Instructor S Manual Publice Finance HARVEY PDF

Chapter 1 - Introduction
Instructor’s Manual to accompany

Public Finance, Seventh Edition, by Harvey S. Rosen
Suggested Answers to End-of-Chapter Discussion Questions
Some of the questions have no single “correct” answer – reasonable people can go off in
different directions. In such cases, the answers provided here sketch only a few possibilities.
Chapter 1 - Introduction
1. a. Putin’s statement is consistent with an organic conception of government.

Individuals and their goals are less important than the state.
b. Rehnquist makes a clear statement of the mechanistic view of the state.
2. a. A person with an organic conception of the state might react favorably, arguing
that even if an individual owner is worse off because he must show only French
movies, the nation is better off because it achieves more unity.
b. A libertarian would certainly reject this policy and the reasoning behind it -- there is
no “national interest” independent of the interests of individuals, and people
should have the right to run their lives in the way that they prefer -- including
seeing whatever movies they want.
c. A social democrat would try to balance these two aims, and it is hard to predict how
he or she would come out.
3. The mechanistic view of government says that the government is a contrivance created
by individuals to better achieve their individual goals. Within the mechanistic tradition,
people could disagree on the obesity tax. Libertarians would say that people can decide
what is best for themselves - whether to consume high calorie food - and do not need
prodding from the government. In contrast, social democrats might argue that people are
too short sighted to know what is good for them, so that government-provided
inducements are appropriate.
4. a. If the size of government is measured by direct expenditures, the mandate does not
directly increase it. Costs of compliance, however, may be high and would appear
as an increase in a “regulatory budget.”
b. It’s hard to say whether this represents an increase or decrease in the size of
government. One possibility is that GDP stayed the same, and government
purchases of goods and services fell. Another is that government purchases of
goods and services grew, but at a slower rate than the GDP. One must also
consider coincident federal credit and regulatory activities and state and local
budgets.
Part 1 – Getting Started
c. The federal budget would decrease if grants-in-aid were reduced. However, if state
and local governments offset this by increasing taxes, the size of the government
sector as a whole would not go down as much as one would have guessed.
5. The inflation erodes the real value of the debt by 0.021 x £311 billion or £6.5 billion. The
fact that inflation reduces the real debt obligation means that this figure should be
included as revenue to the government.
6. The federal government grew by $450 billion. However, because the price level went up
by 16 percent, in terms of 2001 dollars this amounted to a real increase of $224 billion
(=$1.86 trillion - 1.16*$1.41 trillion=$1.86 trillion-$1.64 trillion). Note that the increase
in prices of 16 percent in the Rosen text (p. 18) differs from official sources. According
to the 2004 Economic Report of the President (Table B-60), the CPI-U was 177.1 in 2001
and was 144.5 in 1993, an increase of 22.5 percent, not 16 percent. If one uses these
numbers, government spending increased in constant 2001 dollars from $1.72 trillion in
1993 to $1.86 trillion, or $140 billion. As a proportion of GDP, federal spending in 1993
was 21.2 percent and in 2001 it was 18.2 percent. Hence, by one measure, the size of
government fell and by the other measure, it grew. To get a more complete answer, one
would want data on the population (to compute real spending per capita). Also, it would
be useful to add in expenditures by state and local governments, to see if the total size of
government fell. Also, although it would be harder to measure, one would want to try to
gain some sense of how the regulatory burden on the economy grew during this time
period.
Chapter 2 – Tools of Positive Analysis
1. The reality that astronomers are trying to understand is not influenced by any “policies”
that astronomers might implement. That is, planets and stars do act any differently when
they are being analyzed, whereas people can change their behavior. Moreover, the
parameters with which astronomers must deal are constant over time (at least in the
“short-run” of hundreds of years), while the parameters in economics can quickly change
over time and across geography.
2. A change in the marginal tax rate changes the individual’s net wage. This generates both
an income effect and a substitution effect. As long as leisure is a normal good, these
effects work in opposite directions. Hence, one cannot tell a priori whether labor supply
increases or decreases. One could ask taxpayers to describe how they would change their
behavior under the proposal, but it is hard to imagine that this would yield useful results.
In a social experiment, a control group would confront the status quo, and an
experimental group would face the new tax regime. This is clearly infeasible.
Econometric investigation of labor supply seems the best approach, particularly if data
associated with past changes in tax rates can be brought to bear on the problem.
3. Generally, economic outcomes are affected by a number of variables some of which are
observed and others of which are unobserved. Economists often cannot perform
controlled, randomized experiments, which makes it difficult to assess how any single
variable affects a given outcome. Moreover, even in the cases when experiments are run
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(e.g., the Negative Income Tax experiment or the RAND Health Insurance Experiment),
a number of unintended behaviors can arise because people know they are in the
experiment for a short amount of time and because of lack of generalizability. In the
medical example here, brain impairment may be due to a number of factors that are either
observed are unobserved. Ecstasy users clearly are not a random sample of the
population, but are likely to differ in terms of their attitudes towards risk, their discount
rates, and potentially many other ways. Hence, one cannot definitively conclude whether
brain impairment is due to Ecstasy or some variable that is correlated with Ecstasy use.
There are numerous non-experimental methods that may be helpful in inferring the causal
effect of Ecstasy. For example, if there were a plausible “instrumental variable” (perhaps
the punitiveness of the drug laws in a state) that was correlated with the supply of Ecstasy
but not otherwise correlated with the outcomes of interest, one may be able to estimate
the causal effect of Ecstasy on long-run developmental problems.
4. The text points out the pitfalls of social experiments: the problem of obtaining a random
sample and the problems of extending results beyond the scope of the experiment.
Participants in the study had found it to their advantage to be a part of the experiment,
which may have resulted in a self-selected population unrepresentative of the wider group
of health care consumers. In addition, the RAND Health Insurance Experiment was of
limited duration, after which the participants would move to some other health plan. This
design could induce certain behavior in the short-run that would not necessarily be
present if the health insurance coverage were permanent rather than transitory. Further,
physicians’ “standard practices” are largely determined by the circumstances of the
population as a whole, not the relatively small experimental group.
5. First, it is important to note that the numbers on page 32 of Rosen’s text actually show
the surplus, not the deficit. That is, the negative surplus of $221.2 in 1990 is actually a
deficit, while the positive surplus of $236.4 is a surplus. There is a very weak, negative
relationship between surpluses and interest rates (the correlation coefficient is -.043), or
put differently, a weak, positive relationship between deficits and interest rates. However
it is expressed, it is weak -- by “eyeballing” the data, it might appear that larger deficits
lead to lower interest rates (for example, by comparing the data from 1980 with the data
from 2000). One clearly would need more data to investigate this question. One would
want to look at deficits relative to some benchmark, such as GDP. One would want to
express both interest rates and deficits in real terms, rather than nominal terms. One
would like to control for other factors that can affect interest rates, such as monetary
policy and the level of economic activity. Finally, one would want to determine which
way the causality runs – do larger deficits cause higher interest rates, or do higher interest
rates cause larger deficits (since, by construction, one of the largest items in the federal
budget is interest on the debt).
Chapter 4 – Public Goods
1. a. Wilderness area is an impure public good – at some point, consumption becomes

nonrival; it is, however, nonexcludable.
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b. Water from a municipal water supply is both rival in consumption and excludable.
My consumption of water precludes you from consuming the same water, thus it is
rival. The municipality can control who consumes water by shutting off the flow
to customers, thus it is excludable. This is a useful question for showing that not
all publicly owned facilities are public goods.
c. Medical school education is a private good.
d. Television signals are nonrival in consumption.
e. An Internet site is nonrival in consumption (although it is excludable).
2. We assume that Cheetah’s utility does not enter the social welfare function; hence, her
allocation of labor supply across activities does not matter.
a. The public good is patrol; the private good is fruit.
b. Recall that efficiency requires MRSTARZAN + MRSJANE =MRT. MRSTARZAN=MRSJANE

=2. But MRT=3. Therefore, MRSTARZAN + MRSJANE >MRT. To achieve an
efficient allocation, Cheetah should patrol more.
3. A pure public good is nonrival in consumption, thus it is necessary to determine whether

or not this is the case with the highway. That is, if the additional cost of another person
“consuming” the highway is zero, then it is a public good. So, as long as the highway is
not congested, then it can be considered to be a public good. However, adding another
motorist to an already congested roadway can cause traffic jams that cost motorists more
time to travel the highway, which would represent nonzero costs to having an additional
person use the highway. Therefore, the congestion of the roadway determines whether or
not we could designate it as a public good. Note that we are assuming throughout that the
highway is nonexcludable.
To determine whether or not the privatization of the highway is a sensible idea, it is

necessary to consider the advantages and disadvantages of such an action. First, if the
market structure is such that privatizing the highway would result in a monopolist in
control of the highway, then this would be inefficient. Also, it would be difficult for the
government to write a complete contract for maintaining the highway, which would also
cause inefficiencies that would result from the privatization of the road. However, if the
government owns the highway, it might not have the appropriate incentives to maintain it
properly. In such a case, even ownership by a private monopolist might be a sensible
solution.
4. The benefits of maintaining the incomes of the poor accrue largely to the recipients of
welfare, not to society as a whole. Thus, it is implausible to think of welfare (or the
administration of the welfare system) as a public good. Unless there is a “warm-glow”
from income redistribution, there is little basis for thinking that the provision of TANF,
Medicaid, public housing, or food stamps offers much in terms of benefit to society as a
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whole. In terms of administration of welfare, it is hard to say whether or not it should be

publicly or privately administered. Private administration might be less costly. On the
other hand, private administrators might have an incentive to deprive deserving
individuals of benefits in order to cut costs. It could be difficult to write a contract to
prevent this kind of behavior, because one cannot specify in advance every conceivable
set of circumstances under which welfare should be granted. This kind of subjectivity
was present in the 1960s, when caseworkers had a great deal of discretion in terms of
which households to offer assistance to. This subjectivity led to accusations of
discrimination and, from the 1970s onward, there has been far less subjectivity in terms
of defining eligibility. Since that time, eligibility is fairly mechanically related to
income, assets, family structure, and a number of other observable factors. Given the
current system, it seems less difficult today to monitor a private firm than it would have
been in the 1960s.
5. A lower cost is a necessary (but not sufficient) condition to conclude that prisons should
be privatized. A policy maker should be concerned both with costs and quality of
prisons. Although, in principle, one could write a contract that is concerned about the
quality of prisons (e.g., whether the prisoners are treated decently, whether security is
adequate, and so on), Hart, Shleifer and Vishny (1997) note that it is sometimes
impossible to write a complete contract because one cannot specify in advance every
possible contingency. The key is whether the administration of prisons is a fairly
“routine” activity where complete contracts can be written, or whether there are too many
contingencies.
6. As noted on page 65 of the textbook, the experimental results of Palfrey and Prisbrey
(1997) suggest that there is some free riding, but some people do contribute. Those
authors found that, on average, people contribute a portion of their resources to the
provision of a public good, and there is some free riding. That was the case in
Manchester, Vermont. Also, Palfrey and Prisbrey found that when the experimental
game was repeated, people were more likely to free ride. This also happened in
Manchester -- in the second year, participation was less.
7. There is no compelling reason for museums to be run by the government from the theory
of public goods; thus, it is appropriate to think about privatization. Admissions to
museums are clearly excludable. And viewing the artwork is also rival, because there is
congestion when too many people are consuming the good. Thus, museums may be
thought of as a private good rather than public good. In the United States, many great
museums are run privately (not for profit), and they seem to do quite well. In terms of
private versus public production, the text points out that this decision should be based on
relative wage and material costs in the public and private sector, administrative costs,
diversity of tastes, and distributional issues. There is no compelling reason to think the
private sector would have higher costs than the public sector. In regards to diversity of
tastes, a profit-maximizing private sector museum would likely be more responsive to
consumer tastes than the public sector – e.g., adopting new technologies that make the
museum more enjoyable for the typical customer. In regards to distributional issues, it is
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likely that the private sector would be less responsive than the public sector. The notion
of commodity egalitarianism, however, is a stretch for museums.
8. If households are allowed to supplement public education with private lessons, then the
budget constraint in Figure 4.5 of the textbook is modified by drawing a line starting at
point x (consuming only public education) that runs to the southeast and is parallel to AB.
The figure below is then similar to the analysis of in-kind benefits like food stamps.
FIGURE 4.8a – Supplement public

education with private lessons
Other Goods
BA
ep
Education
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If parents pay for the public schooling (rather than perceiving it as being free), and the
schooling was paid for with a lump sum tax, then the budget constraint shifts in by an
amount that depends on the household’s share of the tax burden. If the household’s tax
burden exactly equals the cost of public school, the budget constraint is no longer the line
segment AB but rather the segment CDB, where the segment DB runs along the original
budget constraint, except that the minimum amount of schooling consumed is eP.
FIGURE 4.8b – Parents pay for “free”

schooling
Other Goods
C D
BA
ep
Education
9. In this case, the apartment’s temperature is a public good because for the “society” of
Rodolfo and Mimi, the temperature is nonrival and nonexcludable. Both get to
“consume” a warmer house, and neither can exclude the other from this. The marginal
benefit for society is the sum of Rodolfo’s and Mimi’s marginal benefit – e.g., $20 at 66
degrees, $17 at 67 degrees, $13 at 68 degrees, $8 at 69 degrees, and $4 at 70 degrees.
The marginal benefit for society equals the marginal cost at 67 degrees; for temperatures
higher than that, the marginal cost is greater than the marginal benefit for society.
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10. Thelma’s marginal benefit is MBTHELMA=12-Z, and Louise’s is MBLOUISE=8-2Z. The

marginal benefit for society as a whole is the sum of the two marginal benefits, or
MB=20-3Z (for Z≤4), and is equal to Thelma’s marginal benefit schedule afterwards (for
Z>4). The marginal cost is constant at MC=16. Setting MB=MC along the first segment
gives 20-3Z=16, or Z=4/3, which is the efficient level of snowplowing. Note that if
either Thelma or Louise had to pay for the entire cost herself, no snowplowing would
occur since the marginal cost of $16 exceeds either of their individual marginal benefits
from the first unit ($12 or $8). Thus, this is clearly a situation when the private market
does not work very well. Also note, however, that if the marginal cost were somewhat
lower, (e.g., MC≤8), then it is possible that Louise could credibly free ride, and Thelma
would provide the efficient allocation. This occurs because if Thelma believes that
Louise will free ride, Thelma provides her optimal allocation, which occurs on the second
segment of society’s MB curve, which is identical to Thelma’s MB curve (note that
Louise gets zero marginal benefit for Z>4). Since Louise is completely satiated with this
good at Z=4, her threat to free ride is credit if Thelma provides Z>4.
Chapter 5 - Externalities
1. Classical economics explicitly requires that all costs and benefits be taken into account
when assessing the desirability of a given set of resources, so Gore’s statement is false.
The notion that rescuing the environment should be “the central organizing principle for
civilization” provides no practical basis for deciding what to do about automobile
emissions (or any other environmental problem), because it provides no framework for
evaluating the tradeoffs that inevitably must be made.
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2.
a. The number of parties per month that would be provided privately is P.
b. See schedule MSBp.
c. P*. Give a per-unit subsidy of $b per party.
d. The total subsidy=abcd. “Society” comes out ahead by ghc, assuming the subsidy
can be raised without any efficiency costs. (Cassanova’s friends gain gchd;
Cassanova loses chd but gains abcd, which is a subsidy cost to government.)
3. a. If you know who was cooking, the externality is easy to identify, and depending
on how many students are involved, the costs of negotiation should be fairly
small.
b. It is unlikely that property rights could be enforced in terms of catching tropical

fish on the Amazon River. The question states that hundreds of divers illegally
catch these fish and sell them on the black market. If the property rights were
given to the divers, it is not clear who is actually harmed (perhaps “society as a
whole”) by the depletion of exotic fish. Given the large number of people who are
harmed (in a small amount), and the large number of people who are engaging in
this activity, it is not clear how bribes would flow from “society” to the “divers.”
c. There are too many farmers and too many city-dwellers for a private negotiation.
d. Too many people are involved for private negotiation and impossible to figure out
how to transfer bribes.
4. a. The price of imported oil does not reflect the increased political risk by
effectively subsidizing authoritarian regimes like those in Saudi Arabia.
b. The tax would estimate the marginal damage (e.g., the increased instability in the
Middle East, etc.) by importing oil from Saudi Arabia.
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c. The supply of vouchers is vertical at 140 billion. The demand curve is downward
sloping. For every gallon of gasoline, you either have to buy a voucher or use up
one of your own. In either case, this increases the opportunity cost by 75 cents.
FIGURE 5.4c – Tradeable vouchers for oil

