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Part 1 – Getting Started

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Instructor’s Manual to accompany

Public Finance, Eighth Edition, by Harvey S. Rosen and ed !ayer
Suggested "ns#ers to End$o%$&hapter 'iscussion (uestions
Some of the questions have no single “correct” answer – reasonable people can go o
different directions. In such cases the answers provided here s!etch onl" a few possibilities
&hapter ) $ Introduction
1. a. Putin#s statement is consistent with an organic conception of gove

Individuals and their goals are less important than the state.
b. $oc!e ma!es a clear statement of the mechanistic view of the state in
individual libert" is of paramount importance.
%. $ibe
$ibert
rtar
aria
ians
ns beli
believe
eve in
in a ver"
ver" limi
limite
tedd gover
governm
nmenentt and are
are s!e
s!ept
ptic
ical
al abou
aboutt the
the abi
governm
government
ent to impro
improve
ve social
social welfare.
welfare. Social
Social democra
democratsts believ
believee that
that sub
governm
government
ent interve
interventi
ntion
on is required
required for the good of indivi
individual
duals.
s. Someon
Someonee
organic conception of the state believes that the goals of societ" are set b" the stat
individuals are valued onl" b" their contribution to the reali&ation of social goals.
a. ' law
law proh
prohiibit
biting gam
gamblin
blingg woul
would d prob
probab
abll" be oppo
oppose
sedd b" a libe
libert
rtar
ar
advocated b" a social democrat. Someone with an organic organic conception of the
would first decide whether gambling would help to achieve the state#s g
before ta!ing a position on this issue. If the view is that gambling
individuals from being productive then someone with an organic view w
probabl" be in favor of prohibiting
p rohibiting it but if gambling is considered a good
Master your semester with Scribd raise more revenue for the state then the" might oppose the prohibition.
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b. $ibertarians oppose the law mandating seat belt use arguing that individuals c Cancel anytime.
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decide
decide whether
whether or not to use seat belts
belts without
without governm
government
ent coercion
coercion..
democrats ta!e the position that the mandate saves lives and ultimatel" ben
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)hapter 1 * Introduction
 Sheet Music
d. $ibe
$ibert
rtar
aria
ians
ns would
would proba
probabl
bl"
" opp
oppos
osee a law
law prohi
prohibi
biti
ting
ng pros
prosti
titu
tuti
tion
on whil
whilee
democrats would li!el" favor such a law. (he organic view depends on the
societ
societ"
" polic"
polic"ma!
ma!ers
ers are attemp
attemptin
ting
g to achieve.
achieve. (he law would
would proba
favored on moral grounds.
e. $ibe
$ibert
rtar
aria
ians
ns woul
wouldd prob
probab
abl"
l" opp
oppos
osee a law
law proh
prohib
ibit
itin
ing
g pol"
pol"gam
gam"
" whil
whilee
societ
societ"
" polic"
polic"ma!
ma!ers
ers are attemp
attemptin
tingg to achieve.
would proba
f. $ibert
$ibertari
arians
ans would
would li!el"
li!el" oppose
oppose the law
law believi
believing
ng that individu
individual
al business
business ow
should
should ma!e the decision about which
which language
language is used for their signs.
signs.
democrats would also probabl" oppose the law in order to foster a more incl
societ".
societ". (hose with an organic view would probabl" favor the law
law if the" ho
view that ever" member of the societ" should spea! the native language.
+. (he mech
(he mechani
anist
stic
ic view
view of
of gove
govern
rnme
ment
nt sa"
sa"ss that
that the
the gove
govern
rnme
ment
nt is
is a cont
contri
rivan
vance
ce cr
b" individuals to better achieve
a chieve their individual goals. ,ithin
,ithin the mechanistic trad
people could disagree on the obesit" ta-. $ibertarians would sa" that people can
what is best for themselves * whether to consume high calorie food * and do not
prodding from the government. In contrast social democrats might argue that peop
too
too shor
shortt sight
sighted
ed to !no
!now w what
what is googoodd for
for them
them so that
that gov
gover
ernm
nment
ent*p
*p
inducements are appropriate.
. a. If the si&e
si&e of gove
goverrnm
nmen
entt is measu
easurred b" dire
direct
ct e-pe
e-pend
ndiitur
tures
es the
the manda
andate
te do
directl" increase it. )osts of compliance however
however ma" be high and would a
as an increase in a “regulator" budget.”
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(his law would not increase government e-penditures but the high cos
compliance would increase the regulator" budget.
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c. It#
It#s hard
hard to sa"
sa" whet
whethe
herr this
this repre
represe
sent
ntss an incr
increa
ease
se or decr
decreaease
se in the
the
governmen
government.
t. /ne possibi
possibili
lit"
t" is that
that G0P sta"e
sta"edd the same
same and gov
purchases of goods and services fell. 'nother is that purchas
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d. $ibe
$ibert
rtar
aria
ians
ns would
would proba
probabl
bl"
" opp
oppos
osee a law
law prohi
prohibi
biti
ting
ng pros
prosti
titu
tuti
tion
on whil
whilee
societ
societ"
" polic"
polic"ma!
ma!ers
ers are attemp
attemptin
ting
g to achieve.
would proba
e. $ibe
$ibert
rtar
aria
ians
ns woul
wouldd prob
probab
abl"
l" opp
oppos
osee a law
law proh
prohib
ibit
itin
ing
g pol"
pol"gam
gam"
" whil
whilee
societ
societ"
" polic"
polic"ma!
ma!ers
ers are attemp
attemptin
tingg to achieve.
would proba
f. $ibert
$ibertari
arians
ans would
would li!el"
li!el" oppose
oppose the law
law believi
believing
ng that individu
individual
al business
business ow
should
should ma!e the decision about which
which language
language is used for their signs.
signs.
democrats would also probabl" oppose the law in order to foster a more incl
societ".
societ". (hose with an organic view would probabl" favor the law
law if the" ho
view that ever" member of the societ" should spea! the native language.
+. (he mech
(he mechani
anist
stic
ic view
view of
of gove
govern
rnme
ment
nt sa"
sa"ss that
that the
the gove
govern
rnme
ment
nt is
is a cont
contri
rivan
vance
ce cr
b" individuals to better achieve
a chieve their individual goals. ,ithin
,ithin the mechanistic trad
people could disagree on the obesit" ta-. $ibertarians would sa" that people can
what is best for themselves * whether to consume high calorie food * and do not
prodding from the government. In contrast social democrats might argue that peop
too
too shor
shortt sight
sighted
ed to !no
!now w what
what is googoodd for
for them
them so that
that gov
gover
ernm
nment
ent*p
*p
inducements are appropriate.
. a. If the si&e
si&e of gove
goverrnm
nmen
entt is measu
easurred b" dire
direct
ct e-pe
e-pend
ndiitur
tures
es the
the manda
andate
te do
directl" increase it. )osts of compliance however
however ma" be high and would a
as an increase in a “regulator" budget.”
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(his law would not increase government e-penditures but the high cos
compliance would increase the regulator" budget.
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c. It#
It#s hard
hard to sa"
sa" whet
whethe
herr this
this repre
represe
sent
ntss an incr
increa
ease
se or decr
decreaease
se in the
the
governmen
government.
t. /ne possibi
possibili
lit"
t" is that
that G0P sta"e
sta"edd the same
same and gov
purchases of goods and services fell. 'nother is that purchas
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2. (he infl
(he inflat
atio
ion
n erod
erodes
es the
the rea
reall valu
valuee of the
the deb
debtt b" 3.3
3.314
14 - 5%
5%3
3 bill
billio
ion
n or 54.6
54.6%
%b
(he fact that inflation reduces the real debt obligation means that this figure shou
included as revenue to the government.
4. (he fede
(he federa
rall gove
govern
rnme
ment
nt gre
greww b"b" 7813
7813 bil
billi
lion
on.. owe
oweve ver
r becau
becausese the
the pri
price
ce leve
levell w
b" % percent in terms of %332 dollars this amounted to a real increase of 723
9:7%.6
9:7%.6 trillion
trillion * 1.%;71.24 trillion:7%
trillion:7%.6
.6 trillion*71.8+
trillion*71.8+ trillion<
trillion<.. 's a proporti
G0P federal spending in 1884 was 18.8 percent 971.24 trillion=76.>% trillion< and in
it was 18.> percent 97%.6 trillion=71%.>
trillion=71%.> trillion<. ence the si&e of government gr
absolute
absolute terms and fell slightl"
slightl" in relative terms.
terms. (o getget a more complete
complete answer
would want data on the population 9to compute
compute real spending per capita<. 'lso i
be useful to add in e-penditures
e-pend itures b" state and local governments
g overnments to see if the total
government fell. 'lso although
although it would be harder to measure
measure one would want to
gain some sense of how the regulator" burden on the econom" grew during this
period.
6. ?ela
?elati
tive
ve to
to G0P
G0P defe
defens
nsee spen
spendi
ding
ng grew
grew fro
from
m .8
.8 perc
percen
entt of G0P
G0P in 18>1
18>1 to 2.>
2.> p
of G0P in 18>2 and then grew from %.8 percent of G0P in %331 to +.> percent of G0
%332. (he increase from %331 toto %332 was proportionall" larger.
larger.
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&hapter * + ools o% Positive "nalysis
1. ' change in the marginal ta- rate changes the individual#s net wage. (his generat
an income effect and a substitution effect. 's long as leisure is a normal good
effects wor! in opposite directions. ence one cannot tell a priori whether labor su
increases or decreases. If there were no political or legal impediments an e-perim
stud" could be conducted in which a control group confronts the status quo an
e-perimental group faces the new ta- regime. /ther things that affect wor! effort
impact both the control group and the e-perimental group so an" difference in
effort between the two groups could be attributed to the change in marginal ta- rates
%. (his is a valid criticism of the e-ercise stud" and the remed" would be to set up
in which individuals are randoml" assigned to groups. In an e-perimental stud"
group engaged in running would not be correlated with good health or a strong hea
if the" en@o"ed longer life e-pectanc" it could be attributed to running instead of
factors.
+. (he wor!ers who spend time on a computer probabl" have other s!ills and abilit
contribute to higher wages so training children to use computers would not neces
cause their earnings potential to improve. (his stud" illustrates the difficul
determining cause and effect based on correlations. (he data do not reveal whether
a computer causes higher You're
earnings or whether
Reading other factors cause wor!ers
a Preview
computers and to earn higher wages.
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. (he te-t points out the pitfalls of social e-perimentsA the problem of obtaining a r
sample and the problems of Download With
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results be"ond the scope of the e-pe
Participants in the stud" had found it to their advantage to be a part of the e-perim
which ma" have resulted in a self*selected population unrepresentative of the wider g
of health care consumers. In addition the ?'B0 ealth Insurance C-periment w
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limited duration after which the participants would move to some other health
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design could induce certain behavior in the short*run that would not necessari
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anytime.than transitor".
ph"sicians# “standard practices” are largel" determined b" the circumstances
population as a whole not the relativel" small e-perimental group.
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4. Since onl" five states reduced income ta-es we could e-amine what happen
control group of states 9those with an income ta- but with no change in the ta- rates
compare savings rates between the two. (his is important because other factors a
savings rates but if other factors affected both the control group and the treatment g
then we can conclude that the treatment 9lower ta-es< caused the change in saving
for e-ample the saving rate for the five states with lower ta-es 9the treatment gr
increased b" two percent while the savings rate for the other states 9the control gr
increased b" one percent then we could conclude that lower ta-es caused the savin
to increase b" one percentEthe difference between the two percent increase i
treatment group and the one percent increase in the control group.
6. (here is a wea! positive relationship between deficits and interest rates impl"in
larger deficits lead to lower interest rates. Inferences based on these data along wou
problematic because there are onl" a few data points and because it would be
informative to loo! at deficits relative to some benchmar! such as G0P and to e-p
both interest rates and deficits in real terms rather than nominal terms. It would als
useful to control for other factors that can affect interest rates such as monetar" po
and the level of economic activit".
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&hapter  + ools o% -ormative "nalysis
1. a. In this particular insurance mar!et one would not e-pect as"mmetric infor
to be much of a problem – the probabilit" of a flood is common !nowl
Foral ha&ard could be an issue – people are more li!el" to build near a bea
the" have flood insurance. Still one would e-pect the mar!et for flood insu
to operate fairl" efficientl".
b. (here is substantial as"mmetric information in the mar!ets for medical insuranc
consumers and also malpractice insurance for ph"sicians. Dor ef
consumption the price must be equal to the marginal cost and the effe
insurance ma" be to reduce the perceived price of medical care consump
(hat would lead to consumption above the efficient level. ecause of the ro
regulation insurance ta-es and the shifting of costs from the uninsured t
insured there is little reason to e-pect the mar!et to be efficient.
c. In the stoc! mar!et there is good information and thousands of bu"ers and se
,e e-pect in general efficient outcomes.
d. Drom a national standpoint there is a good deal of competition and information

