Pub Aff 111 Problem Set 1

PA 111 – Microeconomics: Market failures and inequality Professor R. Jisung Park Problem Set 1 Multiple Choice I (2 pts each) 1. Which of the following factors influences demand? I. consumer income II. prices of complement goods III. prices of substitute goods IV. the number of consumers a) I and IV b) II and III c) I, III, and IV d) I, II, III, and IV 2. The demand curve for a good is Q = 80 – 0.20 P , where Q is the quantity demanded and P is the price per unit. This good's inverse demand curve is: a) P = 80 – 0.20Q. b) P = 40 – Q. c) P = 5Q + 40. d) P = 400 – 5Q. 3. If a 10% increase in the price of pork reduces quantity demanded by 7%, the price elasticity of demand is: a) –1.43. b) –0.14. c) –3.0. d) –0.70. 4. The income elasticity of demand for dental services is 2.40, and the income elasticity of demand for nursing homes is 0.90. Based on these estimates, dental services are a(n) _____ and nursing home care is a(n) _____. a) luxury good; normal good b) normal good; inferior good c) inferior good; luxury good d) normal good; luxury good 5. In the case of producing a good with a negative externality, a firm will likely consider only the _____ marginal costs of production, leading to production of _____. A) external; more output than is socially optimal B) private; more output than is socially optimal C) private; less output than is socially optimal D) external; less output than is socially optimal

6. If consuming a good with a positive externality, a person will likely consider only the _____ marginal benefits of consumption, which causes _____ consumption than is socially optimal. A) external; more B) private, not the external; more C) private, not the external; less D) external; less 7. Which of the following statements is (are) TRUE? I. Public goods tend to be underprovided. II. One person's consumption of a public good diminishes its use to another person. III. The marginal cost of providing a public good to another consumer is infinite. A) I and III B) II and III C) I D) I, II, and III 8. A good is rival if: A) it is produced by more than one firm. B) consuming an item means that no one else can consume that same exact item. C) consumption of it causes negative externalities. D) consumers can be restricted from buying it. Figure 3.2 9. (Figure 3.2) If the price per bag of grapefruit increases from $6 to $8, producer surplus changes by (be sure to show your work): A) $130. B) $50. C) $90. D) $40.

Short Answer I 12. Fill in the rest of the typology of goods below. (2pts) Rival Non-Rival Excludable Private goods (ice cream) Club goods (movies) Non-Excludable Common pool resources (public roads) Public goods (national defense) For each of the four types of goods above, provide one real-world example. (4pts) 13. Many livestock farmers give antibiotics to their herds. The antibiotics help breed drug-resistant bacteria, making them less effective. This harms future users of antibiotics, who will be using less-effective drugs. a. What is the nature of the market failure? (2 pts) The market failure represents a negative externality problem. b. Explain whether livestock farmers are more likely to overuse or underuse antibiotics. (2 pts) Livestock farmers are more likely to overuse antibiotics because they are not likely to factor in external costs when deciding whether to use the drugs. They won’t internalize the negative externality imposed on a third party. c. Using supply and demand curves, illustrate the equilibrium outcome and socially optimal equilibrium in the antibiotic market. Be sure to label your axes and resulting prices and quantities. (4 pts)

Applied Problem: Pigouvian tax This question is intended to allow you to synthesize concepts learned in class in a policy-relevant way. Points will be allocated first and foremost for clear description of economic intuition and clear labeling and interpretation of figures. Until the latter half of the 20 th century, scientists and policymakers were unaware of the potential health and environmental impacts of vehicular transport by combustion of gasoline. A) Draw the market for gasoline, assuming no externalities and competitive markets. Be sure to label supply, demand curves, relevant axes, and equilibrium prices and quantities. (Assume that price-elasticity of demand and supply are roughly similar, and neither are perfectly elastic or inelastic.) (4pts) B) Based on a synthesis of numerous scientific and economic studies, the EPA concludes that gasoline involves many negative externalities, particularly in the form of local air pollution which harms health. They aim to develop an estimate for the per-gallon $-value of the social cost of gasoline consumption. (They also noted the contribution of gasoline combustion to the global carbon externality, which exacerbates climate change, but decided not to include these estimates because the EPA did not have the legal mandate to count global benefits, only benefits for US citizens.) In writing this report, EPA staff were careful to only include research that provided rigorous experimental or quasi-experimental methods that allowed causal inference. Why might this be important in assessing the link between air pollution and health? (4pts) It is important to use methods that allow causal inference in assessing the link between air pollution and health because in other studies, there may be other factors that influence the results of studies, making it appear like there is a causal connection that does not exist.

E) As you present these analyses at a Senate committee hearing, one of the Senate staffers interjects: “Taxes cause deadweight loss and drag down the economy! This is going to bankrupt consumers who need to pay higher prices, and put oil companies out of business.” How would you respond? (Hint: try to use the logic of social vs private costs, and total surplus with and without the tax) (10pts) I would respond that the minimal deadweight loss likely does not outweigh the social cost of gasoline over time. Private costs, while may be the market-optimal price, do not factor in the externalities or social costs that hurt our economy more in the long-run. The total surplus without the tax leads to the deadweight loss of the negative externality shown in the graph in part (C) which is equal to (depending on the slope of the Social Marginal Cost) or greater than the deadweight loss as a result of the total surplus with the tax. F) Libertarians and free-market fundamentalists object that this policy is leading to bigger government. Indeed, the policy raises revenue of , which represents a transfer from $τ×𝑄 * producers and consumers to the government. Is there a way to enact this policy without increasing the size of government? In your answer, provide some intuition as to how it is possible for a policy to be revenue-neutral while also achieving the intended externality correction. (4pts) To enact this policy without increasing the size of the government, the revenue can be redistributed to help with or pay for more climate change mitigation, putting the money back into the communities it came out of. G) Environmental justice groups and advocacy groups representing low-income households express opposition to this policy. They argue that even though this policy will deliver health benefits to their constituents, the policy is fundamentally regressive because low-income households spend a larger proportion of their earnings on driving-related expenditures. What kind of evidence would you want to see in order to verify these claims? (3pts) I would like to see evidence of how much gas people of different incomes use. If everyone uses the same amount of gas or drives the same amount no matter their income, then I would agree that this is a regressive tax fundamentally. However, if people of higher income drive more or drive cars that use more gasoline, then it is likely that this tax is more of a proportional tax. If people’s gasoline use is proportional to their income, then the gasoline tax is a proportional tax, not a regressive one. Is there a way to design the policy so that it achieves most of the externality-correcting (efficiency) benefits while being less regressive (distributional equity)? (3pts) To achieve most of the externality-correcting benefits while being less regressive, the policy could be designed to redistribute the revenue from the gas tax to lower income populations. For example, we could take the government revenue from the gas tax and use it to increase public transportation (for more accessible transit and climate change mitigation) or provide more emergency funding in low-income communities (for helping with climate change symptoms).