PVOUCHER
S
$0.75
140 billion
QVOUCHER
5. The per-unit taxes, which range from 12-27 cents per ounce, are far below the marginal
external cost of $1.19 per ounce. Although the deadweight loss is smaller than with no
tax at all, the allocation is still far from the socially efficient level. The current allocation
produces too much alcohol at too low of a price.
6. By establishing a market for air pollution rights, the Chicago Board of Trade has applied
the Coase Theorem. The potential efficiency of the outcome may be laudable, but the
distributional impact may be unpalatable to some.
7. a. When the Little Pigs hog farm produces on its own, it sets marginal benefit
equal to marginal cost. This occurs at 4 units.
b. The efficient number of hogs sets marginal benefit equal to marginal social cost,
which is the sum of MC and MD. At 2 units, MB=MSC=13.
c. The merger internalizes the externality. The combined firm worries about the
joint profit maximization problem, not the profit maximization problem at either
firm alone. Thus, the LP farm produces 2 units, the socially efficient amount.
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d. Before the merger, the LP farm produced 4 units. By cutting back to 2 units, it
loses marginal profit of $3. On the other hand, the Tipsy Vineyard’s profits
increase by $20. Thus, profits increase by $17 altogether.
8. Private Marginal Benefit = 10 - X
Private Marginal Cost = $5
External Cost = $2
Without government intervention, PMB = PMC; X = 5 units.
Social efficiency implies PMB = Social Marginal Costs = $5 + $2 = $7; X = 3 units.
Gain to society is the area of the triangle whose base is the distance between the efficient
and actual output levels, and whose height is the difference between private and social
marginal cost. Hence, the efficiency gain is ½ (5 - 3)(7 - 5) = 2.
A Pigouvian tax adds to the private marginal cost the amount of the external cost at the
socially optimal level of production. Here a simple tax of $2 per unit will lead to
efficient production. This tax would raise ($2) (3 units) = $6 in revenue.
9. In the absence of persuasive evidence on positive externalities for higher education, there
is no reason for the government to provide free tuition. True, taxes on wages may distort
education decisions (see Chapter 16), but virtually all taxes distort some decision making,
and it is unlikely that it is optimal to subsidize tuition at 100 percent.
10. a. By regulating the number of permits to 50 units, then the demand curve implies
that 50=100-10P, or P=$5.
b.Because it would cost ACME more money to reduce pollution than buy a permit
($8 versus a market price of $5), ACME buys the permit. By doing so, it saves $3
in costs.
Chapter 6 – Political Economy
1. a. Below, the preferences for Person 1 and Person 2 are drawn. Same procedure is
used for the other three people.
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b. C wins in every pairwise vote. Thus, there is a stable majority outcome, despite the
fact that persons 1, 2, and 3 have double-peaked preferences. This demonstrates that
although multi-peaked preferences may lead to voting inconsistencies, this is not
necessarily the case.
2. The votes by the Senators from the northeast and south to subsidize each other’s interests
are consistent with the logrolling model. The senators from the affected states made the
deal for advantage their constituents at the expense of other regions.
3. a. Three percent a year.
b. Assuming that the public sector uses only labor as an input, the price of the public
good increases by three percent a year.
c. The size of government increases. For further discussion of this phenomenon, see the
paper by W. J. Baumol, “Macroeconomics of Unbalanced Growth: The Anatomy
of Urban Crises,” American Economic Review, 1967.
4. Yes, it is consistent, because the theory says that when unanimity is required, no
decisions are likely to be made. A majority system might be more suitable, although it is
subject to cycling and other problems.
5. If these figures are true, then the predictions of the median voter theory are not accurate –
that is, majority voting will not reflect the preferences of the median voter but rather the
median participating voter. The reason for this is because of the different turnout rates
for individuals in different income categories. Consider this simple example: suppose
that voters have single-peaked preferences, and they are trying to determine how much
should be spent on national defense. Their preferences are listed as follows:
Andrew: $500 Bob: $700 Charlie: $850
Allison: $600 Bill: $750 Cathy: $900
Anne: $650 Beth: $800 Cheryl: $1,000
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The median voter theorem predicts that a majority vote will result in $750 being spent on
defense (which is reflective of Bill’s preferences, since he is the median voter).
However, if there are different participation rates by different groups (in this case, the
groups are determined by the first letter in the person’s name), then the preferences of the
median voter (Bill) are no longer reflected in the majority vote. Suppose that Andrew
and Anne don’t vote – then a majority vote will result in $800 of defense spending.
6. When there is a vote over five options, there is the chance that a potential majority vote is
split between four relatively preferred options, and the fifth option wins. The winning
option may have been voted down if it had been a two-way vote with any of the other
options. Further, if preferences are not single-peaked, cycling and inconsistent public
decisions may emerge.
7. Given the U.S. experience with the Budget Enforcement Act of 1990, we would expect
the EU deficit limits to be ineffective. We would expect “accounting tricks” to mask the
size of the deficits (such as itemizing various budget items as “unexpected
emergencies”), and if that didn’t work, we would expect the deficit rules to be ignored.
This is apparently what is happening. When Germany exceeded the deficit target, no
moves were taken to levy the required fines.
8. Since rents, by definition, are the returns above a normal return, then when the licenses
are put on the market, their price will be the value of the rents. Hence, the owner of the
peanut license, whoever he or she is, only makes a normal return. Put another way, the
license is an asset that earns a normal rate of return. If the peanut license system were
eliminated, efficiency would be enhanced. But the elimination would, in effect,
confiscate the value of this asset. It is not clear that this is fair. One could also argue that
when someone buys this asset, the purchase is with the understanding that there is some
probability that its value will be reduced by elimination of the program; hence, it is not
unfair to do so.
9. a. With the demand curve of Q=100-10P and a perfectly elastic supply curve at P=2,
then the milk is sold at a price of $2, and a quantity of 80 units is sold.
b. The marginal revenue curve associated with the inverse demand curve P=10-
(1/10)Q is MR=10-(1/5)Q, while the marginal cost curve is MC=2. The cartel
would ideally produce a quantity where MR=MC, or 10-(1/5)Q=2, or Q=40. The
price associated with a cartel quantity of 40 units is P=10-(1/10)*40, or P=6.
c. The rent associated with the cartel is the product of the marginal profit per unit
and the number of units produced. The marginal profit per unit of milk is $4 (=$6
price - $2 marginal cost), while 40 units are produced. Thus, the rents equal
$160.
d. The most the cartel would be willing to contribute to politicians is the full
economic rent of $160. The cartel situation, the quantity of milk produced is too
low from society’s point of view. The deadweight loss triangle is computed using
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the difference between the cartel output and competitive output as the “base” of
the triangle, and the difference between the cartel price and competitive price as
the “height.” Thus, the triangle is equal to (1/2)*(80-40)*($6-$2)=$40.
e. As Figure 6.5 in the textbook shows (page 130), the deadweight loss could now
go as high as the sum of the conventional deadweight loss and the rents, or $160
rents + $80 DWL = $240. This is because, as noted on page 131, “rent-seeking
can use up resources – lobbyists spend their time influencing legislators,
consultants testify before regulatory panels, and advertisers conduct public
relations campaigns. Such resources, which could have been used to produce new
goods and services, are instead consumed in a struggle over the distribution of
existing goods and services. Hence, the rents do not represent a mere lump-sum
transfer; it is a measure of real resources used up to maintain a position of market
power.”
10. Niskanen’s model of bureaucracy is illustrated in Figure 6.4 of the textbook. In the
aftermath of September 11th, the new concerns over food safety would likely shift the V
curve upward (that is, the value placed on each level of Q). Assuming that C curve (costs
per unit of Q) does not change, then this shift increases the actual number of food
inspectors hired. It is also likely that the slope of the V curve changes, with each
marginal unit of Q becoming more valuable. Thus, the V curve not only “shifts” upward,
but becomes steeper as well. Both of these effects – the shifting of the V curve and the
change in the slope – lead to greater values of Q under the bureaucracy model. The
change in the slope leads to a greater value of Q*, the efficient level of output. Thus, the
optimal number of FDA employees and the actual number of FDA employees are likely
to rise.
11. The lesson in The Economist, that Democrats flourish when they move toward the center,
is basically a description of the median voter rule.
Chapter 7 – Income Redistribution: Conceptual Issues
1. Utilitarianism suggests that social welfare is a function of individuals’ utilities. Whether

the rich are vulgar is irrelevant, so this part of the statement is inconsistent with
utilitarianism. On the other hand, Stein’s assertion that inequality per se is unimportant is
inconsistent with utilitarianism.
2. a. To maximize W, set marginal utilities equal; the constraint is Is + Ic = 100.

So,
400 - 2Is = 400 - 6Ic.
substituting Ic = 100 - Is gives us 2Is = 6 (100 - Is ).
Therefore, Is = 75, Ic = 25.
b. If only Charity matters, then give money to Charity until MUc = 0 (unless all the
money in the economy is exhausted first).
So,
400-6 Ic = 0; hence, Ic = 66.67.
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Giving any more money to Charity causes her marginal utility to become negative,
which is not optimal. Note that we don’t care if the remaining money ($33.33) is
given to Simon or not.
If only Simon matters, then, proceeding as above, MUs. 0 if Is = 100; hence, giving
all the money to Simon is optimal. (In fact, we would like to give him up to
$200.)
c. MUs = MUc for all levels of income. Hence, society is indifferent among all
distributions of income.
3. The main conceptual problem with the poverty gap is that it doesn’t account for the
income effect on labor force participation rates. The poverty gap is calculated assuming
there are no behavioral responses; e.g., that labor income would remain unchanged even
after the income was transferred to the poor population, but economic theory predicts that
this will not be so. In fact, if the poor household were given enough income to bring it
out of poverty, we would believe that the household would work less as a result of
receiving this transfer. This complicates the analysis, of course, because once the
household works less, then it will generate less labor income, thus lowering its overall
income. This means that the poverty gap actually understates the amount of money
necessary to alleviate poverty in the United States. In addition, the poverty gap is based
on the official poverty line, which is thought to be an ad-hoc measure of the true “needs”
of a family.
4. A day care center is an example of an in-kind compensation. The figure below is similar
to Figure 8.2 in the text. The original budget line is G1 H1 If the employee received
$5,000 cash, the budget line moves to G2 H2 . An employee who uses the day care center
may not be $5,000 better off. The employee consumes at point A, but would be better off
at point B, which represents consumption after a cash transfer of $5,000.
15
5. a. This would increase the incomes of the providers of computer equipment and the
individuals who maintain the equipment. In the long run, this might also increase
the incomes of the students who use the equipment. Moreover, giving a laptop to
all seventh graders (rather than poor seventh graders) may simply “crowd-out”
computer transfers from parents to children. One could imagine that nowadays
many children do have a computer at home, paid for by the parents. This
government transfer may simply result in less parental transfer to the child.
b. Providing free after-school programs for children in impoverished families largely

acts as an in-kind transfer for poor, working households. The program is of little
value for unemployed households, as the alternative would be childcare at home.
For those who are employed, and paying for childcare, this program provides an
alternative and effectively changes the after-tax, after-working-cost wage. This
also may affect work behavior on the extensive margin. The likely “losers” from
such a program are childcare providers, who see a reduction in demand for their
services. In principle, this reduction in demand could lower the hourly childcare
cost for all workers with children, though this effect is likely to be modest because
most impoverished families do not have a very large labor force attachment and,
thus, their effect on the childcare market as a whole is likely to be small.
6. a. False. Society is indifferent between a util to each individual, not a dollar to each
individual. Imagine that UL=I and UJ=2I. Then each dollar given to Jonathan
raises welfare more than the same dollar given to Lynne.
b. True. The social welfare function assumes a cardinal interpretation of utility so

that comparisons across people are valid.
c. False. Departures from complete equality raise social welfare to the extent that
they raise the welfare of the person with the minimum level of utility. For
example, with the utility functions UL=I and UJ=2I, the social welfare function
W=min[UL,UJ] would allocate twice as much income to Lynne than Jonathan.
7. Initially the price of food was $2 and the price of other goods was $1. The black market
for food stamps changes the price of food sold to $1. In Figure 7.2 of the textbook, as
one moves to the “northwest” from point F, the segment will now have a slope (in
absolute value) of 1 rather than 2. The black market may make the individual better off if
the best point on her budget constraint AFD was initially at the corner solution of point F,
and the black market certainly does not make her worse off. It is important to note that
the black market does not always make the recipient better off. If the (absolute value) of
the marginal rate of substitution (MRS) were between 1 and 2, the indifference curve
would not “cut” into the new part of the budget constraint with the black market.
16
FIGURE 7.7a – Black market where food

stamps are sold for fifty cents on the dollar,
Other Goods no better off
Sell food stamps for other

goods on black market
A F
U0
D
Food
Stamp Food
Allotment
17
If the MRS were less than (or equal to) 1 in absolute value, the person would be made
better off and would reduce food consumption by selling the food stamps on the black
market.
FIGURE 7.7b – Black market where food

stamps are sold for fifty cents on the dollar,
Other Goods higher utility
Sell food stamps for other

goods on black market
A F U1
U0
Food Stamp Food

Guarantee
8. Pareto efficient redistribution is a reallocation of income that increases (or does not
decrease) the utility of all consumers. With these two consumers, Marsha’s utility
increases as Sherry’s utility increases. Thus, it may be possible to reallocate income from
Marsha to Sherry and raise both of their utility. With Sherry’s initial utility function of
US=100YS1/2, her utility with $100 of income is US=100($100)1/2, or US=1,000. With
Marsha’s initial utility function of UM=100YM1/2+0.8US, her utility with $100 of income is
UM=100($100)1/2+0.8(1,000), or UM=1,800. If the social welfare function is additive, then
initial welfare is W=US+UM=1,000+1,800=2,800. If $36 is reallocated from Marsha to
Sherry, then Sherry’s income is now $136 and Marsha’s is now $64. With Sherry’s
utility function, her utility with $136 of income is US=100($136)1/2, or US=1,166.190.
With Marsha’s utility function, her utility with $64 of income is
UM=100($64)1/2+0.8(1,166.190), or UM=800+932.952=1,732.952. In this case, Sherry’s
utility increases from 1,000 to 1,166.190, while Marsha’s utility falls from 1,800 to
1,732.952. Social welfare increases with this redistribution, going from 2,800 to
2,899.142. Thus, this redistribution increases social welfare, but is not Pareto efficient
redistribution.
Chapter 8 – Expenditure Programs for the Poor
18
1. a. Note that the figure below shows the correct shape of the budget constraint, but
the numbers themselves are outdated. With a wage rate of $10 per hour,
Elizabeth earns $100. Because the deduction in California is $225, none of her
earnings are counted against the $645 welfare benefit. Thus, her total income is
$745 (=$100+$645).
b. The actual welfare benefits collected by a person equals B=G-t(Earnings-D), where

B=actual benefits, G=welfare grant, t=tax rate on earned income, and D=standard
deduction. Thus, (Earnings-D) is the net earnings that are taxed away in the form
of reduced benefits. When benefits equal zero (B=0), the expression becomes
0=G-t(Earnings-D), which collapses to: Earnings=G/t+D. This is known as the
“breakeven formula.” In the California context here, the expression becomes
Earnings=$645/0.5 + 225, or Earnings=$1,515. With a wage rate of $10 per hour,
this corresponds to 151.5 hours of work per month.
c. The diagram shows the correct shape of the budget constraint, but the “577” figure
should be replaced with “645” and the “9” hours should be replaced with “22.5”.
d. The diagram above shows one possibility – in this case, Elizabeth is both working
and on welfare – but she collects a reduced welfare benefit in this case.
2. One could gather data on the earnings of those in the program, as well as earnings data
from nonparticipants. Regress the earnings variable on demographic variables and other
factors that determine earnings (such as education and experience), and a variable that
indicates whether the individual participated in the training program. Factors that affect
local employment conditions, such as unemployment levels, may help explain earnings,
but they may also explain participation in the program. The econometric strategy should
be chosen carefully to account for this.
19
3. If the quantity of leisure consumed by X appears as an argument in the utility function of

Y, then X’s consumption of leisure creates an externality. If the externality is negative
(i.e., Y likes X to work), then a wage subsidy of X might induce him to work the efficient
number of hours. Alternatively, a workfare program might achieve the same goal by
simply forcing X to work. However, to the extent that the feasible quantity of labor
supply is determined less through market incentives now, workfare would be less
efficient.
4. He participates in the public housing program as long as P1P2ca>cef.
5. As illustrated below, the budget constraint with food stamps has a “notch” in it, similar to
the analysis of Medicaid in Figure 8.9 of the textbook. At the notch, the marginal tax rate
is greater than 100%. One key difference from the figure in the textbook is that the
marginal tax rate on earned income for Medicaid is 0% until the “Medicaid notch,” while
the marginal tax rate on earned income for food stamps is 24% until the “food stamp
notch.” The reason the food stamp notch exists at all is that there is a “gross income
test,” where a recipient is ineligible if income is higher than the limit. The
characterization in the Rosen textbook on page 189 that “at some point near the poverty
line, food stamps worth about $1,250 are suddenly lost” implicitly assumes that childcare
costs are quite high. This is likely to be true for many households. In the year 2004, this
monthly (annual) gross income limit was $1,994 per month ($23,928 per year) for a
family of four, while the monthly guarantee was $471 ($5,652 per year). Assuming the
family had earnings at the limit of $1,994 of earnings during the month, and after
applying a 20% earnings deduction and a $134 monthly standard deduction, the
household would receive a monthly (annual) benefit of $32 ($384). We arrive at this
number using the equation B=G-t(E-.2E-D)=471-.3(.8*1994-134)=$471-
$438.36=$32.64, which is then rounded down to $32. In this case, B=actual benefits
received, G=food stamp guarantee, t=tax rate, E=earnings, and D=standard deduction.
20
Increasing annual earnings by $1 from $23,928 to $23,929 would reduce food stamp
benefits from $384 to $0; hence the “food stamp notch.” This notch would be even
higher if the household qualified for a childcare deduction, child support deduction, or
shelter deduction. The childcare deduction ranges between $175 and $200 per child per
month. Assuming this family of four consisted of a mother and three children, each with
$175 of monthly childcare costs, then B=G-t(E-.2E-D-C)=471-.3(.8*1994-134-
525)=$471-$280.86=$190.14, which is then rounded down to $190. The modification
here is that C=childcare costs. This amount corresponds to an annual food stamp benefit
of $2,280. Figure 8.5 below draws the budget constraint using annual levels for the food
stamp program, using 2004 rules and assumes no childcare expenses.
FIGURE 8.5 – The food stamp “notch”

Other Goods or with 24% tax rate on earned income
Annual Income
Food stamp notch; eligibility

determined separately from
benefits. Notch = $384
Statutory food stamp

$23,928 maximum = $5,652
Leisure
6. For an individual who is not working while on welfare, in this case the highest
indifference curve touches the budget constraint on the right vertical axis. Note that the
marginal rate of substitution (MRS) does not necessarily equal the after-tax wage rate at
the time endowment – rather, it is possible that the person would want to consume more
leisure than the time endowment but is obviously constrained from doing so.
21
FIGURE 8.6 – Individual is on welfare and

does not work at all
Other Goods
Statutory TANF
benefit
U0
MRS>(1-t)w
Leisure
22
7. In all cases, the demand curve for housing slopes downward.