regards to personal computers. (he outcome will li!el" be efficient for com
hardware. oweverYou're Reading
some firms a Preview
might e-ercise some mar!et power especia
the software mar!etH in these mar!ets “networ! e-ternalities” ma" be pr
where the value of aUnlock full access with a free trial.
programming language or piece of software is depende
the number of others who also use that software.
e. (he private mar!et allocation is li!el" inefficient without government interv
Student loan mar!ets ma" suffer from as"mmetric information – the
!nows better than the lender whether he will repa" the loan or default on it a
Master your semester with Scribd of adverse selection. Government intervention does not “solve” the ad
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not compulsor"< but it ma" create a 
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mar!et that
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intervention.
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g. declaring ban!ruptc". (he ban!ruptc" “floor” on costs creates various moral h

problems.
%. Point a represents an equal allocation of water but it is not efficient because there
tangenc". Point b is one of man" Pareto efficient allocations representing a case w
)atherine benefits enormousl" b" trade and enr"#s utilit" is unchanged from the i
endowment.
'0A 1< (he dashed line is positioned at the halfwa" point on the hori&ontal
%< Download With Free Trial
Point b is a tangenc"
+. If insurers in )alifornia could no longer use location to determine automobile in

rates some of the higher costs incurred b" urban residents would be shifted to rura
suburban residents. (his change would reduce efficienc" but the pol
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Social welfare increases if the additional utilit" en@o"ed b" urban residents offset
loss in utilit" to rural and suburban residents.
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. a. Social indifference curves are straight lines with slope of –1. 's far as soc
concerned the “util” to 'ugustus is equivalent to the “util” to $ivia.

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b. Social indifference curves are straight lines with slope of –%. (his reflects th
that societ" values a “util” to 'ugustus twice as much as a “u til” to $ivia.

