Practice Midterm 2 (no solutions)

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B EHAVIORAL E CONOMICS , M ARKETS , AND P UBLIC P OLICY Practice Midterm #2 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

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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: ______ 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: ______ 3) True or false: To minimize deadweight loss, the government should tax when consumers are fully salient. a. True b. False Response: ______ 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: ______

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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: ______ 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: ______ 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: ______

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: ______ 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: ______ 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: ______ 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: ______

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) ____________________________________________________________________________ b) ____________________________________________________________________________ c) ____________________________________________________________________________ d) ____________________________________________________________________________ e) ____________________________________________________________________________ 2) a) (3 points) What is a “welfare weight”? _________________________________________________________________________________________________ _________________________________________________________________________________________________ _________________________________________________________________________________________________ b) (2 points) In class we said welfare weights were determined by two things. What are those two things? i) ____________________________________________________________________________________ ii) ____________________________________________________________________________________

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3) Provide an example of a natural monopoly. In two to three sentences, explain what makes it a natural monopoly. _____________________________________________________________________________________________________ _____________________________________________________________________________________________________ _____________________________________________________________________________________________________ _____________________________________________________________________________________________________ _____________________________________________________________________________________________________ 4) a) (4 points) What are the two features of a “common pool” good? i) ____________________________________________________________________________________ ii) ____________________________________________________________________________________ b) (1 point) Name a “common pool” good: _________________________________________________________________________________________________

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? _________________________________________________________________________________________________ _________________________________________________________________________________________________ _________________________________________________________________________________________________ b) (2 points) Assuming the market cleared as expected, was the outcome in the second round on the Pareto Frontier? Why or why not? _________________________________________________________________________________________________ _________________________________________________________________________________________________ _________________________________________________________________________________________________ c) (1 point) What might have happened if we allowed sellers to work together to set a single price for any interested buyers? _________________________________________________________________________________________________ _________________________________________________________________________________________________

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? _________________________________________________________________________________________________ b) (1 point) What is 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. _________________________________________________________________________________________________ _________________________________________________________________________________________________ _________________________________________________________________________________________________ d) (1 point) Briefly describe a policy, which the class could have agreed upon, to achieve 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) à Speed = 10; Bludger Resistance = 2 2. The Firebolt (F) à Speed = 8; Bludger Resistance = 5 3. The Nimbus (N) à Speed = 2; Bludger Resistance = 6 4. The Cleansweep (C) à 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. Gridded area for part (a) b. (2 points) List the broom(s) on Harry’s Pareto Frontier. ___________________________________________________________________________________________________ 2 4 6 8 10 2 4 8 10 6

c. (2 points) With the information above, can we tell which broom is best for Harry to buy? If so, which is it? ___________________________________________________________________________________________________ ___________________________________________________________________________________________________ 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) à $249 2. The Firebolt (F) à $199 3. The Nimbus (N) à $189 4. The Cleansweep (C) à $399 ___________________________________________________________________________________________________ ___________________________________________________________________________________________________ ___________________________________________________________________________________________________

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. _________________________________________________________________________________________________________ _________________________________________________________________________________________________________ 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. _________________________________________________________________________________________________________ _________________________________________________________________________________________________________ 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. _________________________________________________________________________________________________________ _________________________________________________________________________________________________________

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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 reflects what we know about Nick’s transfer “N” Kevin will… Circle one of the following: …give… …get… …an amount K that satisfies the following inequality: K _________________________________________________________________ Nick will… Circle one of the following: …give… …get… …an amount N that satisfies the following inequality: N _________________________________________________________________

iii. What are the two considerations we discussed in class for how to assign property rights? What would they imply here? 1) _________________________________________________________________________________________ _________________________________________________________________________________________ 2) _________________________________________________________________________________________ _________________________________________________________________________________________ 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.) _________________________________________________________________________________________________________ _________________________________________________________________________________________________________ _________________________________________________________________________________________________________

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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 − & ’ ࠵? Marginal cost: ࠵? = 1 + & + ࠵? 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. ࠵? ∗ = ___________ ࠵? ∗ = ___________ ࠵?࠵? = ___________ ࠵?࠵? = ___________ 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, ࠵? 123 , and the new optimal toll, ࠵? 123 . Calculate the size of the negative externality if the toll is set to ࠵? 123 . ࠵? 123 = ___________ ࠵? 123 = ___________ ࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵? = ___________

Gridded area for parts (a) and (b) 2 4 6 8 10 12 2 4 8 10 12 14 16 18 6 20

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, ࠵? 123 , and the new optimal toll, ࠵? 123 . Calculate the size of the positive externality if the toll is set to ࠵? 123 . ࠵? 123 = ___________ ࠵? 123 = ___________ ࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵? = ___________ 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? ࠵?࠵?࠵?࠵?࠵? ࠵?࠵?࠵?࠵?࠵?࠵?࠵? = ___________

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Gridded area for part (c) 2 4 6 8 10 12 2 4 8 10 12 14 16 18 6 20

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? _________________________________________________________________________________________________________ _________________________________________________________________________________________________________ _________________________________________________________________________________________________________

Practice Midterm 2 (no solutions)

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