a. If the price of low income housing gets bid up but there is no increase in the stock
of housing, then the supply curve is perfectly inelastic, e.g., vertical.
FIGURE 8.7a – Demand curve shifts

outward, perfectly inelastic supply
PHOUSING
S
P1
P0
D1
D0
Q0
QHOUSING
23
b. If there is no increase in the price of housing, but there is an increase in the stock
of housing, then the supply curve is perfectly elastic, e.g., horizontal.
FIGURE 8.7b – Demand curve shifts

outward, perfectly elastic supply
PHOUSING
P0 S
D1
D0
Q0 Q1
QHOUSING
24
c. If there is an increase in both the price and quantity of housing, then the supply
curve slopes upward.
FIGURE 8.7c – Demand curve shifts outward,

upward sloping supply curve
PHOUSING
P1
P0
D1
D0
Q0 Q1
QHOUSING
According to Sinai and Waldfogel, there is partial crowding out, consistent with case c
above. Although the underlying housing stock itself is probably quite inelastic in the
short-run, the number of rental homes can be more elastic as (potential) landlords convert
vacation homes or vacant homes into rental units.
8. a. When Eleanor’s hours (earnings) go from 0 to 1,000 ($0 to $8,000), she qualifies
for an additional earned income tax credit (EITC) worth $3,200 (=0.4*8,000).
Thus, her income goes up from $0 to $11,200. Note to instructors – the
distinction between earnings and income may cause confusion in the students’
answers.
b. When Eleanor’s hours (earnings) go from 1,000 to 1,500 ($8,000 to $12,000), she
qualifies for the maximum EITC (according to Figure 8.8 in the textbook). She
receives the full EITC when her earnings exceed $10,510, at which time the credit
equals $4,204 (=0.4*$10,510). The earnings between $10,510 and $12,000 face
neither a subsidy nor phase-out from the EITC. Thus, her income goes up from
$11,200 to $16,204.
c. When Eleanor’s hours (earnings) go from 1,500 to 2,000 ($12,000 to $16,000),

she moves into the range where the EITC is phased out. According to Figure 8.8
25
in the textbook, she receives the maximum subsidy of $4,204 until her earnings
exceed $14,730. For the marginal earnings between $14,730 and $16,000, the
EITC is reduced at a 21.06% tax rate. Thus, her EITC falls by $267.46 from
$4,204 to $3,936.54 (=4,204-0.2106*(16,000-14,730)). Her income rises from
$16,204 to $19,936.54.
Chapter 9 – Social Insurance I: Social Security and Unemployment Insurance
1. With adverse selection, insurance contracts with more comprehensive coverage are
chosen by people with higher unobserved accident probabilities. To make up for the fact
that a benefit is more likely to be paid to such individuals, the insurer charges a higher
premium per unit of insurance coverage.
2. There are many possible implications of a voluntary Social Security system. One
possibility is that people would save less for retirement, betting that society would not put
up with having great numbers of elderly poor. Part of the effect of the Friedman
program, then, would depend on the government's credibility when it promises not to bail
out people who do not save enough to survive during retirement.
3. Use the basic formula for balance in a pay-as-you-go social security system:
t =(Nb/Nw)*(B/w).
Call 1990 year 1 and 2050 year 2. Then

t1 = .267*(B/w)1
t2 = .458*(B/w)2
It follows that to keep (B/w)1=(B/w)2 we require t2/t1=.458/.267=1.71. That is, tax rates
would have to increase by 71 percent. Similarly, to keep the initial tax rate constant, we
would require (B/w)2/(B/w)1=.267/.458=0.58. Benefits would have to fall almost by half.
4. If Social Security benefits are partially taxed for those who have other income over a
certain level, then there is an implicit means test in receiving full, untaxed benefits.
However, there is no explicit means test for eligibility for the program. Everyone
receives benefits, though some recipients must pay some tax on them. Thus, the two
statements are somewhat inconsistent with each other.
5. Austen’s quote seems like it could relate adverse selection, but perhaps more likely, to
moral hazard. The quote “If you observe, people always live forever when there is any
annuity to be paid them” in a sense sounds like they act differently (e.g., better diet, more
exercise, etc.) when an annuity is to be paid – the idea of moral hazard. In contrast,
adverse selection suggests that people who expect to live a long time to be the ones who
purchase annuities. A recent paper by Finkelstein and Poterba (NBER working paper,
December 2000) found that “mortality patterns are consistent with models of asymmetric
information” and that annuity “insurance markets may be characterized by adverse
selection.”
26
6. Equation (9.1) relates taxes paid into the Social Security system to the dependency ratio
and the replacement ratio, that is, t=(Nb/ Nw)*(B/w). If the goal of public policy is to
maintain a constant level of benefits, B, rather than a constant replacement ratio, (B/w),
then taxes may not need to be raised. If there is wage growth (through productivity), then
it is possible to maintain B at a constant level, even if the dependency ratio is growing.
By rearranging the equation, we can see that B=t*w*(Nb/ Nw)-1. That is, increases in
wage rates (the second term) offset increases in the dependency ratio (the third term).
Thus, constant benefits do not necessarily imply higher tax rates.
7. The statement about how the different rates of return in the stock market and government
bond market affect the solvency of the trust fund is false. If the trust fund buys stocks,
someone else has to buy the government bonds that it was holding. So, there is no new
saving and no new capacity to take care of future retirees.
8. Diamond and Gruber’s calculations suggest that the additional year of work (and delayed
retirement) lowers the present discounted value of expected Social Security wealth by
$4,833. If the adjustment were actuarially fair, Social Security wealth would neither rise
nor fall. Since wealth falls, the adjustment is actuarially unfair.
9. For those who argue that the scheme for financing Social Security is unfair because
people with low earnings are taxed at a higher rate than those with high earnings, the key
issue is that the cumulative payroll tax of 12.4 percent is capped for each person, after
which the payroll tax is zero (this ignores the 2.9 percent uncapped Medicare tax,
however). The earnings ceiling in 2004 is $87,900. Hence, Social Security payroll taxes
as a share of earnings fall after the ceiling is passed – thus, the Social Security payroll tax
may be thought of as regressive. The opponents to this view note that the above analysis
only focuses on taxes paid, not benefits received. As shown in Table 9.3, Social Security
redistributes from high earners to low earners, and the formula for the primary insurance
amount offers extremely high replacement rates to very low earners, and much lower
replacement rates to high earners. Thus, the net tax payment (taxes minus benefits) is
likely to be progressive, not regressive. One critical assumption in this kind of analysis is
how one computes lifetime benefits – e.g., do we assume that low earners and high
earners live the same number of years?
10. Let G stand for the individual’s gross earnings. The question assumes that the person
faces a marginal tax rate of 15% and a payroll tax of 7.45%. Thus, the person’s after-tax
earnings (denoted by N) are N=(1-tearn-tpayroll)G, or N=(1-0.15-0.0745)G, or N=0.7755G.
It is assumed that the gross unemployment benefits, U, are equal to 50 percent of before-
tax earnings, or U=0.5G. Net unemployment benefits, B, take out income taxes, so B=(1-
tearn)U=(1-tearn)0.5G=(1-0.15)0.5G=0.425G. The percentage of the individual’s after-tax
income that is replaced by UI is therefore equal to B/N, or 0.425G/0.7755G, which is
approximately 54.8%. Unemployment benefits are about 55% of the individual’s
previous after-tax income. The effects of unemployment insurance on unemployment are
a matter of considerable debate. While the high replacement rates from UI may increase
the duration of unemployment, the longer search time may reduce recurrence of
unemployment by allowing time for a worker to find a better job match. Empirical
27
studies seem to show that the hazard rate into employment spikes up around the time that
benefits run out – perhaps suggesting that job matches are not really improving.
Chapter 10 – Social Insurance II: Health Care
1. The quotation contains several serious errors. First, concern with health care costs does
not mean that health care is not a “good.” Economists do not care about the cost of
health care per se. Rather, the issue is whether there are distortions in the market that
lead to more than an efficient amount being consumed. Second, it makes a lot of
difference how money is spent. One can create employment by hiring people to dig
ditches and then fill them up, but this produces nothing useful in the way of goods and
services. Thus, employment in the health care sector is not desirable in itself. It is
desirable to the extent that it is associated with the production of an efficient quantity of
health care services.
2. a. Those who have a relatively high probability of needing the insurance are the ones
who are most likely to buy it. This raises the premium, which in turn, leads to
selection by people who have an even higher probability of using it. The cycle
continues until the price is so high that virtually no one purchases the policy.
b. Employer-provided health insurance is deductible to the employer and not taxed to

the employee.
c. Because of the tax subsidy, individuals may purchase more than the efficient amount
of health insurance. That is, they “over-insure.” An interesting example of how
the tax system leads to overinsurance is given in a recent Wall Street Journal
(January 19, 2004) article by Martin Feldstein. He gives an example of two
different California Blue Cross health plans – identical in all respects except for
the deductible and annual premiums. The low-deductible plan (the “generous”
plan) has a deductible of $500 per family member, up to a maximum of two and
an annual premium of $8,460. Thus, the maximum out-of-pocket expense is
$1,000. The high-deductible plan (the “less generous” plan) has a deductible of
$2,500 per family member, up to a maximum of two, and an annual premium of
$3,936. Thus, the maximum out-of-pocket expense is $5,000. Note that the
premium savings of $4,524 actually exceeds the maximum incremental deductible
payment of $4,000 (which would only occur if the family had very high health
expenses). In principle, the high deductible plan is unambiguously better. But the
traditional tax rules could lead an employer to choose the low deductible policy.
If the employee faced a marginal tax rate of 45% (the sum of federal, state, and
payroll tax rates), then if the $4,524 premium saving was turned into taxable
salary, the individual’s net income would only rise by $2,488. Thus, families with
high expected medical expenses do better with the “generous” plan, even though it
is more costly in terms of premiums.
3. a. Dd=4.22–(0.044)(50)=2 visits per year.

Total expenditure =(2)(50)=$100
28
b. Now the individual pays only $5 per visit.

Dd = 4.22 – (0.044)(5) = 4 visits, with out-of-pocket costs of $20.
Insurance company pays ($45)(4) = $180
Total expenditure = $200, double its previous level.
4. Examining Figure 10.1, we can see why health care costs increased for the state of
Tennessee. As insurance coverage increases, this lowers the cost of medical expenses for
those who were previously did not have insurance, which increases the overall amount of
medical services they consume. Before receiving insurance, these people demand Mo
units of medical services, and the amount they pay is represented by the area OPoaMo.
But after receiving insurance coverage, they demand M1 amounts of medical services,
paying only OjhM1, while their insurance pays jPobh. The increase in insurance
payments is sizable for two reasons – first, by providing coverage, it pays for the majority
of the already sizable medical expenses incurred by this group, and second, the
introduction of insurance makes the group consume even more medical services. In
short, if the people who designed the Tennessee program had realized that the demand
curve for medical services is downward sloping, they would not have been surprised at
the consequences of their program.
To explain why HMOs have been unable to contain long-run health care costs, it is
necessary to consider the effect of technology on health care costs in the long-term. The
inherent problem is that the market for medical care places a large premium on using the
latest and most-developed medicines and machinery for treating patients. These
technologies tend to be expensive. Hence, while introducing HMOs can lead to a once
and for all decrease in the rate of change in health care costs, there is nothing that an
HMO can do to lower the cost of continually providing the latest in medical treatments.
5. The goal of making the Medicare prescription drug benefit a one-time, permanent
decision is to reduce the adverse selection problem (note: the current “Medigap”
program operates in this manner to some extent – a senior citizen has choice over all 10
of the Medigap plans for only a short period of time after they turn 65, after which they
may be denied based on their health). Imagine a cohort of people turning age 65 and
becoming eligible for the Medicare drug benefit. If the decision to enter (or exit) could
be made every year, then healthy senior citizens would have a strong incentive to wait
until they became unhealthy and needed drugs, and then enter the prescription drug
program (presumably resulting in economic losses for the program). Similarly, when
people who were collecting the prescription drug benefit became healthy, they would
have a strong incentive to “opt-out” of the program. By making the decision opt-in at the
beginning or not at all, the healthy younger seniors are likely initially cross-subsidizing
the older seniors. Note that this “opt-in at the beginning” works because bad health and
older age are positively correlated with each other. If, for example, younger seniors used
more drugs (and perhaps older seniors used more inpatient care, etc.), then older seniors
could simply stop paying annual premiums and give up their option of being in the
program. If this scenario held empirically, this would exacerbate the adverse selection
problem and the opt-in scenario would not completely solve the adverse selection
problem.
29
30
6. The budget constraint initially has units of Medigap on the x-axis, and other goods on the
y-axis. Given initial prices of $1 per unit for each good, and $30,000 of income, the
budget constraint has a slope of -1, and the intercepts on both axes are at 30,000 units. It
is assumed that the initial utility maximizing bundle consumes 5,000 units of Medigap,
hence the indifference curve is tangent at (5000,25000). All of this is illustrated in the
figure below.
FIGURE 10.6a – Medigap choice without

minimum standards
Other Goods
30,000
25,000
U0
5,000 30,000
Medigap
efficiency units
31
After the “minimum Medigap” mandate, the consumer can either choose 0 units of
Medigap or 8,000 or more units of Medigap. Thus, part of the budget constraint is
eliminated (though the overall shape remains the same as before). After the mandate, the
point (0,30000) is available, as well as all of the points to the southeast of the point
(8000,22000). Clearly, the person’s utility must fall since the preferred choice,
(5000,25000) is no longer available. If the person attains a higher level of utility as
(0,30000) compared with (8000,22000), the person chooses to not purchase Medigap. In
this case, the marginal rate of substitution is no longer equal to the price ratio. This is
illustrated below.
FIGURE 10.6b – Medigap choice with

minimum standards; no Medigap is
Other Goods purchased
30,000
25,000
U0
22,000 U1
5,000 8,000 30,000

Medigap
efficiency units
32
7. a. The gross price of insurance is $2, but since insurance is bought with pre-tax
dollars, the effective price of insurance is (1-t)P, where t is the marginal tax rate.
Since Connor’s marginal tax rate is 25%, the effective price of insurance is lower,
only (1-.25)*$2, or $1.50 per unit. At $1.50 per unit, and using the demand curve
of Q=100-8P, this implies that Connor buys Q=100-8($1.50)=88 units of
insurance.
b. If insurance is no longer excluded from taxation, the effective price rises to $2 per
unit. In this case, Connor buys Q=100-8($2)=84 units of insurance.
c. The exclusion of health insurance from taxation lowers its effective price – as
long as the demand for health insurance slopes downward, then lower prices lead
to higher demand for insurance. This can be viewed as “over-consumption” if the
assumptions of the First Fundamental Welfare Theorem hold, which suggests that
the private market allocation without subsidies or taxes yields the Pareto efficient
allocation. On the other hand, there may be (weak) reasons based on the
Fundamental Welfare theorem, there should be a tax subsidy for health insurance.
The main reason would probably be if we thought that health insurance had
positive externalities, which might be possible with communicable diseases.
There are other reasons why government intervention may be warranted in health
insurance markets (e.g., asymmetric information), but it is not obvious that these
reasons lead to the tax subsidy we observe in the U.S.
Chapter 11 – Cost Benefit Analysis
1. Yes, one really must ask these questions, although it may seem distasteful. Otherwise,
there is no way to determine which safety precautions are sensible.
2. The increased time spent at the inspection must be counted as a cost of the program. One
reasonable way to estimate the value of the time would be to use the average wage rate in
the state, and multiply this by the incremental waiting time of 105 minutes.
3. The present value of $25/.10 = $250.

The present value of the perpetual annual benefit = B + B/(1 + r) + B/(1 + r)2 + … = B (r
+ 1 - r)/r = B/r.
4. a. 1,000=80/ρ
ρ =.08
b. If the money comes from consumer spending, use after-tax rate of interest as the
discount rate:
80 - 1,000 = 600 > 0.

.05
The project is admissible.
33
If the money comes from investment, use before-tax rate of interest as the discount
rate:
80 - 1,000 = -200 < 0.

.10
The project is not admissible.
In the “mixed case,” for a discount rate, take a weighted average: .6 x 10% + .4 x
5% = 8%.
80 - 1,000 = 0.
.08
There is no net advantage to undertaking the project.
c. Benefits = 80/.04 = 2,000. Present value of project = 2,000-1,000=1,000.
d. If inflation is fully anticipated, and if market interest rates increase by 10 percentage

points, nothing changes in real terms.
5. a. Bill is willing to pay 25 cents to save 5 minutes, so he values time at 5 cents per
minute. The subway saves him 10 minutes per trip, or 50 cents. The value of 10
trips per year is $5. The cost of each trip is 40 cents, or $4 per year. The annual
net benefit to Bill is therefore $1. The present value of the benefits = $5/.25 =
$20; the present value of the costs is $4/.25 = $16.
b. Total benefits = $20x55,000=$1,100,000.

Total costs = $16x55,000 = $880,000.
Net benefits = $220,000.
c. Costs = $1.25 x 55,000 = $68,750.

Benefits =($62,500/1.25) + ($62,500/1.252) = $90,000.
Net benefit = $21,250.
d. The subway project has a higher present value. If a dollar to the “poor” is valued
the same as a dollar to the “middle class,” choose the subway project.
e. Let λ = distributional weight. set

220,000 = -68,750 + λ [(62,500/1.25) + (62,500/1.252)]
λ = 3.21
This distribution weight means that $1 of income to a poor person must be viewed
as more important than $3.21 to the middle class for the legal services to be done.
6. The report for the Czech government that simply computed the savings to the
government for retirees from smoking is inadequate. After all, if one simply counts as
“benefits” money saved from transfers, then having all of the retirees die would be
considered an enormous benefit. What this analysis obviously missed is the “value of
34
life.” If one computed the value of a life simply based on lost earnings, however, the
retirees would suffer no loss. As the textbook mentions on page 255, this method is
rejected by most economists. The method that is frequently used by economists is the
“value of a statistical life,” which (among other things) compares compensating wage
differentials to the probability of death. Viscusi and Aldy (2003) find that the value of
statistical life ranges between $4 million and $9 million. One could convert these values
from a lifetime into each year of life, to form some estimate of the “cost” of smoking.
7. As discussed on pages 257-8 of the textbook, one of the “games” that cost-benefit
analysts play is viewing the wages paid to labor as a benefit not a cost. This is clearly
wrong. The fact that 1,000 people need to be hired to do the recycling in New York is a
cost of the program, not a benefit.
8. Currie and Gruber (1996) find the cost of the expansion per life saved was approximately
$1.6 million. According to Viscusi and Aldy (2003), the value of a statistical life is
between $4 million and $9 million. If all of these calculations are correct, then the
Medicaid expansion passes a cost-benefit test.
Chapter 12 – Taxation and Income Distribution
1. The incidence of the subsidy depends on the elasticities of the supply and demand curves.
Here the price received by sellers increases from P0 to P1. Buyers also benefit – their
price falls from P0 to P2. In evaluating the claims that energy subsidies to low-income
families do not benefit industry, the figure below could be modified by shifting the
demand curve rather than the supply curve. Nonetheless, what is clear from the diagram
is that demand is relatively inelastic, while supply is more elastic. Thus, the subsidies to
low-income families do benefit the industry.
2. These reports about demand sensitivity suggest that there is a very elastic demand curve
for goods sold over the Internet. Because of this high elasticity, the incidence of a tax
levied on Internet sales is primarily borne by producers, not consumers.
35
3.
4. One expects that those factors that are used intensively in tobacco production will bear
the burden of the tax. Assuming, for example, that tobacco production is capital-
intensive, one expects owners of all capital (not just those with investments in tobacco) to
bear some of the burden.
5. a. Set 2000 – 200P = 200P, so P = $5 and Q = 1000 packs
b. Consumer price = Producer Price + $2. Let P be the producer price.