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2. Fusgrave 91828< developed the concept of merit goods to describe commodi

ought to be provided even if the members of societ" do not demand them. “Sin t
wor! the opposite wa" and appl" to commodities that members of societ" might dem
but ought not to have.
4. a. (here is no obvious reason wh" there is a mar!et failure with burglar alar
the $os 'ngeles police could set a response fee equal to the marginal cost.
b. ,elfare economics provides little basis for such a subsid" of wool and
production.
c. (here is no economic reason wh" cherr" pies should be regulated es

since there are no such regulations for apple blueberr" or peach fro&en pies.
d. It is hard to imagine a basis in welfare economics for this regulatio

hairdressers.
e. (his is not an efficient polic". If the problem is that too much water i
consumed then the answer is to increase the price of water. /n that basis p
can decide whether or not the" want to bu" toilets that require less water.
li!e most other resources is a private good.
f. (here is no economic reason wh" the federal government should subsid
production of electricit" whether the electricit" comes from coal nuclear
or chic!en manure. /ne can assume the question that the R&D pro
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manure is alread" developed so there is
positive e-ternalit" argument. Since the production of electricit" is a
good with no obvious violations of the fundamental welfare theorem there
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In this case the “Cdgeworth bo-” is actuall" a line because there is onl" one 
goo
island. (he set of possible allocations is a straight line 133 units long. Cver" alloc Cancel anytime.
is Pareto efficient because the onl" wa" to ma!e one person better off is to ma!e an
person worse off. (here is no theor" in the te-t to help us decide whether an allocat
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8. 'lthough Lictoria#s marginal rate of substitution is equal to 'lbert#s these are not
to the marginal rate of transformation and the allocation is therefore Pareto ineffi
oth people would give up % cups of tea for 1 crumpet but according to the produ
function could actuall" get 4 crumpets b" giving up % cups of tea. " giving up te
getting crumpets through the production function both utilities are raised.
13. a. Dalse. 's shown in the te-t equalit" of the marginal rates of substitut
necessar" but not sufficient condition. (he F?S for each individual mus
equal the F?(.
b. Jncertain. 's long as the allocation is an interior solution in the Cdgeworth
the marginal rates of substitution must be equal across individuals. (his nee
be true however at the corners where one consumer has all the goods
econom".
c. Dalse. ' polic" that leads to a Pareto improvement results in greater eff
but social welfare depends on equit" as well as efficienc". ' polic" that imp
efficienc" but creates a loss in equit" might reduce social welfare.
d. Jncertain. (he ta- reduces efficienc" but if education creates

e-ternalities then increased funding for education improves efficienc". (hi
You're
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increased efficienc" in the education mar!et
than offsets the reduced efficienc" in the mar!et for cigarettes.

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&hapter  + Public !oods
1. a. ,ilderness ar area is
is an
an im
impure pu
publi
blic go
good – at some po
point
nt co
consumpti
ption be
nonrivalH it is however none-cludable.
b. Satellite television is nonrival in consumption

consumption 9although it is e-cludable<.
c. Fedica
Fedicall school
school educ
educati
ation
on is a privat
privatee good.
good.
d. (elevis
(elevision
ion signal
signalss are nonrival
nonrival in consumption.
consumption.
e. 'n Internet
Internet site
site is
is nonrival
nonrival in consump
consumption
tion 9althou
9although
gh it is
is e-cludable<
e-cludable<..
%. a. Dalse. Cfficient pr
provision of
of a pu
public gogood oc
occurs at
at th
the le
level wh
wher
willingness to pa" for an additional unit equals the marginal cost of producin
additional unit.
b. Dalse. 0ue to the free rider problem it is unli!el" that a private business
could profitabl" sell a product that is non*e-cludable. owever recent
recent rese
reveals that the free rider problem is an empirical question and that we should
ta!e the answer forfor granted. Public goods
goods ma" be privatel" supporte
supported
d thro
volunteeris
volunteerism
m such as when people who attend a firewor!s
firewor!s displa" volunt
contribute enough to pa" for the show.
c. Jnce
Jncert
rtai
ain.
n. (h
(his
is stat
statem
emen
entt is
is tru
truee if
if the
the road
road is not
not con
conge
gest
sted
ed but
but when
when th
heav" traffic adding another vehicle can interfere with the drivers al
using the road.
d. Dalse
Dalse.. (h
(her
eree will
will be mo
more
re use
users
rs in larg
larger
er comm
communi
uniti
ties
es but
but all
all user
userss hav
havee ac
Master your semester with
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that has been provided since the good is non*rival
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reasons larger communities would necessaril" have to provide 
the non*rival good.  Useful  Not useful
a large
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+. , me tha
thatt )heet
)heetah
ah##s util
utilit
it"
" does
does not ent
enter
er the
the soci
social
al welf
welf e funct
functio
ionH
nH he
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on the potential
potential benefi
benefits
ts of the resear
research
ch which
which could
could be sub
substa
stanti
ntial
al if altern
altern
medici
medicine
ne provides
provides effect
effective
ive treatme
treatments
nts and whether
whether or not the treatm
treatments
ents can
patented.
2. 'irc
'ircra
raft
ftss are bot
both
h rival
rival and
and e-cl
e-clud
udab
able
le goods
goods so publ
public
ic sect
sector
or prod
produc
ucti
tion
on of air
air
not @ustified on the basis of public goods. If polic"ma!ers assume that the the benefits o
mega*@
mega*@etl
etline
inerr are public
public then
then the"
the" would
would find
find the effici
efficient
ent level
level of product
product
verticall" summing demand curves rather than hori&ontall" summing demand cu
(his causes the benefits to be significantl" overstated and could be used to @ustif"
high costs.

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4. (his deb
(his debat
atee is simi
simila
larr to the
the deba
debate
te abo
about
ut pri
priva
vate
te ver
versu
suss publ
public
ic edu
educa
cati
tion
on.. Publ
Public
ic s
production is often associated with higher costs
co sts 9for both schools and prisons< but
ma" be other reasons societ"
societ" would
would prefer public
public to private provision.
provision. (hese re
t"picall" relate to equit" considerations. Dor schools the main main argument is to ma!e
ever"one
ever"one child has the opportunit"
opportunit" for a good education.
education. Dor prisons
prisons there ma"
fundamental
fundamental conflict between fair and humane treatmenttreatment of prisoners
prisoners and !eeping
low. Dor e-ample equit" might require that prisoners be fed nutritious
nutritious meals but g
them
them bread and water for ever" ever" meal
meal might be less e-pensiv
e-pensive.
e. (his
(his question
question
students to give personal opinions about privati&ing prisons so there is no single “r
answer.
6. (he e-per
(he e-perimimen
enta
tall resu
result
ltss on fre
free*
e*ri
ridi
ding
ng sug
sugge
gest
st that
that memb
membererss of the
the comm
communi
unit"
t" m
volunt
voluntari
aril"
l" contri
contribut
butee about
about half
half of the requir
required
ed amount
amount.. (he reason
reason these
these
wanted to use private fundraising was because the state government redistribute
dollars from wealth" districts to poor districts 9the so*called ?obin ood plan< so u
private donations was a wa" to avoid losing ta- dollars to other districts.
districts.
>. (heree is no com

(her compel
pelli
ling
ng rea
reaso
son
n for
for mus
museum
eumss to
to be run
run b"
b" the
the gove
govern rnme
ment nt fro
from
m the
the t
of pub
public
lic goodsH
goodsH thus
thus it is appropria
appropriatete to thin!
thin! about
about privat
privati&ai&atio
tion.
n. 'dmis
'dmissio
sio
museums are clearl" e-cludable. 'nd viewing the the artwor! is also rival because th
congestion
congestion when too man" people people are consuming
consuming the good. (hus museums museums m
thought of as a private
private good rather
rather than public good. In the Jnited Jnited States man" man"
museums
museums are run privatel" 9not for for profit<
profit< and the" seem to do quite well. In term
private versus public production
production the te-t points out that this decision should be base
relative wage and material costs in the public and private sector administrative c
diversit" of tastes
tastes and distributional issues.
issues. (here is no compelling
compelling reason to thin
private sector would have higher costs than the public sector. In regards to divers
tastes a profit*ma-imi&ing private sector museum would li!el" be more responsi
consumer tastes than the public sector – e.g. adopting new technologies that ma!
museum more en@o"able for the t"pical customer.
customer.ReadIn up
regards toondistributional
distribut 
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would be less responsive than the public
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of commodit" egalitarianism however is a stretch for museums.

public sector. (he n
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demand curve and the marginal benefit of the 12th unit. (he net benefi
711%.2 for each person for a total of 7%%2.

