Practice problems 1.

This is NOT a practice midterm, just practice problems in addition to your HWs that you can look
at to prepare for the midterm. The actual midterm will have three types of questions:
Short questions about basic concepts that we covered.
Describing graphs.
Long questions, similar to the ones on HWs.

Short questions
Question 1.
1. Which are the four main questions of public finance?
2. Define Pareto efficiency. State the First Welfare Theorem.
3. Which public and private sector solutions are available to solve the problem of externalities?
4. State the Coase Theorem.
5. Why is Coase theorem unlikely to resolve some externalities in real world?
6. List five effects of smoking, that can potentially be externalities, and discuss under what condition
they are not externalities.
7. What is the main claim of the rational addiction model?
8. What is the free rider problem?
9. What is the crowding out problem associated with public goods?
10. Which three issues is government facing when trying to aggregate preferences for public good?
11. Which three approaches did we discuss that can be used to value time and lives saved by public
projects? Which problems arise with each of these approaches when trying to estimate the value
of human life?
Question 2.
In Becker and Murphys rational addicts model, smokers are perfectly aware of the potential for
smoking to cause addiction, and they take this into account when deciding whether or not to smoke.
Suppose a new technology - such as a nicotine patch - has just been invented which makes quitting
smoking much easier (less costly) for an addict. If Becker and Murphys model is correct, what effects
would you expect this invention to have on peoples smoking behavior? Would your answer be different
for young people and older people?
Question 3.
Suppose that after the city of Minneapolis build new lightrail line, the average commute time fell
by 30 minutes per day. Suppose that there is one commuter per household, that the average commuter
works 5 days a week, 50 weeks a year. Suppose that after the station was built we also observe that
the average house price increased by $500. Calculate by how much does on average a commuter value
one hour.
Question 4.
Suppose that the costs of a public project are $0.5 mil. in year 1; $2.4 mil. in year 2; $1.32 mil. in
year 3, and that the interest rate is r2 = 20% between year 1 and year 2, and r3 = 10% between year
2 and year 3. Calculate the total present discounted value of the costs of project.

Graphs
Question 5.
What kind of observations can we make about the US federal government debt based on the
following graph? What change do we observe around 1980s? How did the level of debt of the US
federal government change under each president after 1980 (compare the level when the took the office
and when they left)? Under which presidents did the US debt decrease most? Under which presidents
did the US debt increase most? Any other observations?

Longer problems
These longer problems focus on things that were not covered sufficiently in HWs; again - they intended
just to provide extra practice opportunities, and there may be questions on the midterm on topics from
HWs that do not show up here.
Question 6.
Consider an island with two inhabitants (Tom Hanks, Wilson), and two goods (coconuts, fish).
Denote by cT H , cW , f T H , f W the consumption of coconuts and fish by Tom Hanks an Wilson respectively. The total endowment on the island is C = 10 coconuts and F = 20 fish. The social planners
problem is
h
h
i
i
max
T H log cT H + AT H log fT H + W log cW + AW log fW
cT H ,cW ,fT H ,fW

subject to
cT H + cW C
fT H + fW F
and recall that the solution of social planners problem we found was
T H
C
+ W
W
= TH
C

+ W

cT H =
cW

AW W
F
+ AW W
AT H T H
= TH TH
F
A
+ AW W

fW =

T H

fT H

AT H T H

In this particular case we have C = 10 and F = 20.

1. Suppose that AT H = AW = 1. Plot the Edgeworth box with coconuts and fish. Draw points in
the Edgeworth box that correspond to the allocation for the following cases
(a) W = 1, T H = 0
(b) W = 0, T H = 1
(c) W = 0.5, T H = 0.5
(d) W = 0.75, T H = 0.25
2. Suppose that AT H = 3, AW = 1. Plot another Edgeworth box with coconuts and fish. Draw
points in the Edgeworth box that correspond to the allocation for the following cases
(a) W = 1, T H = 0
(b) W = 0, T H = 1
(c) W = 0.5, T H = 0.5
(d) W = 0.75, T H = 0.25