2000 – 200 (P + 2) = 200 P.
Producer receives $4 per pack; consumer pays $6 per pack.
Quantity sold = (200)(4) = 800 packs.
Tax revenue = (tax/pack)(no. of packs) = (2)(800) = $1600.
6. The equilibrium price can be calculated by setting the quantity supplied equal to the
quantity demanded:
(i) QD = a - bP
(ii) QS = c + dP
If QD = QS, then the equilibrium price can be determined as follows:
a − bP = c + dP
a − c = (b + d ) P
a −c
P=
b +d
The equilibrium output can be determined by substituting the equilibrium price into either
the supply or demand equation.
36
Substituting into the demand equation:

Q = a − bP
 a −c 
Q = a − b 
b + d 
Substituting into the supply equation:
Q = c + dP
 a −c 
Q = c + d 
b +d 
If a unit tax of u dollars is imposed on the commodity, then it doesn’t matter which party
it is imposed upon (the consumer or producer); the new equilibrium will be the same in
a 1 a 1
PC = −  Q P CT = −  Q + u
b b b b
either case. If the unit tax is imposed upon the consumer, then the price the consumer
pays is u higher than the price received by the supplier. The consumer’s price without
the tax, PC, and price that includes the tax, PCT, are:
Similarly, the price received by the producer in the absence of the tax, P P, is u lower than
the price received with the imposition of the tax, PPT. These prices are expressed below:
1 c 1 c
P P =  Q − P PT =  Q − − u
d  d d  d
The equilibrium that prevails after the imposition of the tax can be found by setting PCT =
PP or PC = PPT -- in the end, both approaches will yield the same answer. First, we can
derive the solution setting PCT = PP:
P CT = P P
a 1 1 c
−  Q + u =  Q −
b b  d  d
a c 1 1 
+ + u =  + Q
b d b d 
da + bc + dbu  b + d 
= Q
db  db 
da + bc + dbu
Q=
b+d
Next, setting PC = PPT:
37
P C = P PT
a 1 1 c
−  Q =  Q − − u
b b  d  d
a c 1 1 
+ + u =  + Q
b d b d 
da + bc + dbu  b + d 
= Q
db  db 
da + bc + dbu
Q=
b+d
Therefore, both approaches lead to the same outcome.
7. Equation (12.1) relates progressiveness, v1, to average tax rates. Assume throughout that
I1>I0>0. Then progressivity is measured by v1=[(T1/I1)- (T0/I0)]/(I1-I0). With a $300 lump
sum tax refund for all earners, the progressivity changes to v1’=[((T1-300)/I1)- ((T0-
300)/I0)]/(I1-I0). Rearranging, we have v1’= v1+[(300/I0)-(300/I1)]/(I1-I0). Thus, the
progressivity differs only by the second term, [(300/I0)-(300/I1)]/(I1-I0). This second term
is positive because (300/I0)>(300/I1). Thus, v1’>v1, and average tax rates increase with
income by more when a $300 lump sum tax refund is given. Intuitively, the average tax
rate falls by more for a low-income person from a lump sum tax reduction. Equation
(12.2) relates progressiveness, v2, to the elasticity of tax revenue with respect to income.
Then progressivity is measured by v2=[(T1-T0)/T0]/[(I1-I0)/I0]. With a $300 lump sum tax
refund for all earners, the progressivity changes to v2’=[(T1-300-T0+300)/(T0-300)]/[(I1-
I0)/I0]= [(T1-T0)/(T0-300)]/[(I1-I0)/I0]. Note that v2’ differs from v2 only by the term (T0-
300). Thus, the numerator of v2’ is larger than v2, while the denominator is the same.
Thus, v2’>v2, and the tax system is more progressive under the second measure as well
when the lump sum tax refund is given.
8. The equation T=-4000+.2I is somewhat similar to the exercise in Table 12.1 on page 277
of the textbook. If we follow the text and define progressivity with respect to average tax
rates rather than marginal tax rates, then the average tax rate equal ATR=(-4000/I)+.2 for
any income level. Clearly this average tax rate converges to ATR=20% as income gets
large, and is lower for lower income levels. Replicating Table 12.1 for the tax system
given here, we get:
Income Tax Liability Average Tax Rate Marginal Tax Rate

$2,000 $-3,600 -1.80 0.2
3,000 $-3,400 -1.13 0.2
5,000 $-3,000 -0.60 0.2
10,000 $-2,000 -0.20 0.2
30,000 $2,000 0.066 0.2
38
9. With the schedule T=a+tI, the average tax rate as a function of income is
ATR=T/I=(a+tI)/I=(a/I)+t. A progressive tax system, using equation (12.1), means that
the average tax rate goes up with income, or dATR/dI>0. Taking derivatives, dATR/dI=-
a/I2>0, which implies –a>0 or a<0. Thus, with a linear tax schedule, a negative
intercept, a, implies progressivity. Similarly, a regressive tax system implies dATR/dI<0
or dATR/dI=-a/I2<0, which implies –a<0 or a>0. Thus, with a linear tax schedule, a
positive intercept, a, implies regressivity.
10. a. After New York City increased the tax from $0.08 to $1.50 per pack of cigarettes,
the quantity demanded went down and revenues went up. Define TR1 as the total
revenue after the tax, and TR0 as the total revenue before the tax. Then TR0=QP
and TR1=(Q-dQ)(P+dP)=QP+QdP-PdQ-dQdP. Ignore the last term, dQdP,
which is of second order importance. Then dTR=QdP-PdQ. If this change in
revenue is positive, then dTR=QdP-PdQ>0, or QdP/PdQ>1. Thus (1/εD)>1 or
εD<1. Thus, the absolute value of the elasticity of demand is less than 1, or
demand must be inelastic in this case.
b. The spokesman’s comment was made just one month after the tax increase was
enacted. As more time passes and consumers are able to adjust (e.g., by quitting
smoking, substituting to other forms of tobacco that are not taxed in the same
way, etc.), it is expected that the long-run elasticity of demand for cigarettes will
be larger in absolute value (e.g., become relatively more elastic), and revenues
will likely fall.
11. Even though the statutory incidence of the $51 per month per domestic-help tax is on the
employers, the tax may very well be borne primarily by the foreign domestic-help
workers. This could happen if the demand for the foreign domestic-help workers is
relatively elastic and/or the supply of foreign domestic-help workers is relatively
inelastic. One might imagine, for example, that native domestic-help is a good substitute
for foreign domestic-help, and thus, demand for foreign domestic-help is quite elastic.
Thus, wages of foreign workers are likely to fall, assuming there is no minimum wage in
Hong Kong (if there was a minimum wage, it is likely that employment would fall).
Thus, the Philippine president was correct to be disturbed, because the economic
incidence falls on his countrymen. The figure below illustrates the likely situation with
relatively inelastic labor supply and relatively elastic labor demand.
39
FIGURE 12.11 – Economic incidence of tax on

Hong Kong foreign workers
wFOREIGN
S
wg
w0
tax=$51
wn
D0
D1
Q1 Q0
QFOREIGN
Chapter 13 – Taxation and Efficiency
1. a. Since land is fixed in supply, we expect no excess burden when it is taxed. The
supply curve is inelastic.
b. There are fairly good substitute for cell phones. Therefore, their demand is quite
elastic, and a tax on them will have a substantial excess burden, relative to the size
of revenues collected.
c. Without knowing exactly what “high-tech” means, it is likely that many companies
could relabel themselves as high-tech in order to receive the subsidy. Thus, the
supply is quite elastic, and there will be substantial excess burden.
d. A tax on economic profits does not affect behavior, and hence has no excess burden.
e. & f. A tax on all computer software will have a smaller excess burden (relative to
revenues collected) than a tax on one particular type of software like the Excel
spreadsheet. This is because it is easier to substitute away from one type of
software than software in general.
2. Equation (13.4) computes the excess burden of a tax on labor, which equals ½εwL1t2.
Thus, when taxes are lowered from 39.9% to 34%, the ratio of the excess burden triangles
differs only by the last term, the square of the tax rate. Thus, (34/39.9) 2 =.726. So, under
40
the new regime, excess burden is only 72.6 percent of the excess burden under the old
regime.
3. The quote is misleading. The way in which the presence of the t-squared makes the tax
more “important” is that when the tax increases, the excess burden increases with its
square. Thus, when the tax doubles, the excess burden quadruples.
4. Figure 13.9 shows how a tax on market activity leads to "too much" nonmarket activity.
More generally, the model shows that when different sectors are taxed at different rates,
the allocation of resources is distorted, and real income falls as a result. The more
pervasive distortionary taxes are in an economy, the more severe the misallocation of
resources, and the lower is real income. Hence, it is no surprise that economies with a lot
of distortionary taxes tend to grow relatively slowly.
5. It is likely that the elasticity of demand for television is quite inelastic. It follows that the
excess burden from a $160 per year television tax is small relative to the revenues that are
collected.
6. Figure 13.6 from the textbook is reproduced below, with a perfectly elastic supply curve
and a downward sloping demand curve. The market price of corn is $2.25 a bushel,
while the subsidy is 50 cents; thus the cost of corn is $2.75 a bushel. The excess burden
is given by ovu in the figure.
FIGURE 13.6 – Incidence of a corn subsidy

with perfectly elastic supply
PCORN
Excess burden from subsidy
o v
P0=$2.75 S0
u
P1=$2.25 S1
Q0 Q1
QCORN
41
7. a. The value of the marginal product of capital in the corporate sector is given by
VMPc=100-Kc, and the value of the marginal product of capital in the
noncorporate sector is given by VMPn=80-2Kn. With 50 units of capital
altogether in society (Kc+Kn=50), and no taxation, capital should be allocated
so that the values of the marginal products in each sector are equalized. Thus,
setting VMPc=VMPn gives 100-Kc=80-2Kn and substituting in the constraint of
50 units gives 100-50+Kn=80-2Kn or Kn=10. This implies that Kc=40. This is
illustrated below:
FIGURE 13.7a – Allocation of capital to

the corporate and non-corporate sectors
VMPCORPORATE VMPNONCORPORATE
100
80
VMPN=80-2KN VMPC=100-KC
KC=40
QCORPORATE QNONCORPORATE
KN=10
b. If a unit tax of $6 is leveled on capital employed in the corporate sector, the after-
tax value of the marginal product in the corporate sector falls. It is now given by
VMPc’=100-Kc-6=94-Kc. Now setting VMPc’=VMPn gives 94-Kc=80-2Kn and
substituting in the constraint of 50 units gives 94-50+Kn=80-2Kn or Kn=12. This
implies that Kc=38. This is illustrated below:
42
FIGURE 13.7b – Reallocation after per-

unit tax on corporate capital
VMPCORPORATE VMPNONCORPORATE
100
94
80
Excess burden from

$6 per unit tax
VMPN=80-2KN
VMPC=94-KC
KC=38
QCORPORATE QNONCORPORATE
KN=12
Thus, ΔK=2 and the tax wedge is t=$6, so the excess burden is ½(2)($6)=$6.
8. With a conventional supply and demand model, where the supply curve slopes upward
and the demand curve slopes downward, the excess burden of a unit tax (in this case,
imposed on demanders) is similar to Figure 12.2 (page 280) of the textbook. The shaded
yellow area in the figure below (corresponding to fgh in the textbook) is the excess
burden, and shaded pink area below (corresponding to kfhn in the textbook) is the tax
revenue.
43
FIGURE 13.8 – Excess burden of a unit tax

imposed on demanders
P
S
tax revenue
Pg
excess burden
P0
unit tax
Pn
D0
D1
Q1 Q0
Q
Chapter 14 – Efficient and Equitable Taxation
1. Assuming that all other commodities (except for cable and satellite television) were
untaxed, then optimal tax policy suggests the commodities should be taxed according to
the inverse elasticity rule. Goolsbee and Petrin (2001) find that the elasticity of demand
for basic cable service is -0.51, and the demand for direct broadcast satellites is -7.40.
Applying the inverse elasticity rule would imply that
(tBASIC/tSATELLITE)=(ηSATELLITE/ηBASIC)=(7.40/0.51)=14.5. Thus, tax rates on basic cable should
be 14.5 times higher than tax rates on satellite television because basic cable is
inelastically demanded, while demand for satellite television is highly elastic. Among the
assumptions that go into the inverse elasticity rule are that goods are neither complements
nor substitutes, and that the elasticities are the Hicksian compensated elasticities rather
than the Marshallian uncompensated elasticities. In this case, it is likely that the first of
these assumptions is false – basic cable and satellite television are likely substitutes for
each other. The Hicksian and Marshallian demand elasticities are likely to be close to
each other because the income effects are likely to be small for this commodity.
2. Although the tax schedule is progressive, the incidence is not clear at all. This is
determined by the relative demand and supply elasticities for expensive cars. One may
argue that behavior will be distorted only at the margin, and hence demanders largely
bear the burden. However, administration of this tax would not be straightforward: One
could imagine methods of evasion such as misrepresenting invoices or selling the car in
parts!
44
3. The beard tax was progressive because it was a function of social position. It’s hard to
know about the efficiency consequences unless one knows more about the price elasticity
of demand for the privilege of having a beard. If the elasticity was small, then it would
be an efficient tax. However, conventional notions of horizontal equity suggest that the
tax was unfair.
4. If the nut fee is truly collected whether or not the farmer collects nuts, then it is
independent of the farmer's behavior. Hence, it is a lump-sum tax, and perfectly efficient
(unless it drives some individuals out of farming). However, optimal tax theory tells us
that we must consider equity as well as efficiency considerations. If the fee is the same
for all households, regardless of their incomes, then it is regressive. With a conventional
utilitarian welfare function, this is unlikely to be optimal. Because farmers who are not
alike in relevant aspects (e.g., income) pay the same tax, the nut tax would seem to
violate horizontal equity. Things become even worse when we bring city-dwellers, who
don't have to pay the nut tax at all, into the picture.
Moral: An efficient tax need not be optimal or horizontally equitable.
5. One could use Figure 14.5 on page 351, on tax evasion, to understand this phenomenon.
The horizontal axis now represents the amount of underreporting of the value of
commodities, and the vertical axis represents the cost in dollars. Fisman and Wei (2001)
find that in the case of China, a 1 percent increase in the tax rate results in a 3 percent
increase in evasion (by “reclassifying” a commodity as a lower-taxed commodity). The
1 percent increase shifts up the MB curve, which leads to a new intersection between MB
and MC, and a higher R*, which was found to be 3 percent higher.
45
FIGURE 14.5 – Underreporting of

commodities in China due to tariffs
$ savings
MC
MB1=t+.01
MB0=t
R* 1.03R*
Amount of
underreporting
6. Figure 14.5 equates the marginal benefit of underreporting $1’s worth of income to the
marginal cost. The marginal benefit is equal to the taxes saved, which is simply the
person’s marginal tax rate, or MB=t. The expected marginal cost of underreporting $1 of
income is equal to the product of the probability of getting caught and the fine per dollar
of underreporting, or MC=ρ*Marginal Penalty. As shown in Figures 14.5 and 14.6, the
optimal amount of underreporting, R* equals zero if MC≥MB. Thus, if ρ*Marginal
Penalty≥t, then there will be no underreporting. With ρ=0.02 and t=0.36, the inequality
becomes 0.02*Marginal Penalty≥0.36, or Marginal Penalty≥$18. With a fine of $18 (or
more), Sharlene would not cheat on her taxes. The figure below illustrates this case.
46
FIGURE 14.6 – Fine that induces no

underreporting
$ savings
MC=ρ*MP=0.02*$18
MB=t=0.36
R*=0
Amount of
underreporting
7. The one-time tax of 14.25 percent on net wealth over $10 million is similar to a lump
sum tax and would, on the surface, be efficient. In principle, such a one-time policy
should not affect current incentives to save for the future. As discussed on page 344,
however, such a policy would run into the problem of “time inconsistency of optimal
policy.” The government would have an incentive to renege on its promise that the tax
would only be levied once, because it could conceivably raise more money without
excess burden. Thus, the government’s incentives are inconsistent with the stated policy,
and capitalists realize this and adjust accordingly.
8. a. It is true that a proportional tax on all commodities (including leisure) is

equivalent to a lump sum tax. To illustrate, consider the simplest example where
there are only two goods: consumption goods and leisure. The budget constraint
is equal to: pCC+wL=I, where pC and w are the prices of consumption goods and
leisure, C and L are the quantities of consumption and leisure, and I is income.
Then a proportional tax on all goods changes the budget constraint to: (1-
τ)pCC+(1-τ)wL=I, or rearranging, pCC+wL=I’, where I’=I/(1-τ)<I. Thus, a
proportional tax on all goods does not change relative prices and is equivalent to
taking away income. So it is equivalent to a lump sum tax.
b. It is (usually) false that efficiency is maximized when all commodities are taxed
at the same rate; this will not be true if leisure is untaxed. Imagine a more
complicated budget constraint: pCC+pFF+wL=I. If leisure cannot be taxed, then
47
a tax on commodities leads to a budget constraint of (1-τ)pCC+(1-τ)pFF+wL=I,

which does change the relative price of leisure compared with food or
consumption goods. Thus, it is not a lump sum tax. Instead, the inverse elasticity
rule given in equation (14.9) on page 333 of the textbook would suggest that the
ratio of the tax rates are inversely related to the ratio of the compensated demand
elasticities for all commodities that can be taxed. That is, (tC/tF)=(ηF/ηC).
c. It is true that average cost pricing for a natural monopoly allows the enterprise to
break even, but the outcome is inefficient. Figure 14.3 in the textbook on
page 338 shows the typical natural monopoly problem, with an initial fixed cost,
and an ever-declining marginal cost curve. In this case, the average cost curve is
always declining, but above the marginal cost curve. Setting P=AC results in an
output level of ZA and zero economic profits. The figure illustrates, however, that
the marginal benefit of more output exceeds the marginal cost, so the efficient
level of production occurs at P=MC, or an output level Z*>ZA. The deadweight
loss is the area between the demand curve DZ and marginal cost curve, going from
ZA to Z*. If output were at the efficient level, however, there would be economic
losses rather than zero profits.
d. One notion of horizontal equity is that people in equal positions should be treated
equally by the tax system. Under this traditional notion of horizontal equity, the
fact that Tom’s workplace provides free access to a fitness room suggests this
kind of compensation should be taxed; Jerry pays “full taxes” on his
compensation while Tom does not. Another notion of horizontal equity relies on
the utility definition of horizontal equity. This concept says that if two individuals
have the same utility without taxes, they should have the same utility with taxes,
and the taxes should not affect the utility ordering. One implication of the utility
definition is that any existing tax structure does not violate the notion of
horizontal equity if individuals are free to choose their activities and expenditures.
If Tom and Jerry have free choice between the two different jobs (and identical
preferences), then the net after-tax rewards (including amenities) must be the
same at both jobs; otherwise there would be migration. In this case, the before-
tax wage on Tom’s job adjusts for the fact that there is a fringe benefit.
Chapter 15 – The Personal Income Tax
1. The Haig-Simons definition of income is the net change in the individual’s power to
consume during a given period. This criterion suggests the inclusion of all sources of
potential increases in consumption and also implies that any decreases in an individual’s
power to consume should be subtracted in determining income. Overall, it reflects the
broadest possible base of income. Allowing capital losses of $5,000 to be deductible
against other forms of income, rather than the current $3,000, would move the tax system
more in the direction of the Haig-Simons criterion.
2. From a Haig-Simons point of view, the McCain proposal makes sense. According to
Haig-Simons, all income should be taxed at the same rate, regardless of the use to which
48
it is to be put. Under the status quo, income (in the form of capital gains) is taxed at a
lower rate if it is donated to charity. Note that wage income that is to be donated to
charity does not enjoy the same benefit.
Under the status quo, the tax price of a gift of appreciated property is 1 - t - tk*g, where t
is the marginal tax rate on ordinary income, tk is the tax rate on capital gains, and g is the
proportion of the gift that is appreciated property. With the McCain proposal, the tax
price would be 1 - t. Thus, the tax price goes up. We expect charitable contributions to
go down by an amount that depends on the elasticity of charitable contributions with
respect to their tax price.
3. Suppose Jones buys the oil stock for $1,000 at the start of period 0. At the start of
period 1, he has two options.
a. Hold the oil stock one more period, then sell.
b. Sell the oil stock, buy the gold stock and hold it for one period.
In both cases, it is assumed that all assets are sold, and any taxes paid at the end of
period 2. What are the returns to option a)? At a 10 percent rate of appreciation,
the oil stock is worth $1,210 after period 2, the capital gain is $210 and assuming
a 29 percent rate applies to capital gains, the capital gains tax is 28 percent of
$210 or $58.80. Thus, Jones is left with $1,210 - $58.80 or $1,151.20 after tax.
If Jones follows strategy b), the value of the oil stock at the start of period 1 is
$1,000, the capital gain is $100, and the tax $28. Thus Jones has $1,672 left over
to proceeds (V) from selling the gold stock at the end of period 1.
V = Value of gold stock – taxes

