d. could occur if Blue receives $40, Sir gets $10, and Rumi gets $5. Response: C 11) “Tax incidence” refers to: a. The amount a consumer pays attention to the tax b. The effect of a tax on the distribution of welfare c. The effect of the tax on reducing a negative externality d. The amount of revenue the government gets from the tax Response: B

Short answer (5 points each; 30 points total) 1) The First Welfare Theorem says that if the following five assumptions hold, then a market without government intervention will put us on the Pareto frontier. (Note that you do not need to match the order discussed in class.) a) Agents are selfish and rational b) No market power c) Complete markets d) No transaction costs e) Perfect information Note: You needed to clearly state that all agents (consumers and producers) were selfish and rational; Similarly, if you used “price taking/takers” instead of saying “No market power,” you needed to clearly state that that all agents are price takers; “Symmetric information” or “Complete information” only received partial credit, as there are just aspects of “Perfect information.” 2) a) (3 points) What is a “welfare weight” ? The societal value we place on giving someone an additional dollar Note: answers which closely matched the spirit of this definition were awarded partial credit, but you needed to clearly state this is was a “societal” conc ept. b) (2 points) In class we said welfare weights were determined by two things. What are those two things? i) Marginal utility of income ; NOTE: “Utility curves” was not sufficient ii) Deservingness (how much society values giving someone utility); NOTE: answers that captured morals/values/judgments were accepted

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3) Provide an example of a natural monopoly. In two to three sentences, explain what makes it a natural monopoly. Possible examples: electricity grid, mail, defense services, cable, trains etc. Features: You needed to touch on both (1) increasing returns to scale, capturing why the monopoly occurs from the firm side, and (2) downward sloping marginal cost curve, capturing why there should optimally only be one firm from the consumer side. Note: concepts like barriers to entry or control of scarce resources are often sources of market power, but are not what causes a natural monopoly. Additionally, it was not sufficient to use phrases like provided by government or regulated utilities, as these are consequences of the monopoly, not a cause of it. 4) a) (4 points) What are the two features of a “ common pool ” good ? i) Non-excludable ii) Rivalrous b) (1 point) Name a “ common pool ” good: Possible examples: public roads, commons, fresh water, etc.

5) We played a game in class in which half of the students were buyers (assigned a value) and half of the students were sellers (assigned a cost). In the first round, buyers and sellers had to find each other and negotiate a price at which to trade. In the second round, we ran an auction to find a market-clearing price for all trades to occur. a) (2 points) Was the outcome in the first round on the Pareto Frontier? Why or why not? No. We had high cost sellers who should not have sold who were able to transact. This was possible because we violated the assumptions of no transaction costs (it was difficult for buyers and sellers to find each other) and of perfect information (buyers didn’t know sellers’ values and vice versa, so trades were made when “ better ” buyers/sellers were available). b) (2 points) Assuming the market cleared as expected, was the outcome in the second round on the Pareto Frontier? Why or why not? Yes. The oral auction made it easy for buyers and sellers to find each other (eliminating transaction costs) and because all buyers/sellers of a certain value/costs raised their hands, we could see all available buyers/sellers (allowing for perfect info). Note: It was not sufficient to just explain what it means to be on the Pareto frontier c) (1 point) What might have happened if we allowed sellers to work together to set a single price for any interested buyers? This might take us back off the Pareto Frontier, as it now violates the assumption of no market power. The sellers would likely offer a single price which is just above the highest seller cost of the group. Note: it is not necessarily the case that we would be off the Pareto Frontier in this situation.

6) We played a game in class in which everyone chose whether or not to contribute $4 to a public fund. A $4 contribution to the public fund was worth $0.20 to each person in the class. a) (1 point) What choice would a selfish optimizer make? Not contribute. b) (1 point) What is the socially optimal outcome? Everybody contributes. Note: you must specify that all students had to contribute for the socially optimal outcome. c) (2 points) Briefly describe why, in this setting, the market does not reach the socially optimal outcome. Reference assumption(s) from the First Welfare Theorem. No single individual cares about the positive benefit ($0.20) their $4 has on others, so many people choose to keep their $4. Our setting violated the complete markets assumption ( e.g. there’s no market for me to be compensated for increasing your surplus by contributing) and no transaction costs assumption (e.g. even if there was such a market, it would be costly for everyone to compensate me for increasing their surplus). Note: Perfect information was broken and/or people were acting selfish were not correct answers. d) (1 point) Briefly describe a policy, which the class could have agreed upon, to achieve the socially optimal outcome. Most likely policy: We vote to force everyone to contribute (e.g. we destroy the $0 cards before we play so that everyone has to give the $4 card). Partial credit was awarded to suggestions which might help improve the outcome but would not guarantee that we achieved the socially optimal outcome.