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13. (helma#s marginal benefit is F(C$F':1%*M and $ouise#s is F$/JISC:>*%M

marginal benefit for societ" as a whole is the sum of the two marginal benefit
F:%3*+M 9for MO< and is equal to (helma#s marginal benefit schedule afterward
M<. (he marginal cost is constant at F):14. Setting F:F) along the first seg
gives %3*+M:14 or M:=+ which is the efficient level of snowplowing. Bote t
either (helma or $ouise had to pa" for the entire cost herself no snowplowing w
occur since the marginal cost of 714 e-ceeds either of their individual marginal ben
from the first unit 971% or 7><. (hus this is clearl" a situation when the private m
does not wor! ver" well. 'lso note however that if the marginal cost were some
lower 9e.g. F)O>< then it is possible that $ouise could credibl" free ride and (h
would provide the efficient allocation. (his occurs because if (helma believes
$ouise will free ride (helma provides her optimal allocation which occurs on the se
segment of societ"#s F curve which is identical to (helma#s F curve 9note
$ouise gets &ero marginal benefit for M<. Since $ouise is completel" satiated wit
good at M: her threat to free ride is credit if (helma provides M.

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&hapter / $ E0ternalities
1. )lassical economics e-plicitl" requires that all costs and benefits be ta!en into acc
when assessing the desirabilit" of a given set of resources so Gore#s statement is f
(he notion that rescuing the environment should be “the central organi&ing princip
civili&ation” provides no practical basis for deciding what to do about aut
emissions 9or an" other environmental problem< because it provides no framewor
evaluating the tradeoffs that inevitabl" must be made.
%.
a. (he number of parties per month that would be provided privatel" is P.

b. See schedule FS p. Unlock full access with a free trial.
c. P;. Give a per*unit subsid" of 7b per

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(he total subsid":abcd . “Societ"” comes out ahead b" ghc assuming the su
d.
can be raised without an" efficienc" costs. 9)assanova#s friends gain
Master your semester with Scribd )assanova loses chd but gains abcd  which is a subsid" cost to government.<
Days
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+. a. It is ver" li!el" that the farmer could  negotiate
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propert" rights are clearl" defined. (he )oase (heorem is therefore applicab
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. a. (he price of imported oil does not reflect the increased political
effectivel" subsidi&ing authoritarian regimes li!e those in Saudi 'rabia.
b. (he ta- would estimate the marginal damage 9e.g. the increased instabilit" i
Fiddle Cast etc.< b" importing oil from Saudi 'rabia.
c. (he suppl" of (G?s is vertical at 13.2 billion if government see!s to r

consumption of gasoline to 13.2 billion. )onsumers must have one (G
order to bu" one gallon of gasoline plus the" must pa" the price at the p
$imiting (G?s effectivel" limits the demand for gasoline so the price per g
will fall but consumers must have (G?s in order to purchase gasoline.
mar!et price of one (G? is 73.62 this means that suppl" and demand inters
73.62 as shown in the graph. (his !ind of program curbs consumption w
giving government more revenue because consumers are purchasing the (
from each other. owever the total amount of (G?s is limited b" govern
(hose consumers see!ing to purchase more gasoline than allowed b" the i
allocation of (G?s can purchase additional (G?s from other consumers a
mar!et price of 73.62. " choosing to use a (G? to purchase gaso
consumer incurs an opportunit" cost equal to 73.62 since the" cannot se
(G? once it has been used.

7 Unlock full access
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of (G?s

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(here are man" wa"s to design incentive*based regulations. Polic"ma!ers

determine the efficient level of drug usage and then either allocate or sell the right t
the drug for sic! cows.
4. (here are man" polic" alternatives for addressing problems with traffic congestion.
of these focus on reducing the number of vehicles on the road during high*traffic t
whether through regulation or through incentive*based programs.
6. a. ,hen the $ittle Pigs hog farm produces on its own it sets marginal b
equal to marginal cost. (his occurs at  units.
b. (he efficient number of hogs sets marginal benefit equal to marginal social
which is the sum of F) and F0. 't % units F:FS):1+.
c. (he merger internali&es the e-ternalit". (he combined firm worries ab

@oint profit ma-imi&ation problem not the profit ma-imi&ation problem at
firm alone. (hus the $P farm produces % units the sociall" efficient amount
d. efore the merger the $P farm produced  units. " cutting bac! to % un
loses marginal profit of 7+. /n the other hand the (ips" Line"ard#s p
increase b" 7%3. (hus profits increase b" 716 altogether.
>. Private Farginal enefit : 13 * Q
Private Farginal )ost : 72

C-ternal )ost : 7%
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government intervention PF : PF)H Q : 2 units.
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Social efficienc" implies PF : Social Farginal )osts : 72 K 7% : 76H Q : +units.
Gain to societ" is the area of the triangle whose base is the distance between the effi
and actual output levels and whose height is the difference between private and s
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13. a. (he total cost of emissions reduction is minimi&ed onl" when the margina
are equal across all polluters therefore a cost*effective solution req
that F)1 : F)% or that +33e1 : 133e%. Substituting +e1 for e% in the for
e1 K e% : 3 9since the polic" goal is to reduce emissions b" 3 units< "ield
solution. It is cost*effective for Dirm 1 to reduce emissions b" 13 units
Dirm % to reduce emissions b" +3 units.
b. In order to achieve cost*effective emission reductions the emissions fee shou
set equal to 7+333. ,ith this emissions fee Dirm 1 reduces 13 units and Di
reduces +3 units but Dirm 1 has to pa" 7+333 for each unit of poll
the" continue to produce which gives them a ta- burden of 7+333 - 83
1 generated 133 units in the absence of government interventi
7%63333. Dirm % has a lower ta- burden because it is reducing emis
from >3 units to 23 units. Dirm % pa"s 7+333 - 23 : 7123333. 's the te-t concl
the firm that cuts bac! pollution less isn#t reall" getting awa" with an"
because it has a larger ta- liabilit" than if it were to cut bac! more.
c.Drom an efficienc" standpoint the initial allocation of permits does not matt
the two firms could not trade permits then Dirm % would hav
underta!e all of the emissions reduction. Initiall" Dirm 1#s F)
while Dirm %#s F) is 7333 so there is a strong incentive for Dirm % to pur
permits from Dirm 1. You're
(radingReading
shoulda Preview
continue until F)1 : F)% which i
cost*effective solution. (his means that the mar!et price for perm
equal 7+333 the same as the emissions fee. 't this price Dirm % will pur
13 permits from Dirm % allowing Dirm % to reduce emissions b" +3
than 3 and requiring Dirm 1 to Download With Free
reduce Trialemissions b" 13. (his solution
same as the solution achieved with the emissions fee. owever Dirm 1
off because instead of having to pa" ta-es it will receive a pa"ment of
for its permits. Dirm % must pa"
avoids the pa"ment of ta-es. (he
7+3333 for the e-tra permits but
government 
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(he firms must still pa" the cost of
for the permits purchased from Dirm 1.
emissions reduction plus Dirm 
 Useful Cancel
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anytime.
% mus
11 If m ginal cos ut to be lo han anticip d cap d*trade achi s too

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&hapter 1 + Political Economy
1. a. elow the preferences for Person 1 and Person % are drawn. Same proc
used for the other three people.
b. ) wins in ever" pairwise vote. (hus there is a stable ma@orit" outcome despi
fact that persons 1 % and + have double*pea!ed preferences. (his demonstrate
although multi*pea!ed preferences may lead to voting inconsistencies this i
necessaril" the case.