= (1+r)($1,072) –(.28)[(1+r)($1,072)-($1,072)]
= (1+r)($1,072) –(.28)r($1,072)
= $1,072 + .72r($1,072)
Setting V = $1,151.20 (same as oil stock):
$1,151.20 = $1,072 + .72r($1.072) ⇒ r=10.26%
Thus the gold stock must pay a “premium” of 0.26% (10.26% - 10%) over the oil
stock in order to overcome the tax cost of realizing the capital gain.
4. Dear Newsweek: Your Wall Street editor does not understand the tax code. The bracket
widths, exemptions, and deductions are all indexed and have been since the early 1980s.
In effect, this indexes wage income against inflation.
5. For an itemizer, a $500 tax deduction lowers the tax bill by t*deduction. Thus, for an
itemizer with a 30% marginal tax rate, the tax bill is lowered by 30%*$500, or $150. A
(refundable) tax credit, on the other hand, directly lowers the tax bill by that amount, in
this case, $500.
49
6. a. With a tax rate of t=0.3, and a nominal interest rate of i=0.13, the nominal after-
tax rate of interest is (1-t)i=(1-0.3)0.13=0.091. With an expected inflation rate of
π=0.08, the real after-tax rate of interest is (1-t)i-π=(1-0.3)0.13-0.08=0.091-
0.08=0.011.
b. If the expected inflation rate increased by 3 percentage points to π=0.11, and the
nominal interest rate also increases by 3 percentage points to i=0.16, then the real
after-tax rate of interest is now (1-t)i-π=(1-0.3)0.16-0.11=0.112-0.11=0.02. The
real after-tax rate of return falls from 1.1% to 0.2%. This is because the tax
system taxes nominal, not real, returns.
c. In general, consider two rates of inflation, π<π’. The key question is when taxes
are present, by how much must the nominal interest rate increase in order to have
the same real rate of return. This is calculated by equating real rates of return
under different inflation rates (holding constant taxes): (1-t)i-π=(1-t)i’-π’. One
can rearrange this equation: (π’-π)=(1-t)(i’-i), or (i’-i)= (π’-π)/(1-t). This can in
turn be expressed as: Δi=Δπ/(1-t). Intuitively, the left-hand side of this final
equation is the change in nominal interest rates that keeps the real after-tax rate of
interest unchanged. It is equal to the change in the expected inflation rate divided
by (1-t). Thus, returning to part 6b, for a 3 percentage point change in the
inflation rate and a marginal tax rate of t=0.30, nominal interest rates would have
to increase by approximately 4.3 percentage points.
7. Lowering the tax rate on the earnings of the secondary earner has better efficiency
properties. By lowering the marginal tax rate, it reduces excess burden. Since the
elasticity of labor supply for secondary earners is relatively high, the gain in efficiency
should be substantial. In contrast, for most households, an increase in the standard
deduction is “infra-marginal,” i.e., it does not affect the incremental returns from working
another hour.
8. Proponents argued that letting nonitemizers take an additional deduction for charitable
giving would stimulate giving. This is because the after-tax “price” of giving $1 to
charity falls from $1 to (1-t)$1, where t is the marginal tax rate. The argument presented
in the question, that “critics argued that a deduction was not necessary to stimulate giving
because part of the standard deduction can be used for a charitable donation” have little
in the way of argument. The price of giving remains $1. Although it is true that some
giving is inelastically supplied, changes in tax-prices may stimulate giving. The Bush
administration proposal would have lowered the price of giving for nonitemizers, who
comprise about two-thirds of all tax returns. One suspects that the marginal tax rates that
nonitemizers face, however, is relatively low compared to itemizers, so the after-tax price
may not have changed very dramatically.
9. a. i. A family of four would receive four exemptions that totaled $12,200

(4*$3,050) in 2003, according to the figures on page 371 of the textbook.
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ii. Ignoring other features like the exemption phaseout, an increase in income
of $2,500 leads to an increase in taxes of $750 with a marginal tax rate of
30% ($750=$2,500*30%).
iii. Personal exemptions are reduced by 2 percentage points for each $2,500
increase in AGI. Thus, the exemption falls from $12,200 to
98%*$12,200, and taxable income goes up by 2%*$12,200, or $244.
iv. The additional increase in taxable income of $244 increases the tax
liability by 30%*$244, or $73.20.
v. The total change in tax liability, the effective tax rate, is ($750+$73.20)/
$2,500, or 32.928%.
b. i. With $100 of income initially, the family would owe 30%*$100, or $30 in
taxes.
ii. According to the textbook (page 377), the phaseout on itemized

deductions is at a rate of 3% for AGI above a certain threshold. The
itemized deduction falls by 3%, or $3, for the $100 increase in income.
Taxable income goes up by $3.
iii. The $3 change in taxable income increase the tax liability by $0.90
(=30%*$3).
iv. The effective tax rate is ($30+$0.90)/$100=30.9%.
10. Of the $4,000 of earnings that Sam has, he is able to invest (1-tI)*earnings in the market,
or (1-0.25)*$4,000=$3,000. Assume that when he saves the money in a taxable account,
he has to pay taxes each year on the capital gains, and that those capital gains are treated
as ordinary income and taxed at 25%. In this case, his after-tax rate of return is (1-tI)*r,
or (1-0.25)*8%, or 6%. Thus, after 10 years of investment, the amount of money in the
taxable savings account is $3,000*(1.06)10=$5,372.54. If he invests the money in a Roth
IRA, the money accrues at the before-tax rate of return, and there is no tax liability at the
end. Thus, the amount in the Roth IRA is $3,000*(1.08)10=$6,476.77. It turns out that
the key difference between a traditional IRA and a Roth IRA is whether the income tax
rate today differs from the income tax rate in retirement. Thus, the amount in the Roth
IRA would be identical to that of a traditional IRA if tax rates 10 years from now were
the same 25%.
Chapter 16 – Personal Taxation and Behavior
1. The supply of labor (and other factors) in and out of a state is more elastic than the supply
of factors to the nation as a whole. Therefore, an income tax reduction at the state level is
likely to lose less revenue than such a reduction at the federal level, ceteris paribus. Just
as one can think of “welfare-induced” migration for poor households, one can think of
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“tax-induced” migration for businesses and possibly workers. If the state lowers tax rates
(and other states do not respond accordingly), then one imagines that a number of
businesses will enter that state and spur economic activity.
2.
If individuals view their loss in the labor income taxes as offset by the benefits of public
services, labor supply falls by AB hours. This is the compensated change in hours with
respect to a change in the net wage rate.
3.
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4. The effect of the change in the highest marginal tax rate on the individual’s budget
constraint is demonstrated below:
Income
Leisure
The resulting change in the tax rate moves part of the budget line out to the new, dotted
budget constraint. This policy has an effect on labor supply analogous to the effect of an
increase in an individual’s wage rate on labor supply: it is theoretically ambiguous. The
reason for this ambiguity is that there are two competing effects -- a substitution effect
which acts to decrease leisure, and an income effect which increases leisure. The
decrease in the tax rate makes leisure more expensive, so the substitution effect dictates
that less of it is to be consumed. However, there is extra income provided by this tax cut,
and the income effect makes the individual want to consume more leisure. These two
competing effects make the overall change in labor supply ambiguous. Existing
empirical work suggests that for prime age males, the income and substitution effects
more or less cancel each other out. For working wives, the substitution effect dominates,
meaning that the reduction in marginal tax rates would tend to increase their labor supply.
The effect on savings can be demonstrated using a diagram illustrating the change in the
intertemporal budget constraint that results from this tax change:
Future
Consumption
E E’
Current Consumption
The policy moves the endowment point from point E to E’, and it changes the slope of
the intertemporal budget constraint, which is equal to [1 + (1-t)r], where “t” is the tax
rate, and “r” is the real interest rate. Once again, the overall effect of this policy on
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savings will be ambiguous, since there are again competing income and substitution
effects. The extra income gained from the tax cut will make this individual want to opt
for more consumption in both periods (now and in the future), so this will cause savings
to increase (intuitively, the individual will consume some of her extra income now, and
some in the next period). However, the tax cut will also change the slope of the budget
line. This causes a substitution affect which makes consuming in the current period more
expensive (so savings will increase), but it causes income to rise, which makes this
individual want to consumer more in the current period. The counteracting effects make
it difficult for us to say what will happen to overall savings. Econometric work suggests
that changes in marginal tax rates have little effect on individual saving.
Lastly, the effect on tax revenues will be negative (a decrease in the tax rate will have a
direct effect in this case). However, this decrease will not be as pronounced as we might
think. First, to the extent that some individuals work more, taxable income will increase.
More importantly, individuals will opt for more taxable income instead of nontaxable
income as the tax rate falls. For instance, since fringe benefits are like non-taxable
income, an individual will prefer them to cash payments (which are taxable) when the tax
rate is high. However, the opposite is true when the tax rate falls. Thus, although with a
lower tax rate less revenue is collected from a given tax base, this decrease is somewhat
counteracted by the increase in the base itself. That said, there is no evidence that the
increase in the base would be large enough to make the tax self-financing.
5. The $300 tax rebate is unlikely to be successful at stimulating consumer spending.

According to life-cycle model, a transitory, one-time change in income will have little
effect on current consumption. To induce a major effect on current consumption, need to
make the tax cut permanent.
6. Note that the basic framework presented in Chapter 16 (and Chapter 11) for obtaining
training weighed costs versus benefits, and the person obtained training if B-C>0. In this
case, B is the present discounted value of the earnings increase, and C is the opportunity
cost, namely forgone wages. If earnings were taken away at a proportional rate (and
similarly, forgone taxes paid during the training period were reduced), then the training
decision becomes (1-t)(B-C)>0, which always leads to the same decision as before. The
Wall Street Journal’s assertion that “high marginal tax rates discourage incentives … to
invest in one’s human capital with additional training or education,” implicitly assumes a
more complicated model. There are several ways in which this basic cost-benefit
analysis could be modified to get such a result. For example, in focusing on the nature of
the costs of the human capital investment, it is assumed that C represents only forgone
earnings, and therefore a tax lowers the cost (as well as the benefits) of getting training.
Imagine instead that C=C1+C2, where C1=deductible costs, such as forgone earnings, and
C2=non-deductible (or partially-deductible) costs, such as college tuition. With the
imposition of taxes, the net benefit of training now becomes (1-t)(B-C1)-C2<(1-t)(B-C).
With nondeductible costs, it is not necessarily true that the net benefit will be positive, so
there will likely be less human capital accumulation. Another important consideration is
the proportional tax assumption. Imagine instead that the tax schedule is progressive,
with t1>t2, and the higher tax rate applies to the incremental earnings from training, but
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not the previous lower earnings. In this case, the net benefit now becomes (1-t1)B-(1-
t2)C. Relative to the case with a proportional tax, this expression is smaller, and not
necessarily positive. Finally, to the extent that taxes lower labor supply, this will tend to
reduce the return to human capital accumulation and lower the amount undertaken.
7. One extreme possibility is that there will be no new personal saving—people just shuffle
assets from taxable to nontaxable accounts. It is more likely that there will be some new
saving, although less than the amount by which the IRA limits are increased. Hubbard
and Skinner (1996) conclude that a good guess is that 26 cents per dollar of IRA
contribution is new saving. Many of the studies that look at the “reshuffling” of assets
examine IRA limits of $2,000; many employees today would have a current 401k limit of
$13,000 (along with a Roth IRA limit of $3,000 per person); thus a married couple with
two workers may be able to contribute as much as $32,000 in tax-deferred plans. It may
be the case that with the dramatic increase in the limits over time, the additional saving is
not infra-marginal.
8. The statement is correct. When there is full loss offset, the tax system will tend to reduce
the risk as well as the return to risky investments. The effect on risk taking is therefore
ambiguous. With less than full loss offset, the tax system does not reduce risk as much,
which tends to bias the individual against risky investments, other things being the same.
9. a. The supply curve is given by S=-100+200wn. The gross wage is w=10, and the
net wage is wn=(1-t)w=(1-t)10. The difference, then, between the gross and net
wage for any tax rate is w-wn=10t. This is the tax collected per hour of work.
The tax revenue for any given hours of work is then the product of the tax
collected per hour of work and the labor supply curve: tax revenue=10t*(-
100+200(1-t)10)=-1,000t+20,000t-20,000t2=19,000t-20,000t2. The tax rate t=0.7
is beyond the revenue maximizing point (this can be shown by computing tax
revenue for a slightly lower tax rate, like t=0.69.
b. Taking the derivative dTax Revenue/dt=0 yields 19,000-40,000t=0, or

t=(19,000/40,000), or t=0.475 as the revenue maximizing tax rate.
Chapter 17 – The Corporation Tax
1. This statement suggests that corporations are people with independent abilities to pay, a
view that parallels the legal status of corporations. Economists believe that only people
have an independent ability to pay.
2. a. The real value of depreciation allowances, Ψ of equation (17.1), falls.
b. When Ψ falls, the user cost of capital increases.
c. Index appreciation allowances.
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3. If the $20 million is expensed, the firm gets a deduction of $20 million in the current
year. If the $20 million is depreciated, the deductions are spread over time (in a way that
depends on the specifics of the depreciation schedule). The present value of the future
flow of deductions is less than $20 million. Because the package design will yield
benefits that extend over a period of time, it would seem sensible to view it as a capital
expenditure. If so, depreciation is appropriate, and the IRS was right.
4. Under a strict Haig-Simons rule, there would not be any separate corporate tax at all.
Given that there is a corporate tax, the spirit of the Haig-Simons criterion is that different
forms of corporate income should be treated the same way. The partial dividend
exclusion at the personal level can be rationalized in Haig-Simons terms. Given that the
income that generated the dividends has been taxed once (at the corporate level), then
excluding part of it at the individual level seems appropriate.
5. Under the proposal from the Wall Street Journal article, dividends would be totally
exempt from taxation. On the other hand, interest income would be taxed at the
individual level. Thus, the statement
“Abolishing the tax in both places not only ends the double taxation of dividends
but creates the same incentives for equity and dividends as for debt and interest.
Voila! A level playing field.”
is only partially correct. The playing field would not be level; now, rather than the tax
system favoring debt finance over equity finance, the reverse is true.
6. A retroactive rebate of the alternative minimum tax for corporations would simply be a
lump sum transfer. Thus, according to neoclassical theory, such a rebate would not have
an effect on investment, because it does not affect the user cost of capital. The user cost
of capital depends on current individual and corporate tax rates, after-tax rates of return
in the capital market, economic depreciation, depreciation allowances, and investment tax
credits. None of these is affected by the AMT rebate described in the text. Moreover,
because the firms involved in the AMT rebate were very large, it is hard to imagine that
the rebate would relax liquidity constraints either.
7. O’Neill’s statement that, as chief executive of Alcoa, he “never made an investment

decision based on the tax code,” is problematic for the shareholders of Alcoa. It makes
no sense to ignore tax incentives when making business decisions; that is, after-tax
returns are what matter. O’Neill’s lack of tax sophistication likely lowered the value of
Alcoa relative to what it would have been had he taken account of the tax system.
8. The MIPS financial instrument, which could interchangeably be called debt or equity,
would be attractive to a corporation because firms would want tax authorities to view the
instrument as debt because the interest paid is tax deductible. On the other hand, firms
want potential investors to view the instrument as equity, because more debt makes the
firm a riskier investment. Although the tax law might be forced to view this MIPS
instrument as debt, there is no reason why investors in the market (or credit rating
56
agencies) would then view it as equity, however. In principle, investors and credit
agencies should be able to see through such accounting gimmicks, though in practice, the
accounting scandals showed that this was not the case.
9. The user cost of capital (ignoring depreciation allowances and investment tax credits) is
given by equation (17.4) in the textbook, C=(r+δ)/[(1-θ)(1-t)], where r=after tax rate of
return in the capital market, δ=economic depreciation, θ=corporate tax rate, and
t=individual tax rate. Substituting the numbers from the problem into the formula, gives
the user cost: C=(.08+.01)/[(.65)*(.7)]=.1978. Since the project’s return, 30%, is higher
than this user cost of 19.8%, the company does invest in the project.
Chapter 18 – Deficit Finance
1. a. The government borrowing to finance a Memorial Day parade increases the

national debt. In designing an accounting system for the government, the
borrowing in this case should, in fact, increase the national debt.
b. The sale of the Statue of Liberty to private entrepreneurs would decrease the
national debt under current measurement. In the discussion on capital spending,
on pages 458-9, the exercise here is similar to the sale of nondefense federal
buildings in 2002. In designing an accounting system, this transaction is simply
an exchange of assets and should have no effect on the debt, rather than
decreasing the debt. The current system ignores tangible assets.
c. The law promising free (future) medical care to children under five affects future
spending, not current spending. As such, it does not affect the current
measurement of the debt. This is similar to the discussion of the implicit
legislative promises about Social Security on page 460. In designing an
accounting system, the present value of the entitlement should be counted as a
current expense, so the debt should increase. The current system ignores implicit
obligations.
d. The $100 tax would reduce the size of the national debt. The implicit promise to
pay Lynne back $105 next year does not increase the size of the debt, assuming
this is similar to the implicit promise to pay Social Security in the future. In
designing an accounting system, again, this implicit promise should be counted.
Assuming the present discounted value of the of the $105 paid back next year
equals the $100 tax this year, then the impact on the debt should be zero, rather
than to decrease it.
e. The $100 bond would increase the size of the national debt. The present value of
these payments is the amount by which the bond contributes to the debt. In
designing an accounting system for the government, the borrowing in this case
should, in fact, increase the national debt.
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2. Montyon’s assertion makes sense. Because the excess burden of taxation rises with the
square of the tax rate, it is efficient to spread the increases in tax rates over time by
borrowing and then repaying the debt with tax revenue. However, if there are distortions
in the capital market and the borrowing crowds out capital formation, this result may not
hold. If the Ricardian model holds, such crowding out will not occur, and the efficiency
case for borrowing is strengthened. All this assumes that the expenditure in question is a
one-time increase, such as a war.
3. The arrival of surpluses in the late 1990s, and the subsequent spending spree, are
consistent with Milton Friedman’s view of deficits and government spending. His view
is that, “What is predetermined is not spending but the politically tolerable deficits.”
Since the deficit is fixed, increases in revenue lead to one-to-one increases in spending.
4. If the elasticity is zero, then taxing labor markets creates no distortion. But in the
presence of taxes on capital income, crowding out in the capital market will generate an
excess burden. Therefore, use tax finance.
5. While this is a matter of opinion, one should note that the effect of a debt reduction on
the economy depends on whether that implies higher taxes or reduced spending, as well
as the portfolio of reductions in spending. Thus, without stipulating how the debt
reduction will be accomplished, it is hard to say much about the effect on the economy.
6. The benefits-received principle, which states that the beneficiaries of a particular