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Long Answer 1: Pareto Optimal Potter (9 points) Harry Potter is deciding which broom to buy his son, Albus, before sending him off to wizarding school. He cares about two features of the broom: Speed (higher is better) and Bludger Resistance (higher is better). Harry has four options for brooms: 1. The Thunderbolt (T) → Speed = 10; Bludger Resistance = 2 2. The Firebolt (F) → Speed = 8; Bludger Resistance = 5 3. The Nimbus (N) → Speed = 2; Bludger Resistance = 6 4. The Cleansweep (C) → Speed = 6; Bludger Resistance = 6 a. (3 points) Plot all of the brooms by their Speed and Bludger Resistance on the grid below (labeling the brooms by their letter) and label the axes. Note: It is fine if Speed was on the Y-axis and Bludger Resistance was on the X-axis. b. (2 points) List the broom(s) on Harry’s Pareto Frontier . The Cleansweep, the Firebolt, and the Thunderbolt

c. (2 points) With the information above, can we tell which broom is best for Harry to buy? If so, which is it? No; given the information above, we only know that he should not buy the Nimbus. Note: If you answered this question correctly while assuming Harry values speed and bludger resistance equally, full credit was awarded so long as you made clear that was an assumption you were making (e.g. Harry picks the Firebolt because 8+5 is the biggest number) . Note, however, that you’d still be assuming these are measured on the same scal e/both enter linearly into Harry’s utility function. d. (2 points) Without drawing anything, would your answer to “ List the broom(s) on Harry’s Pareto Frontier” (i.e., part b) change if Harry also cares about price and the prices of the brooms were as follows? If so, how would the answer change? 1. The Thunderbolt (T) → $249 2. The Firebolt (F) → $199 3. The Nimbus (N) → $189 4. The Cleansweep (C) → $399 Yes. We would now add the Nimbus to his Pareto Frontier, because it is cheaper than all other brooms. Now if Harry bought the Nimbus, he could not switch to another broom and be better off on all dimensions (i.e., there is none that has higher speed AND higher bludger resistance AND lower price).

Long Answer 2: Getting the Band Back Together (14 points + 1 extra credit point) Kevin wants to be part of a band with his two brothers, Joe and Nick, and does not have hope of a solo career. However, Joe and Nick both prefer to pursue solo careers and do not get any value from being in a band. Kevin values being in a band at $90; Joe values his solo career at $30; and Nick values his solo career at $80. Assume they are the only people who can get enjoyment from their music. a. (2 points) Is it socially optimal for the Jonas Brothers to be in a band or for Joe and Nick to have solo careers? Write an equation that justifies your answer. Solo career. 80+30>90 b. (2 points) Their little brother, Frankie, points out that it is not just the boys who get enjoyment from their music, but also their fans. The fans get $X more value from the boys being in a band than from the boys having solo careers. Considering the three brothers and the fans, write an equation (with X as a variable) that tells us when it will be socially optimal for the boys to stay in a band. Optimal when 90 + x > 80 + 30, or x > 20. c. (1 point) Their father, Kevin Sr., wants his rock star sons to be happy but recognizes that they are much better off than their fans. Let’s say his welfare weight for the fans is 2, and his welfare weight for each of the brothers is 1. Rewrite an equation (with X as a variable) now accounting for the welfare weights, which tells us when Kevin Sr. thinks it will be socially optimal for the boys to be in a band. Optimal when 90 + 2x > 80 + 30, or x > 10.

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d. (9 points) Assume we have Kevin Sr.’s welfare weights, that X=30, and that there are no transaction costs. i. What does the Coase Theorem predict if the Jonas Brothers have the right to have solo careers: Circle one of the following: Band No Band ii. If transfers take place, what do we know about these transfers (what direction and how big)? Circle the relevant words and write one inequality that reflects what we know about Kevin’s transfer “K” and one inequality that re flects what we know about Nick’s transfer “N” Kevin will… Circle one of the following: …g ive … …g et … …an amount K that satisfies the following inequality: K ≤ 90 Note: full point awarded if you just said “ < ,” although “≤” is the most accurate. Nick will… Circle one of the following: …give… …get… …an amount N that satisfies the following inequality: N ≥ 80 Note: full point awarded if you just said “>,” although “≥” is the most accurate. Answers that tried to put an upper bound on Nick’s transfer or lower bound on Kevin’s transfer were incorrect. Note: the question is only asking about what Kevin and Nick — as individuals — would transfer/receive in this situation, so any assumptions about the fans or his brothers were not necessary here.