%. (he belief that the ta- bill will pass because it contains provisions sought b" so
different lawma!ers is consistent with the logrolling model. It could be the case that
lawma!er has inserted favored provisions with the understanding that other lawm
will support the overall pac!age provided it contains the provisions the" favor.
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,ithout vote*trading neither bill would pass. If there Free
is Foron
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vote*trading
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then voter 
& The New York
agree toTimes

support issue Q provided voter ' supports  Issue
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Only in net benefits is K+ for Issue Q and *% for Issue  so logrolling results
$4.99/month.
gain of K1.
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option ma" have been voted down if it had been a two*wa" vote with an" of the
options. Durther if preferences are not single*pea!ed c"cling and inconsisten
decisions ma" emerge.

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6. Given the J.S. e-perience with the udget Cnforcement 'ct of 1883 we would e
the CJ deficit limits to be ineffective. ,e would e-pect “accounting tric!s” to mas
si&e of the deficits 9such as itemi&ing various budget items as “une-pected emergenc
and if that didn#t wor! we would e-pect the deficit rules to be ignored.
apparentl" what is happening. ,hen German" e-ceeded the deficit target no m
were ta!en to lev" the required fines.
>. Since rents b" definition are the returns above a normal return then when the li
are put on the mar!et their price will be the value of the rents. ence the owne
peanut license whoever he or she is onl" ma!es a normal return. Put another wa
license is an asset that earns a normal rate of return. If the peanut license s"stem
eliminated efficienc" would be enhanced. ut the elimination would in e
confiscate the value of this asset. It is not clear that this is fair. /ne could also arg
when someone bu"s this asset the purchase is with the understanding that there is s
probabilit" that its value will be reduced b" elimination of the programH hence
unfair to do so.
8. a. ,ith the demand curve of N:133*13P and a perfectl" elastic suppl" curve a
then the mil! is sold at a price of 7% and a quantit" of >3 units is sold.
b. (he marginal revenue curve associated with the inverse demand curve
You're Reading
91=13<N is F?:13*91=2<N while the a Preview
marginal cost curve is F):%. (he
would ideall" produce a quantit" where F?:F) or 13*91=2<N:% or N:3.
price associated with a cartel quantit" of 3 units is P:13*91=13<;3 or P:4.
c. Download
(he rent associated with WithisFree
the cartel theTrial
product of the marginal profit p
and the number of units produced. (he marginal profit per unit of mil! is 7
price * 7% marginal cost< while 3 units are produced. (hus the rents equal
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(he most the cartel would be willing to  is the
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rent of 7143. (he cartel situation the quantit" of mil! produced
low from societ"#s point of view. (he deadweight loss triangle is computed
the difference between the cartel output and competitive output as the “bas
the triangle and the difference between the cartel price and competitive pri
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13. Bis!anen#s model of bureaucrac" is illustrated in Digure 4. of the te-tboo!.

aftermath of September 11th the new concerns over food safet" would li!el" shift
curve upward 9that is the value placed on each level of Q<. 'ssuming that C curve 9
per unit of Q< does not change then this shift increases the actual number of
inspectors hired. It is also li!el" that the slope of the V curve changes with
marginal unit of Q becoming more valuable. (hus the V curve not onl" “shifts” upw
but becomes steeper as well. oth of these effects – the shifting of the V curve an
change in the slope – lead to greater values of Q under the bureaucrac" model.
change in the slope leads to a greater value of Q* the efficient level of output. (hu
optimal number of D0' emplo"ees and the actual number of D0' emplo"ees are l
to rise.
11. a. (he outcome of the first election 9F vs. < is F. (he outcome of the s
election 9 vs. $< is $. (he outcome of the third election 9$ vs. F<
Fa@orit" rule leads to a stable outcome since F defeats both  and $. Givin
person the abilit" to set the agenda would not affect the outcome in this case.
b. ,ith the change in Cleanor#s preference ordering ma@orit" rule no

generates a stable outcome. In a vote between F and  the outcome is .
vote between  and $ the outcome is $. In a vote between $ and F the out
is F. So giving oneYou're
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the abilit" to set the agenda affects the outcome.
e-ample 'bigail prefers  so she might pit $ against F first in or
eliminate $ and avoid having $ defeat .

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&hapter 2 + Education
1. (here are numerous rationales given for government provision of education.

though education is primaril" a private good man" argue that educating a child pro
e-ternal benefits. owever the e-istence of a positive e-ternalit" impl
government should subsidi&e education rather than ma!ing it free and mandator".
rationales are based on equit" including a belief in commodit" egalitarianism.
%. If households are allowed to supplement public education with private lessons th

budget constraint in Digure .2 of the te-tboo! is modified b" drawing a line starti
point - 9consuming onl" public education< that runs to the southeast and is parallel to
(he figure below is then similar to the anal"sis of in*!ind benefits li!e food stamps.
Parents can supplement public education

/ther Goods with private lessons
A

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If parents pa" for the public schooling 9rather than perceiving it as being free< an
schooling was paid for with a lump sum ta- then the budget constraint shifts in b
amount that depends on the household#s share of the ta- burden. If the household
burden e-actl" equals the cost of public school the budget constraint is no longer th
segment AB but rather the segment CDB where the segment DB runs along the ori
budget constraint e-cept that the minimum amount of schooling consumed is eP.
/ther Goods
Public School is financed b" ta-es levied on parents
A
C D

BA
e p
Cducation

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+. (he question distinguishes between a private  Usefulfor
mar!et higher education in w
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education. (he e-amples cited in Drance and German" illustrate a third option of
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. a. If income is 723333 per "ear the budget constraint is a straight line as s

below.
/ther Goods
723333
723333
You're Reading a Preview Cducation
b. ,ith 7>333 worth ofDownload With

free public Free Trial
education the famil" can consumer up to 7
worth of education without reducing the consumption of other goods.
/ther Goods

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c. (he famil
(he famil" " ma-i
ma-imi
mi&e
&edd utili
utilit"
t" at
at poin
pointt ' befo
before
re the
the int
intro
rodu
duct
ctio
ion
n of free
free pu
educa
educati
tion
on and
and ma-i
ma-imi
mi&e
&ess util
utilit
it"
" at poin
pointt  afte
afterr free
free publ
public
ic educa
educati
ti
introduced so the optimal consumption of education
edu cation fell.
/ther Goods
723333 . 
.
'
7>333 723333
Cducation
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d. ,ith an
an 7>3
7>333
33 edu
educa
cati
tion
on vou
vouch
cher
er the
the fami
famil"
l" can
can spe
spend
nd som
somee of its
its inco
inco
education
education to purchase
purchase more education
education if it desires.
desires. If the optimal
optimal point m
from
from ' to  as sho
shown
wn in the graph
graph below
below then the introdu
introducti
ction
on of vouc
causes the famil" to purchase more education.
/ther Goods
723333
. 
. '