government spending program should pay for it, suggests that deficit finance is
appropriate for war if the benefits are received by future generations. An efficiency
standpoint would say that debt is appropriate if the expenditure is temporary, and there
are not major pre-existing distortions in capital markets.
Chapter 19 – Taxes on Consumption and Wealth
1. The market value of Microsoft is a stock figure. Gross domestic product is a flow figure.
It makes no sense to compare them directly. One way to make a sensible comparison
would be to convert the market value of Microsoft into a flow, i.e., compute the stream of
income that could be generated annually by $500 billion of wealth. Using a rate of return
of 10% for convenience, this gives us $50 billion per year, considerably below Spain's
GDP.
2. The statement is misleading because it ignores the business part of the Hall-Rabushka
tax. Capital incomes are generated by businesses; effectively, the H-R tax captures this
income at its source. Note, however, that investment expenditures are expensed under
the H-R proposal. Hence, only returns to capital in excess of normal returns are taxed.
3. There is a fundamental confusion here. There is no reason to assume that the incidence
of a general consumption tax (a VAT) will be the same as the incidence of a partial factor
tax (corporate income tax).
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4. a. For a fan giving a million-dollar ball to McGwire or Sosa, there would be a federal
gift tax liability. Depending on the fan's circumstances, it could reach $150,000 or
more. The person receiving the gift owes no tax.
b. If the fan keeps the ball, the fan would owe no tax now. But the ball would
become part of his or her estate, taxable after death under the estate tax.
c. The fan can avoid tax entirely by giving the ball to a charity, since he could
entirely deduct the value of the ball from his taxable income. The charity could
sell the ball; the proceeds from the sale would not be taxed.
d. If the fan sells the ball, the fan owes tax on the net proceeds, just as the seller of
any property would. The transaction would put the fan in the highest tax bracket,
so that the marginal tax rate on the proceeds would be 39.6 percent.
e. If the fan holds onto the ball for a year, it becomes a long-term capital asset,
subject to the maximum capital-gains tax rate of 28 percent. Unless the fan thinks
that there is going to be a substantial drop in the market value of the ball, he or
she should hold onto it for a year.
5. a. The expression “What you earn is what you keep” is false, because a consumption
tax is equivalent to a tax on wages. The two are related by the expression
(1+τ )=1/(1-t), where τ =consumption tax rate and t=income tax rate.
b. The expression, “Investment and savings would soar” may be true. A

consumption tax raises the return to saving, but because of the conflict between
income and substitution effects, one cannot know whether or not this will increase
saving. Figures 16.9 and 16.10 in the textbook illustrate these possibilities.
c. The statement that “There is no evading the Fairtax” is false. Evasion can be a
major problem with retail sales taxes, especially at high rates.
6. In the simplest possible case, the budget constraint is pC = wH, where p is the price of
consumption, C is units of consumption, w is the wage rate, and H is hours of work.
With an income tax, pC=(1-t)wH, where t=income tax rate. With a consumption tax,
(1+τ )pC=wH, where τ =consumption tax rate. Thus, for any income tax rate t, we can
find a consumption tax rate, τ , that is equivalent by solving the expression: (1+τ )=1/(1-
t).
7. a. Rich receives $100 in period 1 and $75.6 in period 2, while the interest rate is 8%.
Thus, the present discounted value of his income stream is I=$100+
$75.6/1.08=$170. If second period consumption is $108, the discounted value of this is
$108/1.08=$100. Thus, first period consumption is $70.
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b. Recall that the expression (1+τ )=1/(1-t) relates consumption taxes (τ ) to

income taxes (t). Thus, if the income tax rate is t=0.25, then (1+τ )=1/(1-
0.25)=4/3, or the equivalent consumption tax is τ = 1/3.
8. Under an income tax, Amy's burden is $1,000*t in the first period, and .08($800)t in the
second period (e.g., her investment income is taxed). Shirley's burden is identical in the
first period, $1,000*t, but is lower in the second period, equal to .08($700)t. This is
because Shirley consumed more in the first period and saved less. Thus, Amy has a
higher lifetime tax burden because she has higher investment income. Under a
proportional consumption tax, Amy and Shirley have the same lifetime tax burden,
$1,000*τ , where τ is the consumption tax rate.
Chapter 20 – Public Finance in a Federal System
1. a. To the extent that autos tend to be used within a given jurisdiction only, it would
make sense for states or localities to control pollution regulations. To the extent
that a given car is driven in many states, or that pollution created in one
jurisdiction affects residents in another, it would make sense for the federal
government to be in charge.
b. To the extent that the negative externalities of a landfill affect only people who
live nearby them, then local or state regulation is appropriate.
c. Provision of weather satellites would make most sense for the federal government.
d. Public refuse collection seems a natural function for local government.
e. In the case of airport security, inter-jurisdictional externalities are present. If one

airport in one community does not have adequate security, it affects the security of
individuals at airports in other jurisdictions. Thus, a federal role is appropriate in
this situation.
2. Yes. David bore the burden of the tax increase while Jonathan did not. Because the
future tax payments are incorporated into the price of the house, Jonathan was able to
purchase the (same) house at a lower price. The previous owner effectively “pays” the
tax.
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3.
c.
61
4. The theory of federalism indicates that one of the main purposes of decentralization is to
allow people to select bundles of public services and taxes that suit them. The more
diverse their tastes, the greater the benefits of being able to pick different bundles, and
hence, the greater the benefit to decentralization. Hence, the finding is consistent with
our theory.
5. The figure looks essentially like Figure 20.6 (without segment JH). What actually
happens to spending on education depends on the income elasticity. The government
need not increase spending on education by the full amount of lottery money collected
because the rest of the state revenue is fungible. Thus, if previously 20 percent of general
state revenue had been spent on education, after the lottery is implemented, perhaps only
17 percent of general state revenue is spent on education.
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6. In the figure below, the (constant) marginal cost of hiring a firefighter is C. The demands
for the two communities are D1 and D2. Suppose that initially the quantity is set at Q0.
After decentralization, each community hires firefighters up to the point where the
marginal benefit equals marginal cost, i.e., where their respective demand curves
intersect C. This is at Q1 for community 1 and Q2 for community 2. Community 1 gains
abc. Community 2 gains dbe. Community 1 gains more because its demand curve is
more inelastic.
7. The “user-fee” view of property taxes regards property taxes as payment for local public
services. The statement “its presence would raise property values and the extra tax
revenues would easily repay the construction costs” reflects this view -- that people pay
for the recreational services made available by the part with their property taxes. The
statement is not consistent with the “traditional view” or the “new view,” both of which
ignore the local services aspect.
8. Originally, the effective state price of $1 spending on welfare recipients was $0.50 with a
one-for-one federal match rate. If the federal match rate changes to two-for-one, the
effective state prices of $1 spending falls to $0.33, or a 34 percent change in the price.
Using Baicker’s (2001) elasticity estimate of 0.38, a 34 percent change in price should
increase state spending by 12.92% (=0.38*34%).
LECTURE TIPS
Chapter 1
Decisions about public policy cannot be made on the basis of economic analysis alone. Value
judgments are also required. The purpose of the beginning part of Chapter 1 is to make this
63
point, and to try to force the students to think hard about the values they bring to bear on public
policy problems.
One point I emphasize in class is that even the way we formulate our questions depends on value
judgments. For example, the question that economists in the United States and United Kingdom
usually ask is, “Under what conditions is it a good idea for the government to intervene in the
economy?” I ask the students what question might be asked if the course were being taught in a
socialist economy such as Cuba. There the question might be, “Under what conditions is it a
good idea to allow the private sector to undertake an activity?”
The lecture on the second part of the chapter should try to convey some sense of the scope of
government activity. About a third of the GNP goes through the public sector; most students do
not realize that government is that large. The lecture should also emphasize the arbitrariness
involved in selecting a measure of public sector size. To make the issue more concrete, one can
relate it to current debates over various “mandates.” While any given measure may convey
useful information, no single measure can tell the whole story. I try to emphasize that this is a
theme that will be recurring in the course – it is often difficult to measure things we care about;
this fact does not mean that we should abandon attempts at measurement, but it does mean that
we have to be cautious in interpreting data.
Chapter 2
Students should come away from this chapter realizing that just because economists disagree on
many issues does not mean that economists are stupid or dishonest. One point to emphasize is
that in this respect, economists are pretty much in the same boat as practitioners in other
disciplines generally considered to be more “scientific,” e.g., medicine. Just remember the
controversy over whether drinking coffee “causes” cancer of the pancreas.
In recent years there have been more attempts to answer economic questions with experiments.
It might be interesting to use this chapter’s summary of Rouse’s work on the Milwaukee voucher
experiment as the basis for a classroom discussion of the advantages and disadvantages of
experiments in economics.
Chapter 3
After I distinguish between “positive” and “normative,” I find that students tend to equate
“normative” with “not subject to rational discussion.” This is a good opportunity to remind
students that it is possible to have rational discourse about value judgments, despite the fact that
it is impossible to prove “scientifically” that one set of values is better than another.
My students are intrigued by Edgeworth Boxes and the notion of Pareto efficiency. It pays to go
through this material very carefully. If many of your students have seen the Edgeworth Box
analysis of exchange efficiency in a previous course, you may want to go through the analysis of
productive efficiency in class. Students have been seeing the production possibilities curve since
practically their first day in economics; now they will know where it comes from. One way to
provoke discussion on the topics in this chapter is to discuss the longstanding controversy over
64
whether to abolish the National Endowment for the Arts. Many students support this and related
programs but find it hard to articulate just why. A discussion of paternalism and policy toward
cigarettes is another way to students thinking.
Chapter 4
This is the first chapter on the expenditure side of the budget. I have found that there is a
tendency for lectures in this part of the course to degenerate into a mere cataloging of programs,
without a central theme. The text tries to counter this tendency, but it helps in lecture to keep
coming back to the basic question raised in Chapter 3: From the point of view of welfare
economists, is this program sensible?
With respect to the material on public goods, I find that students often have problems
understanding the necessary condition for Pareto efficiency in their provision. As preface, I
began with some intuition of the following kind – given that everyone must consume the public
good, it only makes sense to increase its provision by a unit if the sum of the marginal values that
each person puts on an extra unit exceeds the marginal cost. Next, review carefully why
“marginal value” corresponds to the familiar notion of marginal rate of substitution, and
“marginal cost” corresponds to marginal rate of transformation. Then it is easy to get to the final
step, that the sum of the MRSs must just equal the MRT.
Students are very interested in the issue of privatization. I try to relate current controversies over
whether some particular service should be privatized to the theory of public goods. Example:
Should welfare be administered by private companies? The text takes advantage of the Hart-
Shleifer-Vishny incomplete contracts framework to analyze the choice between public and
private production. My hope is that students will find this a compelling and coherent way to
think about privatization issues. To bring the material close to home, try discussing the material
on public versus private provision of education.
The material on preference revelation mechanisms is relatively difficult for many students,
which is why it has been place in the appendix to this chapter. My experience is that, even after
students have read this material, they need to be led through it a step at a time. As above, it helps
to keep reminding students that “MRS” corresponds to “marginal benefit,” and “MRT”
corresponds to “marginal cost.”
65
Chapter 5
Although environmental externalities are critically important, it is important for students to
realize that externalities come up in other contexts as well. Some of the new examples include
Lojack devices on cars and the conservation of elephants in Zimbabwe.
I find that students tend to think that any activity that is “desirable” produces positive
externalities, and therefore should be subsidized. The book emphasizes that for a subsidy to be
efficient, the activity must produce, on the margin, a benefit that exceeds the return to the
producer of the activity. Still, this point requires emphasis in class. Ask the students whether
they think that medical school educations should be subsidized and, if so, why.
It is important for students to realize the difficulties involved in implementing the models for
dealing with externalities. Sometimes it is hard to determine even whether or not a particular
substance causes harm. The controversy in early 2001 over standards for arsenic in water might
be a good topic to discuss in this context.
Chapter 6
This chapter is divided into two major sections - the first on direct democracy and the second on
representative democracy. I prefer to give a separate lecture on each part, but to stress the
linkages between the two problems. (For example, the median voter theorem derived in the
direct democracy context gives predictions on the outcomes of election contests.)
Virtually all of the students have heard of “logrolling” and tend to assume that is a bad thing. It
is, therefore, a good idea to go patiently through the example in which a logrolling system
improves efficiency. Of course, the efficiency-decreasing case should also be discussed. Ask
the students which case they think is more realistic in their community.
Public discussions of statutory and constitutional measures to reduce government spending