Question 7.
Consider an island with two inhabitants - Tom Hanks and Wilson, and one good - coconuts. Denote
by cT H , cW the consumption of coconuts by Tom Hanks and Wilson respectively. Their utility functions
are simply
U T H (cT H ) = log cT H
U W (cW ) = log cW
There is NO endowment of coconuts on this island, and to have something to eat Tom Hanks and
Wilson have to climb the palm trees and gather coconuts. Moreover, Tom Hanks and Wilson have to
first learn how to do that. Thus each of them decides how much time to spend learning how to most
efficiently gather coconuts; denote this time by hTs H and hW
s . The rest of the time they spend gathering
coconuts; denote this by hTc H and hW
c . Both Tom Hanks and Wilson have T hours at disposal to divide
W
among hTs H , hTc H and hW
s , hc respectively.
(a) Suppose that in an hour Tom Hanks gathers z T H coconuts with z T H = sT H hTs H where sT H
captures how smart Tom Hanks is and thus how much he learns in the time he spends studying
the art of climbing palm trees and gathering coconuts. Similarly for Wilson we have z W = sW hW
s .
Assume that they can not trade among themselves and write down the consumer problems for
Tom Hanks and Wilson.
(b) Solve the problems of Tom Hanks and Wilson from part (a).
(c) Suppose now instead that knowledge is shared - in one hour both Tom Hanks and Wilson gather
z coconuts with z = sT H hTs H + sW hW
s . Write down the modified consumer problems for Tom
Hanks and Wilson, again assuming that they can not trade.
(d) Solve the problems of Tom Hanks and Wilson from part (c).
W W

in part (d) Pareto efficient, which problem

(e) Why isnt the choice hTs H , hTc H , cT H , hW
s , hc , c
arises in this environment?

(f) How could the problem arising be solved? Propose either a private sector solution or a public
sector solution that would improve the situation.
(g) Which real world counterparts are similar to the situation in this example and how does the
government/private sector deal with the problem that you identified in part (e)?

Question 8.
Recall the economy with fireworks that we looked at in class, where Tom Hanks and Wilson are
facing following problems
max log cT H + AT H log(f T H + f W )

cT H ,f T H

subject to
pc cT H + pf f T H = M T H
and
max log cW + AW log(f T H + f W )

cW ,f W

subject to
pc cW + pf f W = M W
where c are coconuts and f are the fireworks. Notice that fireworks are a public good - fireworks
bought by Tom Hanks f T H also benefit Wilson since they increase Wilsons utility.
(a) Suppose now that there is a government which is trying to resolve the problem with underprovision of fireworks that we discussed in class. To do that the government imposes taxes T T H , T W
(in dollars) and uses it to purchase some additional fireworks f g , so that the total amount of
fireworks in economy is now
F = fTH + fW + fg
Write down the consumer problems for Tom Hanks and Wilson.
(b) Solve the problems of Tom Hanks and Wilson.
(c) Suppose that pc = pf = 1, AT H = AW = 0.5, M T H = M W = 100 and that government wants
to achieve the optimal amount of fireworks that we obtained in class. Which problem should the
government be aware of when it is choosing f g ? Where can we see this problem in the expression
for f T H and f W ?

Question 9.
Consider an endowment economy with two consumers - Tom Hanks and Wilson, and two goods coconuts and fish. Denote by cT H , cW , f T H , f W the consumption of coconuts and fish by Tom Hanks
an Wilson respectively. Assume that their utility functions are
U T H (cT H , f T H ) = log cT H + AT H log f T H
U W (cW , f W ) = log cW + AW log f W
Tom Hanks an Wilson dont have money, but they do have endowments of coconuts and fish which we
TH W
denote by eTc H , eW
c , ef , ef .
(a) Suppose that prices of fish pf and coconuts pc are determined by competitive markets. Write
down the consumer problems for Tom Hanks and Wilson.
(b) Define a competitive equilibrium for the economy.
(c) Suppose now that Tom Hanks and Wilson find out that a hostile tribe living on the neighboring
island plans to attack them and take their fish and coconuts. To prevent this Tom Hanks and
Wilson decide to invite The Expendables to take vacation on their island and to protect them.
To do that they will however need to save some of the coconuts and fish to be able to feed The
Expendables.
Suppose that the contribution of coconuts and fish by Tom Hanks and Wilson to feed The
Expendables are voluntary. What kind of problem is likely to arise? Write down the consumer
problems for Tom Hanks and Wilson. Where in their problems can we see the source of the
above problem?
(d) Define a competitive equilibrium for the economy with Expendables.
(e) Suppose now instead that there is a government on the island that spends Gf fish and Gc coconuts
TH W
to feed The Expendables. The government, and that is using taxes tTc H , tW
c , tf , tf to collect
enough coconuts and fish from Tom Hanks and Wilson. Write down the consumer problems for
Tom Hanks and Wilson.
(f) Define a competitive equilibrium for the economy with government and Expendables.