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2. a. (he re
result
ults m
miight be biased if
if the
therre ar
are ot
other
her di
differenc
ences be
between th
the tw
two s
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&hapter 3 + &ost 4ene%it "nalysis
1. es one
one rea
reall
ll"
" mus
mustt as!
as! thes
thesee ques
questi
tion
ons
s alt
althou
hough
gh it
it ma"
ma" see
seem
m dist
distas
aste
tefu
ful.
l. /the
/the
there is no wa" to determine which safet" precautions are sensible.
%. (he incr
(he increa
ease
sed
d time
time spen
spentt at
at the
the ins
inspe
pect
ctio
ion
n must
must be cou
count
nted
ed as
as a cos
costt of
of the
the pro
progr
gram
am
reasonable wa" to estimate the value of the time would be to use the average wage ra
the state and multipl" this b" the incremental waiting time of 132 minutes.
+. (he present value of 7%2

7%2=.13 : 7%23
%23.
(he present value of the perpetual annual benefit :  K =91 K r< K =91 K r< % K U :
K 1 * r<=r : =r.
. a.(he in
internal
nal ra
rate of
of re
return is
is th
the di
discount
unt ra
rate tha
thatt wo
would mama!e th the pr
pro@e
present value 9BPL< equal &ero. (o solve solve for the internal rate of retu
set the present value of benefits minus the present value of costs equal to
we assume
assume the benefit
benefit of using the bic"cle
bic"cle is immediate
immediate 9and worth
there is also the benefit of re*selling the bic"cle for 7+23 but it can#t
sold until ne-t "ear so must be discounted. (herefore BPL is 163 K V+23=9
– 233 : 3. Solving this e-pression for ρ "ields ρ : 4 percent
percent.. If we we as
that the benefits of the vacation will not be en@o"ed for one "ear then

is V9163K+23<=91Kρ<W –
for ρ "ields ρ : 
233 and setting
percent.
setting this e-pression
e-pression equal to &ero and
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Special offer for students: If the discount rate is 2 percent purchasing the bic"cle is a good idea if
percent but a bad idea if ρ is  percent.
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Bet benefit : 7%1%23.
d. (he subwa" pro@ect has a higher present value. If a dollar to the “poor” is va
same as a dollar to the “middle class” choose the subwa" pro@ect.

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e. $et λ : distributional weight. set

%%3333 : *4>623 K λV94%233=1.%2< K 94%233=1.%2%<W
λ : +.%1
(his distribution weight means that 71 of income to a poor person must be vi
as more important than 7+.%1 to the middle class for the legal services to be d
4. 7133 billion invested for 133 "ears at 2 percent per "ear would generate over 71+ tr
a little more than twice the 7633 billion in damage caused b" the climate change.
might be other considerations offered when evaluating this proposal but the cri
correct from a financial standpoint.
6. (his question demonstrates that assessing the costs and benefits of different pr
often involves value @udgments and ma" reflect attitudes toward governmen
e-ample a libertarian would argue that if carpooling resulted in lower co
individuals then the" would alread" be carpooling and would not need a govern
requirement to force them to carpool.
>. (he Senator#s slip revealed her interest in creating and protecting @obs in )alifor
!eeping the pro@ect alive.
8. )urrie and Gruber 91884< find the cost of the e-pansion per life saved was appro-
71.4 million. 'ccording to Liscusi and 'ld" 9%33+< the value of a statistical l
between 7 million and 78Unlock
million. If with
full access all aoffreethese
trial. calculations are correct the
Fedicaid e-pansion passes a cost*benefit test.

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&hapter 5 + he Health &are Mar6et
1. (he quotation contains several serious errors. Dirst concern with health care co
not mean that health care is not a “good.” Cconomists do not care about the co
health care per se. ?ather the issue is whether there are distortions in the mar!e
lead to more than an efficient amount being consumed. Second it ma!es a
difference how mone" is spent. /ne can create emplo"ment b" hiring people t
ditches and then fill them up but this produces nothing useful in the wa" of good
services. (hus emplo"ment in the health care sector is not desirable in itself.
desirable to the e-tent that it is associated with the production of an efficient quanti
health care services.
%. C-amining Digure 8. we can see wh" health care costs increased for the
(ennessee. 's insurance coverage increases this lowers the cost of medical e-pens
those who were previousl" did not have insurance which increases the overall amou
medical services the" consume. efore receiving insurance these people deman
units of medical services and the amount the" pa" is represented b" the area /P
ut after receiving insurance coverage the" demand F1 amounts of medical serv
pa"ing onl" /@hF1 while their insurance pa"s @Po bh. (he increase in insu
pa"ments is si&able for two reasons – first b" providing coverage it pa"s for the ma
of the alread" si&able medical e-penses incurred b" this group and seco
You'rethe
introduction of insurance ma!es Reading
groupa Preview
consume even more medical services
short if the people who designed the (ennessee program had reali&ed that the de
curve for medical services is downward sloping the" would not have been surpris
the consequences of their program.
(o e-plain wh" F/s have been unable to contain long*run health care costs
necessar" to consider the effect of technolog" on health care costs in the long*term.
inherent problem is that the mar!et for medical care places a large premium on usin
latest and most*developed medicines and machiner" for treating patients.
Days

& The New York Times technologies tend to be e-pensive. ence while introducing F/s can lead  to a
and for all decrease in the rate of change in health care Useful  Not useful
costs
Cancel anytime.there is nothing th
F/ can do to lower the cost of continuall" providing the latest in medical treatmen
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2. a. P:133*%2N:723 so N:% visits per "ear. (otal cost is 9723<9%< : 7133.
b. ,ith 23 percent coinsurance the individual pa"s 7%2 per visit and the qua
demanded is + visits per "ear. (he individual#s out*of*poc!et costs ar
and the insurance compan" pa"s 762 97%2 per visit + visits per "ear<.
c. (he introduction of insurance caused the quantit" demanded to increase fr

+ because the individual#s effective price fell from 723 to 7%2 bu
marginal cost is still 723 per visit. (he individual consumes
services past the point where the marginal benefit to the individual equal
marginal cost leading to inefficienc" or deadweight loss. (he margina
of the third visit is 723 but the marginal benefit is 7%2 so the deadweigh
is equal to this difference or 7%2. If the method presented in Digure
applied the deadweight triangle will have an area equal to 71%.23.
d. If the marginal benefit of visiting the doctor is 723 there is no deadweig