continue to be lively. Ask the students if they favor a balanced-budget amendment.
Chapter 7
The material on the optimal income distribution exemplifies the interplay between economics
and philosophy. Philosophy determines the form of the social welfare function; economic
analysis shows how to maximize this welfare function subject to the relevant constraints.
Students often have strong views on the “fair” distribution of income. One can have a good class
discussion by getting the students to try to rationalize their feelings using the framework of
welfare economics.
After the discussion of the inferiority of in-kind transfers to cash, students always ask why we
have in-kind transfers. This is a good opportunity to relate income distribution policy to the
public choice issues raised in Chapter 6. That is, Chapter 6 discussed logrolling and special
interest groups; it is useful to analyze how these factors have influenced the formulation of
income maintenance policy.
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Chapter 8
This chapter stresses the changes in welfare policy introduced in 1996 and the preliminary
research on their impact. Students can be asked whether they think that workfare requirements
are good social policy, and whether it makes sense to allow the states a bigger role in
determining welfare policy. Such a discussion also provides an opportunity to anticipate some of
the federalism issues that will arise toward to the end of the course.
Income maintenance issues provide a good opportunity to show how the economist’s standard
leisure-income model sheds light on the labor supply incentives of welfare. It is also a good
opportunity to review the points about methodology raised in Chapter 2. Just why is it so hard to
find out whether the welfare system creates long-term dependence, whether AFC increases
divorce rates, etc.?
Chapter 9
This chapter devotes a substantial amount of space to a potentially confusing topic – the
privatization of Social Security. It is important to stress in this lecture that merely investing the
Social Security surplus in the stock market will not make future retirees better off. Any serious
privatization scheme requires some mechanism for increasing social saving. And given that
political and ethical considerations require that obligations to the current generation of retirees be
met, this probably means some kind of additional taxation.
In addition to discussing the nuts and bolts of Social Security, it is important to relate this
program to broader themes in the course. In particular, why should this kind of “insurance” be
provided publicly? What kind of market failure is created in the presence of adverse selection?
Is the government program better than the free market alternative?
Chapter 10
It is important to emphasize that even though health care decisions are often made under
conditions of great uncertainty, this does not mean that the tools of positive economic analysis
must be discarded. Rather, these tools must be modified to take the uncertainty into account.
Thus, for example, the principal-agent model allows discussion of the incentive problems that
arise when physicians act as patients’ agents.
My students tend to have very strong preconceptions about the reasons for the increase in health
care costs. To begin the discussion of this matter, I ask the students why they think that the
health care sector has been increasing relative to the size of the GDP. Then I ask them how they
would test whether their views are correct. This provides a segue into a discussion of
Newhouse’s analysis of the sources of growth in health care costs. In the context of this
discussion, it is always important to emphasize that it is not obvious whether health expenditures
are “too big.”
In recent years, the discussion of health care policy has moved away from global reform to
incremental change. Students might be asked whether they think that incremental change is
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sufficient to develop “good” health care policy. A discussion of reform options for Medicare
might be helpful in this context.
Chapter 11
There is a tendency for students to think that cost-benefit analysis allows one to make a
“scientific” unambiguous choice among projects. The tricky part of this material is to disabuse
the students of this notion, but at the same time convince them that cost-benefit analysis is a
useful tool. It is the only way to force an analyst to explain systematically why he or she favors
a project.
The students find the material on the value of life to be intriguing. It is useful to keep reminding
the students that this is not merely an academic issue. The problem comes up, for example,
whenever there is a lawsuit after an air disaster. It is important to emphasize that, in this and
other contexts, one cannot avoid explicitly or implicitly putting a value on life.
I find that it is also useful to discuss the material on the problem of double counting in benefit-
cost analysis. The text’s discussion of land values can be amplified with an explicit algebraic
discussion of the capitalization of benefits into land prices. A side benefit of such a discussion is
that is provides another illustration of the usefulness of present value analysis.
This edition contains a new extended example of cost-benefit analysis. The question is whether
reductions in class size have benefits that exceed their costs. This is an issue on which the
students are likely to have strong opinions, and I have found it worthwhile to work through the
example in class carefully.
Chapter 12
This is the first of three chapters on tax analysis. The emphasis in these chapters is providing a
theoretical framework for thinking about tax policy issues. The danger in presenting this
theoretical material all at once is that students will get impatient to see it applied to the actual tax
structure. I have tried to avoid this danger by putting a lot of examples into the text. In
particular, in light of the current interest in public policy toward cigarettes, I have included a
number of examples dealing with cigarette taxation. I have also framed the discussion of
international taxation in terms of “globalization” which may increase its appeal to students.
Many students have seen in an earlier course the standard tax incidence analysis done in a supply
and demand framework. My experience is that although such students can shift the relevant
curves, they don’t know why they are doing it. Thus, it pays to begin with a patient discussion of
the distinction between the price paid by consumers and the price received by producers, and
why this leads to a new “effective” demand curve after an excise tax is levied.
I find that working through the partial equilibrium analysis with an explicit algebraic example is
often helpful. Posit specific linear supply and demand curves, and demonstrate how a unit tax of
a specified amount changes: a) output and b) price paid by the consumer. This will make the
incidence model seem more concrete.
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Chapter 13
It pays to spend some time developing an intuition for why taxes create excess burdens before
doing any formal analysis. I find that going over the extreme case discussed at the beginning of
the chapter is a big help. That is, when a tax drives demand all the way to zero, clearly it
generates no revenue, yet it lowers welfare. Thus by distorting choices, a tax can create a burden
in excess of the revenues it generates.
After making this point, next go through the indifference curve analysis very carefully. Once
this is done, the students will understand why excess burdens arise, but they will still have no
idea how they can actually be measured. At this point, the (compensated) demand curve analysis
of excess burden should be done. This discussion should emphasize that with knowledge of the
relevant supply and demand elasticities, excess burdens can be calculated. Remind students that
the tools of positive analysis, discussed in Chapter 2, can be used to find these elasticities; hence,
the concept of excess burden is operational.
Chapter 14
This chapter discusses a number of issues that arise in the design of a tax system; you will have
to pick and choose with respect to the ones you emphasize in lecture. I like talking about the
Ramsey Rule for several reasons. First, it is a nice application of marginalistic logic, and it
reinforces the material on excess burden from the previous chapter. Second, it leads to an
interesting counterintuitive result – neutral taxation is not necessarily efficient. Third, it shows
how empirical work is needed to make theory useful – without knowing the relevant behavioral
elasticities, one doesn’t know that set of tax rates will in fact lead to proportional reductions in
demand for all taxed goods.
Students find the material on tax evasion to be interesting. There always seems to be someone
famous in the newspaper who is being prosecuted for tax evasion. I like to stress that although
tax evasion may be undesirable from a social point of view, this is not necessarily the case. As
noted in the text, it depends on whether evaders’ utilities appear in the social welfare function,
and on the supply elasticities of labor to the “underground” and “above ground” sectors. The
material on the optimal punishment for evasion also allows discussion of a philosophical issue
raised earlier in Chapter 7 – do we care only about outcomes or the processes used to generate
them, as well?
The model of the efficiency consequences of partial factor taxation has been considerably
simplified in this edition. However, it still needs some patient explanation in class, particularly
about why the area under the value of marginal product schedule is the value of total product.
Chapter 15
Some of your students have never filled out a tax return; those who have done so probably have
not had to itemize deductions, be concerned with IRAs, etc. In short, you cannot take for granted
that your students are aware of the basic mechanisms of computing income tax liability.
Figure 15.1 is designed to put the income tax system as a whole in perspective. Some time
should be devoted to discussing it before turning to the details of the system.
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Despite the material on the differences between average and marginal tax rates in Chapter 12,
some students will still think that being in the 28 percent bracket means that the average tax rate
is 28 percent. This needs to be explained carefully. Also, the differences between statutory and
effective marginal tax rates need to be stressed. This is particularly important after the 1997
income tax act, which introduced a number of credits and deductions that are phased out as
income increases, thus increasing effective marginal tax rates.
Chapter 16
For many students, the most difficult subject in this chapter is the effect of taxation upon saving.
As a first step, take a poll of the students to see whether they think a tax on interest will increase,
decrease, or leave saving unchanged. Then indicate that you will examine this question
theoretically using a life-cycle model. Before going through the graphical analysis, give some
intuition for the life-cycle model. For example, explain why it is quite likely that the students
will be borrowers early in their careers, when their long-term prospects exceed their current
income.
When covering the graphical analysis of intertemporal choice, it is important to emphasize the
formal similarities between it and the standard theory of choice between two goods. In
particular, the slope of the budget constraint gives the opportunity cost of one good in terms of
the other.
Another topic that is fun to cover in lecture is the Laffer Curve. Most students have heard of it,
but do not know its relationship to economic theory. The discussion should emphasize that
whether we are on the “wrong” side of the Laffer Curve depends fundamentally on the elasticity
of supply of labor, among other things. In this context, however, it is important to note that, in
recent years, the academic discussion has shifted a bit away from labor supply and to taxable
income more generally. That is, there are ways other than labor supply in which a reduction in
tax rates can generate increases in taxable income (e.g., fewer nontaxable fringe benefits and
more cash in compensation packages).
Chapter 17
Many students have heard about “depreciation allowances,” “tax shelters,” “investment tax
credits,” etc., but they are regarded as esoterica that cannot possibly by understood by people
other than tax specialists. Hence, there is a special feeling of satisfaction when these concepts
are mastered. My experience is that a very patient approach to this material pays off. For
example, in teaching depreciation allowances, explain precisely how much a given depreciation
schedule is worth to a firm each period. Then show how taking present value can collapse this
stream of tax reductions into a single number.
Given the recent public attention to international tax issues, students are quite interested in
finding out about the rules relating to international business activity. Hence, you may want to
spend some time in lecture discussing transfer pricing and why the problem is so complicated.
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Chapter 18
The national debt currently receives more attention than any other public finance issue. It is
important to emphasize at the outset that there is a certain arbitrariness in measuring the debt.
This issue can be made relevant with two different examples. Recently, the federal government
has been running surpluses. This is taken as a sign that U.S. public finance is in good shape.
Should it be? Second, deficit accounting has taken on new importance in Europe, where a
country’s ratio of deficit spending to GDP must be below some value to enter the European
Union. The idea is to make sure that EU members are disciplined in their fiscal affairs. Is this a
sensible approach? My lectures on debt emphasize that formally it is not a “new” problem. That
is, debt is just a particular way of collecting revenue, and hence the standard tools of tax analysis
(suitably modified) can be used to analyze the efficiency and equity consequences of debt
finance.
Chapter 19
These days there is a lot of talk about replacing the income tax with some kind of consumption
tax. The flat tax, in particular, is something that many of my students want to hear about.
Learning about the relationships between the Forbes flat tax and more conventional consumption
tax alternatives, such as a VAT, is something that the students enjoy.
It is useful to spend a few minutes on the possible implications of a value-added tax for U.S.
“competitiveness.” Specifically, one often hears arguments that if the corporate tax were
eliminated and replaced by value-added tax, the United States would be able to export more
goods. The fallacies of this position are discussed in the text; the students generally like to hear
them discussed. A lot of attention has been focused recently on the estate tax, in part because the
Bush administration proposed its elimination. Estate taxation raises a lot of interesting ethical as
well as economic issues, and is a good topic for class discussion.
Chapter 20
Discussing fiscal federalism provides an excellent opportunity to bring together many other parts
of the course – public goods, externalities, income distribution issues, and public choice, among
others. The material on public education is particularly useful in this contest. Hence, when I
lecture on this material, I like to emphasize that although the institutional material is new, these
institutions can be analyzed using familiar basic tools.
The material on the property tax provides a good opportunity to review the theory of tax
incidence. That is, remind the students that tax incidence depends on assumptions on how
markets work, and the “three views” are really just three different assumptions on the appropriate
way to view the market of the commodity being taxed. In my discussion of the “traditional”
view, I find that it is important to emphasize that the demand for housing depends on permanent
income, and the elasticity of demand with respect to permanent income is probably close to one.
Hence, even if one holds the traditional view, the property tax is probably not regressive.
71
With respect to grant policy, by this stage of the course, the students should have little trouble
manipulating the indifference curve diagrams. But they may not realize the implications of these
diagrams – federal attempts to stimulate certain kinds of spending can be frustrated by
adjustments that states and localities make in other parts of their budgets. The new material on
the block grants for welfare contained in the 1996 welfare reform can be used to illustrate this
point.
SAMPLE MIDTERM EXAM I
Part I is worth 36 points. Part II is worth 24 points.
Part I. (6 points each). Indicate whether each of the following statements is true, false, or
uncertain, and explain your answer. Your grade will depend primarily on the quality of
your explanation. If a word or phrase is underlined, your answer must include a concise
definition of the word or phrase.
1. A consumption-efficient allocation of resources is socially desirable.
2. Suppose that everyone has a utility function that depends only on his or her
income. Then the value of a utilitarian social welfare function is maximized when
everyone has the same after-tax income.
3. Under the 1996 welfare reform, each state receives a fixed grant from the federal
government to pay for its income maintenance policies. However, for each dollar
of its own money that the state spends on welfare, the federal grant is reduced by
a dollar.
4. Under the Social Security system, an individual’s retirement benefits are directly
proportional to the amount of payroll taxes that he or she has paid into the system.
5. Former President Clinton once proposed that individuals between the ages of 55
and 64 be allowed to buy into the Medicare system if they so choose. This is a
good example of how social insurance can solve the adverse selection problem.
6. Political economy models of bureaucratic behavior assume that a bureaucrat’s

goal is to maximize the welfare of the citizens.
Part II. Your answers to the following questions should take advantage of the relevant economic
tools.
7. (10 points) Several months ago, the newspaper USA Today published an article
that was critical of the large amount of money that the government spends to
subsidize the energy industry. In response, a spokesman for the industry
observed, “Some of the alleged subsidies don’t even go to the industry. For
example, the government provides money to low-income families to help pay
72
heating bills.” Evaluate this response carefully. Your answer should include an
appropriate graphical model.
8. (14 points) Stanley and Wendy both operate factories along a lake. Stanley
produces an output X. In the process, he pollutes the lake, which increases the
costs of production for Wendy. Assume that the total damages to Wendy increase
in proportion to the amount of X that Stanley produces.
a. Draw a sketch that depicts this situation.

b. Show the amount that Stanley produces, and show the socially efficient
amount for Stanley to produce.
c. On the diagram, show the Pigouvian tax that will induce Stanley to produce
the efficient amount, and the amount of revenues collected by the tax.
SAMPLE MIDTERM EXAM I: SUGGESTED ANSWERS
Part I. (6 points each)
1. False. An allocation of commodities is said to be consumption-efficient when the

only way to make one consumer better off is to make another worse off, given
fixed quantities of the various commodities. We cannot know whether such an
allocation is socially desirable without explicit ethical judgments relating to
equity.
2. False. A utilitarian social welfare function says that social welfare is a function of
the utilities of everyone in society. Even if all that utility depends on is income
(so that incentive issues are not relevant), additional assumptions are needed to
get the result. These include identical utility functions and diminishing marginal
utility of income.
3. False. Each state gets a grant from the federal government, but the grant is not
reduced by the amount that the state spends on welfare.
4. False. The schedule that relates benefits received to payroll taxes paid is
progressive. As a lifetime taxes increase, benefits increase less than in
proportion.
5. False. Adverse selection occurs when the people who are most likely to benefit
from a given insurance policy are also the ones who are most likely to purchase it.
Under the Clinton plan, enrollment is optional in this age group. Those who are
most like to be sick are the ones who would be most likely to participate, so the
program does not solve the adverse selection problem.
6. False. While it is not clear exactly what objective bureaucrats have, political
models generally assume that bureaucrats are trying to maximize their own utility,
which is related to the size of the agency they administer.
73
Part II.
7. (10 points) Just as is the case for a tax, it does not matter which side of the
market a subsidy is applied to. The beneficiary depends on the elasticities of the
demand and supply curves. This can be illustrated either with a supply-demand
diagram or a formula which shows that the equilibrium outcome is independent of
whether the subsidy is received by producers or consumers.
8. (14 points) This is essentially the model of Figure 5.4 in the text, except that the
marginal damage curve is horizontal (because the problem stipulates that the total
damage is directly proportional to the amount of output).
SAMPLE FINAL EXAM I
The maximum number of points is 110. Please answer every question. Your answers should
make use of the tools of economics and the material presented in this course, including diagrams
and/or formulae where appropriate.
You are advised to include a minimum of irrelevant material in your answers. Points will be
subtracted for all incorrect statements you make.
Part I. (40 points)
Indicate whether each of the following statements is true, false, or uncertain, and explain
your answer. Your grade will depend primarily on the quality of your explanation. If a
word or phrase is underlined, your answer must include a concise definition of the word
or phrase.
1. “I promise to lower income tax rates. And I won’t have to cut spending, because
the lower rates will induce so much economic activity that tax revenue will rise.”
This promise would be more credible coming from a candidate for governor of a
state than from a candidate for president of the country.
2. Over time, health care costs in the United States have been increasing. This is
due primarily to the fact that the population has been aging.
3. Suppose that a public good is provided in a Pareto-efficient amount. It is possible

that different members of society will place different values on the last unit of the
public good that they consume.
4. Rent-seeking models of government behavior assume that the goal of

policymakers is to maximize a social welfare function.
74
5. In a pay-as-you-go social security system, the dependency ratio equals the

replacement ratio.
6. Under the Hall-Rabushka flat tax, each individual completes a tax return that
includes his or her wages and capital income, no deductions are allowed, and total
income is taxed at a constant rate.
7. Consider a tax system that is neutral with respect to marital decisions. In general,
such a system will lead to a situation in which two families with equal total family
incomes will pay different amounts of tax.
8. Under current law, corporations may deduct payments of interest to their

bondholders. Disallowing this deduction would bring the tax base into closer
alignment with the Haig-Simons definition of income.
Part II.
9. (12 points) What is the Tiebout model? What are the key assumptions behind the
model? Are they realistic?
10. (6 points) In Russia, the prices of commodities such as food and clothing are set
in a free market, but housing is heavily subsidized by local governments. A
two-bedroom apartment in Moscow, for example, might rent for $1.50 per month.
(Utilities and other fees increase the cost to about $35.) “Because of subsidized
rents, some tenants live in larger apartments than they need and might not
otherwise afford.” Explain how this situation relates to the concept of excess
burden, and illustrate with a diagram.
11. (6 points) In 1997, House Republicans proposed that capital gains be indexed for
inflation. Newsweek’s Wall Street editor stated that this was unfair to wage
earners: “Inflation pushes up salaries, too. But would paychecks get the same
generous treatment? Nope. No inflation indexing.” [Sloan, 1997, page 59].
Compose a letter to Newsweek in which you comment on this statement.
12. (9 points) According to conventional welfare economics, under what conditions

is a government intervention in the economy appropriate? (There is no need to
explain the conditions; just list them. Be specific; don’t simply answer “market
failure.”) In one of the budgets that he submitted to Congress, former President
Clinton proposed a multi-million dollar program to subsidize training to day-care
workers. Consider each criterion you listed above and indicate whether or not it
provides a rationale for this government intervention.
13. (9 points) In the current debate over the public policy toward the tobacco
industry, some politicians seem particularly interested in punishing the industry
for its bad behavior, and other politicians are primarily interested in deterring
smoking. Consider the following two policy options: 1) a large lump-sum tax
75
that must be paid by the tobacco companies; 2) a large unit tax on cigarettes.
Which tax is more suitable for achieving each objective? Explain carefully.
14. (9 points) “It is undesirable for an economy to be to the right of the peak of the
Laffer Curve, because the peak depicts the socially optimal tax rate.” Comment
on this statement.
15. (7 points) The Hope Scholarship credit is a tax credit of $1,500 per student for
qualified expenses associated with each of the first two years of higher education.
The credit is phased out linearly for AGIs between $80,000 and $100,000. (Thus,
when AGI exceeds $100,000 the family is ineligible for the credit.) Consider a
family in the 28 percent tax bracket that has two children who qualify (i.e., the
family is eligible for a $3,000 tax credit). What is the family’s effective marginal
tax rate between $80,000 and $100,000?
16. (12 points) In a recent op-ed piece in an undergraduate newspaper, a student once
argued that the U.S. should move to a privatized Social Security system. To
finance the payment of benefits to the elderly during the transition, he proposed
raising the federal tax on gasoline by $2.50 per gallon.
a. One justification the student gave for the gasoline tax is that driving leads
to “higher prices for good and services.” According to the theory of
externalities, if this fact is true, is it alone a justification for taxing
gasoline? Explain carefully.
b. The student noted an alternative policy for financing benefits during the
transition would be a federal sales tax. However, he characterized that
option as “unimaginative (sic)…What good would a sales tax do?
Discourage buying?” On the basis of efficiency, which is to be preferred,
a gasoline tax or an equal yield general sales tax? Explain carefully what
you mean by “efficiency” in your answer. Which tax would be fairer?
Again, explain your definition of “fair.”
c. The student also noted that gasoline taxes are much higher in Europe than
in the U.S., and that consequently, “Europeans do a fraction of the driving
that Americans do for noneconomic purposes, but they make nearly as
many trips to work and for other economic purposes.” What does the
student mean by the distinction between “economic” and “noneconomic”
uses of gasoline? Suppose that it were possible to tax these two uses of
gasoline at different rates. In order to minimize excess burden, how would
you set the tax rates?
SAMPLE FINAL EXAM I: SUGGESTED ANSWERS
76
1. True. The effect of a tax reduction on tax revenues depends upon the elasticity of
the taxed activity with respect to the tax rate. The elasticity of a factor of
production to a state is greater than the elasticity of a factor to the country as a
whole, because a factor can migrate from a state in response to a tax increase.
This is easier than migrating from the country. That said, even for a state, it is not
clear the elasticity is sufficiently large that a tax decrease would be self-financing.
2. False. The graying of American is not sufficient to explain the long-term increase
in health care costs. Many investigators believe that the main cause is changes in
technology.
3. True. The condition for the efficient provision of a public good is that the sum of
the marginal rates of substitution equal the marginal rate of transformation. This
does not require that MRSs be the same. Put another way, everyone must
consume the same quantity of a public good, but there is no need for everyone to
value the last unit by the same amount.
4. False. Rent-seeking models assume that individuals seek to use the political
system to obtain financial returns that are above the market rate of return
(“rents”). In general, this is not consistent with maximizing a social welfare
function.
5. False. The dependency ratio is the ratio of the number of people being supported
by social security to the number of workers. The replacement ratio is the ratio of
social security benefits to prior earnings. The correct statement is that, under a
pay-as-you-go system, the dependency ratio times the replacement ratio equals
the social security tax rate.
6. False. Under the Hall-Rabushka flat tax, each individual’s tax return includes
only his or her wage income. There is an exemption depending on family size.
There is a business-level tax at the same rate; the base of the business tax is
revenues minus purchases of material inputs minus wages.
7 True, providing that marginal tax rates vary with income.
8. According to the Haig-Simons criterion, income during a given period is the

increase in potential to consume. According to this criterion, business income
must be measured net of the expenses incurred in producing it. Interest is such an
expense. Hence, according to H-S principles, it is appropriate for business to
deduct interest and for it to be taxable at the individual level. The statement is
false.
Part II.
9. (12 points) The Tiebout model shows that, under certain assumptions, the ability
of individuals to move among jurisdictions produces a market-like solution to the
77
local public goods problem. The Tiebout model assumes the government
activities generate no externalities, individuals are completely mobile, people
have perfect information with respect to each community’s public services and
taxes, there are enough different communities so that each individual can find one
with public services meeting her demands, the cost per unit of public services is
constant, and that public services are financed by a proportional property tax. The
assumptions obviously are not totally realistic. However, there is a lot of mobility
in the American economy, and several of the empirical implications of the model
(e.g., tax and expenditure capitalization) appear to be consistent with the data.
10. (6 points) The subsidy induces people to consume housing in excess of its social
marginal cost, which is inefficient, and generates an excess burden. Alternatively,
the cost of the subsidy is greater than the benefits received. This is depicted
graphically in Figure 13.6 in the text.
11. (6 points) Dear Editor: Under the personal income tax, wages have effectively
been indexed since the mid 1980s. This has been accomplished by provisions that
increase bracket widths, the standard deduction, the personal exemption, etc., by
changes in the CPI. On the other hand, no steps have been taken to index capital
income. In short, your writer’s statement is wrong: Indexing capital income
would not advantage it relative to wage income because wage income is already
indexed. Rather, the proposal would bring the treatments of wage and capital
income into parity.
12. (9 points) According to conventional welfare economics, government