iii. What are the two considerations we discussed in class for how to assign property rights? What would they imply here? 1) Assign to people with higher welfare weight. In this case we would give the rights to Kevin/the fans for the band. 2) Assign to people based on minimizing transaction costs. In this case, since we end up with a band, it is cheaper to give the property rights to Kevin and the fans so that there is no transaction. Note: If, in this case, you wrote that because we stated in part (d) that there are no transaction costs, this implies that it does not matter who we assign it to here, this was accepted for full credit. However, we generally still want to reduce the total number of transactions occurring. Note: “ Property rights are clearly defined ” and “ transaction costs must be low/non-existent ” are assumptions we need for the Coase Theorem to hold, not considerations we discussed as to whom we should assign property rights. e. Extra Credit (1 point, no partial credit). Why should we ignore the arguments in (d. iii.) in this case? (Hint: your argument can come from outside of the content of the class.) Here we can ignore the arguments in d. iii. because we value giving individuals the freedom to decide what they want to do. In this case, Nick and Joe have the right to do what they want with their careers and so should have the property right to make that choice (and be compensated for joining a band).

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Long Answer 3: Time to Play Bridge (25 points + 1 extra credit point) The bridges across the Schuylkill River can get quite congested, leading to traffic between University City and Center City. Philadelphia is considering building a toll bridge for cars that want to get across the river quickly. Daily bridge demand and the marginal cost per car on the bridge (e.g., due to wear and tear on the bridge) are: Demand: ? = 10 − 1 2 ? Marginal cost: ? = 1 + 1 4 ? a) (9 points) On the gridded area, graph demand and marginal cost. Assume Philadelphia sets the toll to maximize social surplus from the bridge. Label q* and p* for the socially optimal quantity and price on the figure, and fill in the blanks below. Label and calculate CS and PS. ? ∗ = 12 ? ∗ = 4 𝐶? = 36 = .5(10-4)12 ?? = 18 = .5(4-1)12 b) (6 points) An analyst at the Philadelphia Streets Department suggests that the pollution from driving creates an externality of $3 for each car that crosses the bridge. On the same gridded area, draw the proposed social cost curve. For that social cost, find the new optimal quantity, ? ??𝑡 , and the new optimal toll, ? ??𝑡 . Calculate the size of the negative externality if the toll is set to ? ??𝑡 . ? ??𝑡 = 8 ? ??𝑡 = 6 𝐸??𝑒??𝑎𝑙𝑖?? = 8 x 3 = 24

Gridded area for parts (a) and (b) Note: you were not asked to draw the externality.

c) (7 points) The analyst does some calculations of demand, however, and realizes that the bridge is not going to change the number of drivers crossing the Schuylkill, it’s just going to pull them off of other river crossings. Consequently, the toll pricing is not going to affect the level of the pollution externality. The analyst concludes that the only real externality of the bridge is a positive externality of $3 per car that is generated by reducing traffic on the other Schuylkill bridges. On a new gridded area, redraw the demand and marginal cost curves and draw the new social cost curve. For this new social cost curve, find the new optimal quantity, ? ??𝑡 , and the new optimal toll, ? ??𝑡 . Calculate the size of the positive externality if the toll is set to ? ??𝑡 . ? ??𝑡 = 16 ? ??𝑡 = 2 𝐸??𝑒??𝑎𝑙𝑖?? = 16 x 3 = 48 Notes: The question makes clear that the externality described in (b) is not actually occurring. Thus, your graph and math should have had the world described in (a) as a starting point, with the positive externality factored in accordingly. If you did not capture this, but instead factored in the externality to the situation described in (b), you were awarded partial credit, assuming your math/graph was correct. Additionally, a fully correct drawing of the social cost curve needed to extend below the y-axis. d) (3 points) Given your answer to part c) what is the total social surplus created by the bridge each day, including the positive externality created? ???𝑎𝑙 ????𝑙?? = .5(10 – (-2))16 = 96

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Gridded area for part (c) Note: you were not asked to draw the externality.

e) Extra Credit (1 point, no partial credit). The analyst calculates the present discounted value of the social benefits of the bridge from part d). Assume this calculation is exactly correct about the social value of the bridge. The analyst finds that the costs of building the bridge are just slightly less than this present discounted value. What other consideration should the City of Philadelphia keep in mind before deciding whether it is socially optimal to implement a tax to raise the funds to build the bridge? They should consider the dead weight loss associated with the taxation and whether the cost of building the bridge plus the DWL needed to raise the tax revenue is still less than the NPV of the social benefit of the bridge.

Practice Midterm 2 (with solutions)

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