because marginal benefit equals marginal cost.
4. a.
(here is a 82 percent chance of no illness in which case income is 7+3333
2 percent chance of illness in which case income is 713333 becau
the 7%3333 loss. (hus e-pected income is 93.82<9+3333< K 93.32<91333
%8333. (he You're
utilit" Reading
of having a Preview
income of 7%8333 with certaint" is 1
but the e-pected utilit" is onl" 93.82<J9+3333< K 93.32<J91333
93.82<911.482< K 93.32<913.286< : 11.4.
b. Downloadwould
'n actuariall" fair premium With Free Trial since there is a one in
be 71333
chance that the insurance compan" will have to cover losses of 7%3
If the individual bu"s insurance for 71333 then the" have certain incom
7%8333 and the utilit" of 7%8333 is 11.44.
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c. Setting the e-pected utilit" equal to 11.4 and solving for income "ields 
appro-imatel" 7%>+>> indicating that the individual is ind
between bearing the ris! and having e-pected income of 7%833
purchasing insurance with certain income of 7%>+>>. If the insurance
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&hapter )7 + !overnment and the Mar6et %or Health &are
1. /ne e-planation discussed in the chapter is that the shift toward managed care le
one*time decrease in e-penditures but advances in medical technolog" cont
resulting in concomitant growth in e-penditures. (his e-planation implies that 
helped prevent rising health care costs during the 1883s but have been unable to
costs low due to rapid advances in technolog". (he structure of F/s creates incen
for health care providers to s!imp on the qualit" of care. F/s used “gag rule
prohibited ph"sicians from discussing treatment options that were not covered
plan but government regulation has since banned these gag rules allowing
greater access to information. Fedical technolog" creates new and often
e-pensive treatment options which man" patients believe the" should have.
become increasingl" difficult for F/s to !eep costs down b" den"ing more e-pe
treatment options especiall" since the" can no longer prevent ph"sicians from infor
patients of these options.
%. Fedicare covers nearl" the entire population aged 42 and older and is not means
'bout 88 percent of the eligible population chooses to enroll in supplementar" me
insurance 9SFI< or Part  of Fedicare which pa"s for ph"sicians and services rend
outside the hospital. Patients pa" a monthl" premium a small annual deductible
%3 percent coinsurance rate. (he Fedicare program has not improved the health
the elderl" ver" much but isYou're Reading
has led a Preview
to significant benefits in the form of reducin
ris! of facing ma@or reductions in consumption due to medical e-penses.
+. 'llowing individuals to @oin the Fedicare prescription drug benefit plan at an"
would li!e lead to an adverse Download With
selection Free Trial's individuals age and their h
problem.
deteriorates the li!elihood that the" will need e-pensive prescription drugs increase
individuals wait until several "ears after becoming eligible for Fedicare to
prescription drug benefit plan the" pa" less in premiums which adds to the
enormous e-pense of the Fedicare drug benefit.
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. (he budget constraint initiall" has units of Fedigap on the -*a-is and other good
"*a-is. Given initial prices of 71 per unit for each good and 7+3333 of incom
budget constraint has a slope of *1 and the intercepts on both a-es are at +3333 uni
is assumed that the initial utilit" ma-imi&ing bundle consumes 2333 units of Fed
hence the indifference curve is tangent at 92333%2333<. 'll of this is illustrated i
figure below.
Fedigap choice without minimum

standards
/ther Goods
+3333
%2333
U 0
2333 +3333 Fedigap

efficienc" units
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'fter the “minimum Fedigap” mandate the consumer can either choose 3 un
Fedigap or >333 or more units of Fedigap. (hus part of the budget const
eliminated 9though the overall shape remains the same as before<. 'fter the mandat
point 93+3333< is available as well as all of the points to the southeast of the
9>333%%333<. )learl" the person#s utilit" must fall since the preferred
92333%2333< is no longer available. If the person attains a higher level of util
93+3333< compared with 9>333%%333< the person chooses to not purchase Fediga
this case the marginal rate of substitution is no longer equal to the price ratio.
illustrated below.
Fedigap choice with minimum standardsH

no Fedigap is purchased
/ther Goods
+3333
%2333
U
You're 0Reading a Preview
U 1
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2. If individuals are allowed to purchase supplemental private insurance then the b

constraint in Digure 13.2 of the te-tboo! is modified b" drawing a line starting at po
that runs to the southeast and is parallel to ').
Individuals can purchase supplemental

/ther Goods private insurance
A
B

C
M
Download With Free Trial ealth Insurance

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If individuals pa" for health insurance 9rather than perceiving it as being free< an
insurance was paid for with a lump sum ta- then the budget constraint shifts in b
amount that depends on the household#s share of the ta- burden. If the household
burden e-actl" equals the cost of health insurance the budget constraint is no longe
line segment AD but rather the segment )0 where the segment )0 runs alon
original budget constraint e-cept that the minimum amount of health in
consumed is F.
/ther Goods
Government health insurance is financed b" ta-es
A
B C

D
M
ealth Insurance
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&hapter )) + Social Security
1. ,ith adverse selection insurance contracts with more comprehensive cover

chosen b" people with higher unobserved accident probabilities. (o ma!e up for th
that a benefit is more li!el" to be paid to such individuals the insurer charges a h
premium per unit of insurance coverage.
%. Individuals who do not save enough for their retirement "ears ma" believe
government will feel obliged to come to their aid if the" are in a sufficientl" desp
situation. ,ith this belief "ounger individuals ma" purposel" neglect to save adequ
/ne @ustification for the compulsor" nature of Social Securit" is to addr
inefficientl" low saving caused b" moral ha&ard.
+. Jse the basic formula for balance in a pa"*as*"ou*go social securit" s"stemA
t :9B b=Bw<;9=w<.
)all 1883 "ear 1 and %323 "ear %. (hen

t1 : .%46;9=w<1
t% : .2>;9=w<%
It follows that to !eep 9=w< 1:9=w<% we require t%=t1:.2>=.%46:1.61. (hat is ta-
would have to increase b" 61You're Reading
percent. a Preview
Similarl" to !eep the initial ta- rate constan
would require 9=w<%=9=w<1:.%46=.2>:3.2>. enefits would have to fall almost b"
. Social Securit" redistributes incomes from "ounger generations to older gener

Download
from men to women from high* With Freeindividuals
to low*income Trial and from two*earner to
earner married couples.
Social Securit" benefits older generations because it is largel" financed on a pa"*as

Master yourgosemester with
basis. (he most Scribd
e-treme e-ample is Ida Duller the first Social Securit"
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 benefi
who paid onl" 7%.>2 and received benefits of 7%3>86 over her lifetime. 
,omen have gained because the" have lived longer. (he te-t cites $i
calculations which show that among people who retired in the 1883s on average
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/ne*earner married couples benefit because a non*wor!ing spouse is entitled

percent of a wor!ing spouse#s benefit. Dor a two*earner married couple the indiv
with lower earnings ma" gain little or nothing in benefits from wor!ing since he
would have been entitled to benefits based on the other spouse#s earnings.
2. 'usten#s quote seems li!e it could relate adverse selection but perhaps more li!
moral ha&ard. (he quote “If "ou observe people alwa"s live forever when there i
annuit" to be paid them” in a sense sounds li!e the" act differentl" 9e.g. better diet
e-ercise etc.< when an annuit" is to be paid – the idea of moral ha&ard. In con
adverse selection suggests that people who e-pect to live a long time to be the ones
purchase annuities. ' recent paper b" Din!elstein and Poterba 9BC? wor!ing
0ecember %333< found that “mortalit" patterns are consistent with models of as"mm
information” and that annuit" “insurance mar!ets ma" be characteri&ed b"
selection.”
4. Cquation 98.1< relates ta-es paid into the Social Securit" s"stem to the dependenc
and the replacement ratio that is t:9B b= Bw<;9=w<. If the goal of public poli
maintain a constant level of benefits  rather than a constant replacement ratio 9
then ta-es ma" not need to be raised. If there is wage growth 9through productivit"<
it is possible to maintain  at a constant level even if the dependenc" ratio is grow
" rearranging the equation we can see that :t;w;9B b= Bw<*1. (hat is incre
wage rates 9the second term< You're Reading
offset a Preview
increases in the dependenc" ratio 9the third t
(hus constant benefits do not necessaril" impl" higher ta- rates.
6. (he statement about how the different rates of return in the stoc! mar!et and gove
Download
bond mar!et affect the solvenc" of theWith
trustFree
fundTrial
is false. If the trust fund bu"s
someone else has to bu" the government bonds that it was holding. So there is no
saving and no new capacit" to ta!e care of future retirees.
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>. a. (he problem does not provide information about the utilit" function so
optimal point is where the indifference curve is drawn tangent to the budget
which can occur at different values depending on how the curve is drawn.
diagram below the optimal point involves saving 7>333 and future consump
consists of period % income 972333< plus savings with interest 97>>33<.
Duture
)onsumption
7%6333
71+>33 . /ptimal Point