intervention in the economy may be appropriate in the presence of market failure
due to market power, adverse selection, externalities or public goods. In addition,
even if markets are operating efficiently, government intervention may be
appropriate to secure a distribution of income that is consistent with society’s
ethical views.
The subsidy will tend to increase the incomes of the individuals who receive the
training. To the extent that there are more daycare workers, this may lower their
overall wages, benefiting the people who hire them. It is not clear that either
group is particularly deserving from an income distribution point of view. It is
hard to imagine that adverse selection is an important issue in this market; to the
extent it is, there is no reason why a training subsidy would deal with the problem.
Neither does an important externality appear to be present – if families want better
trained daycare workers, then they will be willing to pay more for workers who
have such training so there will be a private incentive to undertake such training.
13. (9 points) A lump sum tax will reduce profits of the companies, without changing
their price and output decisions. A unit tax will increase prices paid by
consumers, lower prices received by producers and lower the quantity exchanged.
The magnitudes of these effects depend on the demand and supply elasticities. To
78
the extent that demand is inelastic, cigarette consumers will bear the burden of the
tax without much of a decrease in cigarette consumption.
14. (9 points) An economy to the right of the peak of the Laffer Curve would be able
to raise the same amount of revenues with a lower tax rate and therefore a lower
excess burden. Hence, it cannot be efficient to be to the right of the peak of the
Laffer Curve. However, it does not follow that the peak is in the best point for
society. The peak is where tax revenues are maximized. Determination of the
optimal tax system depends on a wide array of social and economic
considerations. For example, those who believe that the government sector is too
large should presumably be quite happy to see tax revenues reduced below the
maximum.
15. (7 points) The $3,000 credit is phased out over a $20,000 range. Hence, for each
dollar earned in this range, the individual loses a credit of $0.15. The effective
marginal tax rate is the statutory marginal tax rate plus the loss of the credit: .
28+.15=.43.
16. a. (4 points) The fact that some activity increases (or decreases) prices in
other markets is not justification for government intervention. The key
issue is whether the activity influences the welfare of other individuals or
firms in a way that is external to the market.
b. (4 points) Excess burden increases with the square of the tax rate on a
commodity. One can therefore reduce total excess burden by spreading
the tax over a variety of commodities, which a sales tax would do.
Alternatively, by constraining the rates that apply to a set of commodities
to be zero, the gasoline tax does not allow one to follow the Ramsey rule
for minimizing excess burden. If fairness refers to horizontal equity, then
a gasoline tax does not seem very fair – two individuals with similar
abilities to pay can end up with very different tax burdens (assuming that
the incidence of the tax is on consumers). With respect to vertical equity,
one would need more information. However, to the extent that a sales tax
would end up taxing commodities that have a higher income elasticity
than gasoline, it would have a more progressive impact on the distribution
of income (again assuming the incidence of the tax is on consumers).
c. (4 points) Presumably all driving, whatever the purpose, is increasing the

utility of the individual who undertakes it. Hence, elimination of
“noneconomics” driving entails a social cost. Indeed, to the extent that
the demand for gasoline for “noneconomics” driving is elastic with
respect to its price, Ramsey principles suggest that it may be desirable to
tax it at a relatively low rate, if that is possible.
79
SAMPLE MIDTERM EXAM II
Part I. (6 points each) Indicate whether each of the following statements is true, false, or
uncertain, and explain your answer. Your grade will depend primarily on the quality of
your explanation. If a word or phrase is underlined, your answer must include a concise
definition of the word or phrase.
1. A Pigouvian tax is any kind of tax levied on pigs.
2. Suppose that a program is available that would make the poorest person in society
better off by a small amount, and everyone else in society worse off (but still
better off than the poorest person), except for a few rich individuals who would
become even more wealthy. According to a Rawlsian social welfare function,
society should implement the program.
3. If the assumptions of the Coase Theorem hold, then divorce rates in states with
no-fault divorce laws should be the same as the divorce rates in other states with
fault-based laws.
4. Conventional welfare economics suggests that, because income maintenance

programs for the poor are associated with moral hazard, it is undesirable for the
government to sponsor such programs.
5. As long as all individuals have single-peaked preferences and all eligible voters
participate, then the outcome of a referendum conducted by majority voting will
reflect the preferences of the median voter.
6. The government would ease the burden of taking care of the baby-boomers when
they retire by using the money in the Social Security Trust Fund to invest in the
stock market.
Part II.
7. (14 points) In a hypothetical society, the government has decided to right the
historic wrongs done to vertically challenged (i.e., “short”) people. Part of the
program involves subsidizing the purchases of stilts by short people. Specifically,
each pair of stilts purchased by a short person receives a subsidy of s percent. To
finance this subsidy, each pair of stilts purchased by someone who is tall is taxed
at a rate of t percent.
Assume that i) the relevant supply curves are perfectly horizontal so that the price
to short people falls by exactly s percent and the price rises by exactly t percent;
ii) there are no other taxes, subsidies or market imperfections in the economy; and
iii) the economy’s only inputs, capital and labor, are each fixed in supply.
80
After the subsidies and taxes are imposed,
a. Is the allocation of resources production efficient? That is, is the allocation

on the production possibilities curve?
b. Is the allocation of resources consumption efficient? That is, is it on the

contract curve in an Edgeworth Box with individuals’ consumption of
various commodities measured along the sides?
c. Is the allocation of resources Pareto efficient?
Explain your answers carefully.
SAMPLE MIDTERM EXAM II: SUGGESTED ANSWERS
1. False. A Pigouvian tax is a tax levied to correct an externality. It is equal to the

marginal damage (positive or negative) at the optimum.
2. True. According to a Rawlsian social welfare function, social welfare equals the
minimum of the utilities of all the individuals in the society. This program does
increase the utility of the worst-off individual and, hence, increases social welfare.
3. True. According to the Coase Theorem, provided that transaction costs are
negligible, an efficient solution to an externality problem is achieved as long as
someone is assigned property rights, independents of who is assigned those rights.
Applied to a marriage, the theorem implies that divorces will occur as long as it is
efficient for them to occur. No-fault and fault states have different rules for
assigning the property rights, but according to the Coase Theorem, all this affects
is the settlement, not whether the divorce occurs.
4. False. Moral hazard is when an individual’s behavior is affected by the fact that
he is insured. It is doubtless true that social insurance programs such as income
maintenance affect behavior. This does not imply, however, that the government
should refrain from implementing such programs. It does mean, however, that
there will be a tradeoff between efficiency and equity goals, and this should be
taken into account in design of the program.
5. True. Preferences are said to be single-peaked when utility consistently falls as a

voter moves away from her most preferred outcome. When preferences are not
single-peaked, then a stable majority voting equilibrium may not exist.
6. False. By itself, such an action will not increase total national saving. Thus, the
capital stock will not be any bigger than it was before, productivity in the future
81
will be no higher, and it will be no easier to provide for the consumption of the
retired boomers.
Part II. (14 points)
7. a. Yes, because there are no taxes or subsidies on inputs.

b. No, because short and tall people have different MRSs.
c. No, because it can’t be Pareto efficient if it isn’t also consumption
efficient.
SAMPLE FINAL EXAM II
Part I. (5 points each) Indicate whether each of the following statements is true, false, or
uncertain, and explain your answer. Your grade will depend entirely on the quality of
your explanation. If a word or phrase is CAPITALIZED, your answer should include a
concise definition of the word or phrase.
1. An IN-KIND TRANSFER can never increase a person’s utility as much as a cash

transfer or equal dollar value.
2. ADVERSE SELECTION is a prime reason for why the government should not
provide universal health insurance.
3. In any insurance scheme, co-insurance (e.g., a deductible) reduces MORAL
HAZARD problems.
4. The cost-benefit ratio is a reliable guide when it comes to comparing the value of
two different projects.
5. COMMODITY EGALITARIANISM follows as a logical extension of the
concepts embodied in Nozick’s minimal state.
6. In order to secure neutrality with respect to global investment decisions, U.S.
multinational corporations should be allowed to deduct tax payments made to
foreign governments.
7. If the HAIG-SIMONS DEFINITION OF INCOME is used as the tax base, then
one should be allowed to deduct from taxable income any amounts.
8. According to the traditional view of the property tax, the part of the tax that falls
on land is progressive.
9. If the United States eliminated the corporate income tax and replaced it with a
VALUE-ADDED TAX, then the U.S. savings rate would increase.
10. A possible problem with a federal fiscal system is that taxes levied by
decentralized communities are unlikely to be efficient from a national point of
view.
82
Part II. Answer each question, taking advantage of the appropriate tools of economic analysis.
Each question is worth 12.5 points.
11. (12.5 points) Several years ago, gasoline taxes were increased substantially. In
all newspaper accounts, this was termed a regressive tax since poor people spend
a greater fraction of their income on gasoline than do rich people.
a. What assumption about demand and supply elasticities underlie these

assumptions?
b. In 1974, motor vehicle fuel consumption fell by nearly 4 percent in the

aftermath of the first Arab oil embargo. In 1980, motor vehicle fuel
consumption fell by 6 percent as oil prices jumped over 70 percent. How
should we reconcile these facts with the assumptions made by the
newspapers about the incidence of the gasoline tax?
c. Environmentalists argue that gasoline taxes should be raised because of the

negative externalities associated with automobile pollution. How might we
alter our estimate of the regressivity of the gasoline tax in light of this
externality?
12. (12.5 points) Many economists have argued that the corporate and individual
income taxes should be integrated. Explain what integration means. What would
the effect of integration be on national saving, economic efficiency, corporate
investment and corporate financial policy?
13. (12.5 points) There has been considerable controversy in recent years over the
appropriate way to ensure the viability of Social Security into the 21st century.
That has led to changes in the funding structure of the system.
a. Describe the two alternative ways of funding a national retirement system

such as Social Security. Which type of funding method is used in the
United States?
b. Under the funding system that prevailed in the United States until the
middle 1980s, how was private saving affected by the existence of the
Social Security system? If different aspects of the system affected private
saving differently, be sure to note this.
c. What elements of the payroll tax contribute to its perceived regressivity?

Are there any offsetting progressive elements of the system?
d. What economic reasons might justify a nationally organized and mandated

retirement system such as Social Security?
83
14. (12.5 points) Under current law, long-term capital gains are taxed at a lower rate
than other income. A proposed reform is to tax capital gains at the same rate as
other income. Discuss each of the following statements. Defend your answers.
a. Such a reform would cause individuals to switch toward safer investments.
b. The tax system would be more efficient with such a reform because the tax
treatment of capital gains would conform to the Haig-Simon income
concept.
c. Such a reform would improve individuals’ welfare because they could

change their portfolio at lower costs.
d. Because the overall tax on the returns to saving would be higher, personal
savings would under the reform.
SAMPLE FINAL EXAM II: SUGGESTED ANSWERS

1. An in-kind transfer is a transfer in terms of goods or services as opposed to cash.

The statement is false. An in-kind transfer can at most increase a person’s utility
as much as a cash transfer of equal dollar value.
2. False. Adverse selection refers to the situation that occurs when the people who
are most likely to receive benefits from a certain type of insurance are the ones
who are most likely to purchase it.
3. True. Moral hazard is the situation that occurs when an individual’s behavior is
affected by the fact that he or she is insured. Co-insurance forces the insurer to
bear a part of the risk and thereby reduces moral hazard.
4. False. The value of the cost-benefit ratio can be changed by arbitrary decisions
about whether certain attributes of a project are “costs” or “negative benefits” (or
vice versa). Hence, it is not a reliable tool for comparing projects.
5. False. Nozick emphasizes the use of a “good” set of rules to govern society’s
operation and attacks any kind of redistribution scheme – either income or
commodity.
6. False. In order to make firms indifferent with respect to the country in which they
invest, a full credit against foreign taxes paid is required.
7. The Haig-Simon definition says that income during a given period is the increase
in an individual’s power to consume. This is true for all income, whether it is
actually consumed or saved. Hence, the statement is false.
84
8. According to the traditional view, the part of the tax that falls on land is borne by
landlords. To the extent that landlords have incomes that are relatively high, this
part of the property tax will be progressive.
9. Value-added is the difference between sales and the cost of purchased material
inputs at each production. A value-added tax is a percentage tax on value added
at each stage of production. Although replacement of the corporation tax with a
value-added tax would probably increase the return to saving, it is not clear that
this would increase the amount of saving. This is because of the conflict between
income and substitution effects in individuals’ saving decisions.
10. True. For example, suppose that capital is fixed in supply from a national point of
view. Then efficiency considerations suggest a relatively high tax rate. However,
if capital is mobile across jurisdictions, then jurisdictions will “compete” for
capital, resulting in relatively low tax rates on capital.
Part II.
11. a. There are two implicit assumptions: (i) Supply of gasoline is much more
elastic than demand so that the incidence of the gas tax is primarily on the
consumers; (ii) income elasticity of demand for gasoline is less than one,
i.e., when income increases the budget share on gasoline falls.
b. These facts imply that the price elasticity of demand for gasoline is
definitely quite small, but demand is not completely inelastic.
c. Our estimate of regressivity will depend on how differently the negative

externality from pollution affects the rich and the poor. A case can be
made that the poor suffer more from pollution as they live in
predominately urban and industrial areas. Then, a reduction of pollution
will benefit them more than it does the rich. In that situation, the gas tax
should be estimated to be less regressive.
12. Integration refers to schemes that would configure the corporate and individual
taxes in such a way that dividends would not be double-taxed. Under so-called
full integration, all earnings of the corporation during a given year would be
attributed to stockholders just as if the corporation were a partnership, whether or
not the earnings were actually distributed. From a theoretical point of view, the
effect of integration on saving is ambiguous. (See Chapter 16.) Integration
would probably increase economic efficiency, because under the current system,
there is a bias against investment in the corporate sector. (However, to make a
more definitive statement, one would need to know what types of taxes were used
to make up for any revenue losses associated with the integration plan.) With
respect to financial policy, integration would remove the bias toward debt
financing that occurs in the present system because there would be no separate
corporate tax base from which to deduct payments of interest. In addition,
85
integration would remove the incentives for “excessive” retained earnings that
characterize the current system.
13. a. Two possible alternatives are pay-as-you-go and fully funded. The
current U.S. system is a hybrid.
b. The pay-as-you-go system affects private savings in three ways: wealth

substitution effect (tends to decrease private savings), retirement effect
(tends to increase private savings), and bequest effect (tends to increase
private savings). Empirical evidence: Feldstein found the wealth
substitution effect to dominate so that private savings was reduced by the
existence of the Social Security system. Revised opinion has been that
Social Security has a negative effect on savings, but not a very significant
effect.
c. The payroll tax may be regressive because (i) it taxes only earned income.
The share of earned income in total income is much larger for the poor
than for the rich; (ii) earned income is taxed only up to a ceiling so that the
ratio of the payroll tax to earned income is constant for a range of income
and then falls. As the benefits of the Social Security system are tilted in
favor of the poorer elderly people, there are elements of progressivity in
the system.
d. Adverse selection, paternalism, economizing on the decision-making

costs, and income redistribution are important reasons given for a Social
Security system.
14. a. We know that the effect of taxation on portfolio choice is ambiguous on

the basis of theory, and empirical work is inconclusive. Thus, one cannot
say anything definite about this.
b. This is false for (at least) two reasons. First, Haig-Simons is not
necessarily the same as efficient taxation – we would need to have a
Ramsey Rule solution. Second, H-S income is based on unrealized capital
gains. The U.S. tax is based on realized capital gains.
c. This is false because the lock-in effect would be worse, not better. Thus,
the effect on welfare from this alone would be negative.
d. The basic result in most of the empirical literature is that savings do not
respond to real, after-tax returns. Thus, there is no reason to expect that
personal savings would fall.
86

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Chapter 1 - Introduction

Instructor’s Manual to accompany

Suggested Answers to End-of-Chapter Discussion Questions

1. a. Putin’s statement is consistent with an organic conception of government.

b. Rehnquist makes a clear statement of the mechanistic view of the state.

Chapter 2 – Tools of Positive Analysis

Chapter 4 – Public Goods

1. a. Wilderness area is an impure public good – at some point, consumption becomes

c. Medical school education is a private good.

d. Television signals are nonrival in consumption.

e. An Internet site is nonrival in consumption (although it is excludable).

a. The public good is patrol; the private good is fruit.

b. Recall that efficiency requires MRSTARZAN + MRSJANE =MRT. MRSTARZAN=MRSJANE

3. A pure public good is nonrival in consumption, thus it is necessary to determine whether

To determine whether or not the privatization of the highway is a sensible idea, it is

whole. In terms of administration of welfare, it is hard to say whether or not it should be

FIGURE 4.8a – Supplement public

FIGURE 4.8b – Parents pay for “free”

10. Thelma’s marginal benefit is MBTHELMA=12-Z, and Louise’s is MBLOUISE=8-2Z. The

a. The number of parties per month that would be provided privately is P.

b. See schedule MSBp.

c. P*. Give a per-unit subsidy of $b per party.

b. It is unlikely that property rights could be enforced in terms of catching tropical

FIGURE 5.4c – Tradeable vouchers for oil

8. Private Marginal Benefit = 10 - X

Private Marginal Cost = $5

Without government intervention, PMB = PMC; X = 5 units.

Social efficiency implies PMB = Social Marginal Costs = $5 + $2 = $7; X = 3 units.

Chapter 7 – Income Redistribution: Conceptual Issues

1. Utilitarianism suggests that social welfare is a function of individuals’ utilities. Whether

2. a. To maximize W, set marginal utilities equal; the constraint is Is + Ic = 100.

b. Providing free after-school programs for children in impoverished families largely

b. True. The social welfare function assumes a cardinal interpretation of utility so

FIGURE 7.7a – Black market where food

Sell food stamps for other

FIGURE 7.7b – Black market where food

Sell food stamps for other

Food Stamp Food

b. The actual welfare benefits collected by a person equals B=G-t(Earnings-D), where

3. If the quantity of leisure consumed by X appears as an argument in the utility function of

4. He participates in the public housing program as long as P1P2ca>cef.

FIGURE 8.5 – The food stamp “notch”

Food stamp notch; eligibility

Statutory food stamp

FIGURE 8.6 – Individual is on welfare and

7. In all cases, the demand curve for housing slopes downward.

FIGURE 8.7a – Demand curve shifts

FIGURE 8.7b – Demand curve shifts

FIGURE 8.7c – Demand curve shifts outward,

c. When Eleanor’s hours (earnings) go from 1,500 to 2,000 ($12,000 to $16,000),

Chapter 9 – Social Insurance I: Social Security and Unemployment Insurance

Call 1990 year 1 and 2050 year 2. Then

Chapter 10 – Social Insurance II: Health Care

b. Employer-provided health insurance is deductible to the employer and not taxed to

3. a. Dd=4.22–(0.044)(50)=2 visits per year.

b. Now the individual pays only $5 per visit.

FIGURE 10.6a – Medigap choice without

FIGURE 10.6b – Medigap choice with

5,000 8,000 30,000

Chapter 11 – Cost Benefit Analysis

3. The present value of $25/.10 = $250.

80 - 1,000 = 600 > 0.

80 - 1,000 = -200 < 0.