Cndowment
72333 .
Point
71%333 7%3333 7%222

Present
)onsumption
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b. If Social Securit" ta!es 7+333 from the individual in the first period and
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8. If the implicit rate of return from Social Securit" is lower than the private retu
budget line becomes flatter at the endowment point as present consumption falls
7%3333 to 716333 when 7+333 is ta!en for social securit". (his middle segment o
budget line is flatter reflecting the lower rate of return on Social Securit" compare
private saving. Dor savings be"ond the 7+333 ta!en for Social Securit" the private
of return is available so the budget line is parallel to the original line. (his would c
the optimal point to change and put the individual on a lower indifference curve.
graph below the effect is to increase private saving slightl".
7%6333
Dirst /ptimal
71+>33
Bew /ptimal
..
You'rePoint
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Point
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Trial
72333 .Point

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is li!el" to be progressive not regressive. /ne critical assumption in this !ind of ana
is how one computes lifetime benefits – e.g. do we assume that low earners and
earners live the same number of "earsX

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11. If the e-pected present value of the benefit reduction @ust equals the decrease in ta
then the solvenc" of the s"stem is unaffected. (he pa"*as*"ou*go formula shows t
s"stem is solvent if ta-es collected equal benefits paid or twB w : B b. 0ividing
sides b" the number of covered wor!ers "ields tw : 9B b=Bw<. If a wor!er diverts 71
from pa"roll ta-es to a private account then the left*hand side of this e-pression fall
71333. (o maintain solvenc" the right*hand side must also fall b" 71333 so ben
must fall b" 1333 times the ratio B w=B b. If for e-ample there are three covered wo
for ever" retired wor!er so that B w=B b is equal to + then the necessar" reduction in
e-pected value of benefits is 7+333. If a wor!er invests 71333 for 3 "ears at abo
percent per "ear that wor!er will have enough in his private account to compensat
the lost benefits. If the offset rate is lower than the rate of return wor!ers can ear
private accounts wor!ers will gain and vice versa.

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&hapter )* + Income Redistribution8 &onceptual Issues
1. Jtilitarianism suggests that social welfare is a function of individuals# utilities. ,h

the rich are vulgar is irrelevant so this part of the statement is inconsiste
utilitarianism. /n the other hand Stein#s assertion that inequalit" per se is unimport
inconsistent with utilitarianism.
%. a. (o ma-imi&e , set marginal utilities equalH the constraint is Is K Ic : 133.

So
33 * %Is : 33 * 4Ic.
substituting Ic : 133 * Is gives us %Is : 4 9133 * Is <.
(herefore Is : 62 Ic : %2.
b. If onl" )harit" matters then give mone" to )harit" until FJc : 3 9unless a
mone" in the econom" is e-hausted first<.
So
33*4 Ic : 3H hence Ic : 44.46.
Giving an" more mone" to )harit" causes her marginal utilit" to become neg
which is not optimal. Bote that we don#t care if the remaining mone" 97++.
given to Simon or not.
You're
If onl" Simon matters thenReading
proceeding a Preview
as above FJ s. 3 if Is : 133H hence g
all the mone" to Simon is optimal. 9In fact we would li!e to give him
7%33.<
c. FJs : FJc for all levelsDownload With Freeence

of income. Trial societ" is indifferent amon
distributions of income.

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+. Suppose the government is initiall" providing an in*!ind benefit of 13 units of fre

transportation worth 7% each so the cost of the subsid" is 7%3. ,ithout the sub
income is 73. ,ith no subsid" the consumer ma-imi&es utilit" at point ' and wi
in*!ind benefit of 13 units of free public transportation the consumer ma-imi&es util
point . ' cash subsid" equal to 7%3 would allow the consumer to reach point  as
so the government could convert an in*!ind subsid" valued at 7%3 to a cash subsid
7%3 and leave people equall" well off.
/ther goods
'

13 %3 +3
Public (ransportation

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'nother possibilit" is that the utilit"*ma-imi&ing point for a cash subsid" differs from
utilit"*ma-imi&ing point for an in*!ind subsid" as illustrated in the ne-t graph.
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In this case an in*!ind subsid" costing 7%3 would allow the consumer to move
point '# to point # while a cash subsid" of 7%3 would ma!e the consumer better
point #. In order to ma!e the consumer equall" well off the cash subsid" shou
little less than 7%3.
/ther goods
#
)#
'#
13 %3 +3
Public (ransportation
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. ,ith a 723 cash grant an individual could purchase 13 units of food since the
value of each unit of food is 72. 'ssume household income is 723 and that the
value of “other goods” is also 72 per unit. 'dding the 723 cash grant would giv
individual 7133 to spend on some combination of food and other goods and the rel
budget line would be ') in the graph below. If instead the individual is given
worth of food stamps then the budget line is the hori&ontal line 0 and
segment ). If the utilit"*ma-imi&ing combination of food and other good
been at point C with the cash grant 9or an" other point on the segment '<
switching from a cash grant to food stamps would force the individual to a
indifference curve and the new equilibrium would occur at point .
It is possible that switching from food stamps to a cash grant would ma!e
individual better off as illustrated b" a movement from point  to point C in
graph below.
It is also possible that the individual would choose the same combi
regardless of whether he is given a cash grant or food stamps 9if the
indifference curve were tangent to the budget line on the segment )< in w
case it would ma!e no difference.
(here is no circumstance under which switching from food stamps to a cash g

You're worse
would ma!e the individual Reading
offa given
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the assumptions of the model.

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/ther Goods
'
%3
0

)
13 %3
Unlock full access with a free trial. Dood

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2. 'ccording to the ma-imin criterion social welfare depends on the utilit" of the ind
who has the minimum utilit" in the societ". ' peculiar implication of this criterio
noted b" Deldstein is that if societ" has the opportunit" to raise the welfare of the
advantaged b" a slight amount but ma!e almost ever"one else substantiall" wors
e-cept for a few individuals who would become e-tremel" wealth" then societ" sh
pursue this opportunit". (ransferring large sums of income from the middle class to
the poor and the rich would achieve this end and so would be supported b" som
with the ma-imin social welfare function.
4. a. Dalse. Societ" is indifferent between a util to each individual not a dollar

individual. Imagine that J$:I and J:%I. (hen each dollar given to ona
raises welfare more than the same dollar given to $"nne.
b. (rue. (he social welfare function assumes a cardinal interpretation of util
that comparisons across people are valid.
c. Dalse. 0epartures from complete equalit" raise social welfare to the e-t
the" raise the welfare of the person with the minimum level of utilit"
e-ample with the utilit" functions J$:I and J:%I the social welfare fun
,:minVJ$JW would allocate twice as much income to $"nne than onathan.

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6. Initiall" the price of food was 7% and the price of other goods was 71. (he blac!
for food stamps changes the price of food sold to 71. In Digure 1%.+ of the te-tboo
one moves to the “northwest” from point D the segment will now have a slop
absolute value< of 1 rather than %. (he blac! mar!et may ma!e the individual better
the best point on her budget constraint 'D0 was initiall" at the corner solution of po
and the blac! mar!et certainl" does not ma!e her worse off. It is important to not
the blac! mar!et does not always ma!e the recipient better off. If the 9absolute valu
the marginal rate of substitution 9F?S< were between 1 and % the indifference c
would not “cut” into the new part of the budget constraint with the blac! mar!et.
lac! mar!et where food stamps are sold

for fift" cents on the dollar no better off
/ther Goods
Sell food stamps for other

goods on blac! mar!et
A !
U
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If the F?S were less than 9or equal to< 1 in absolute value the person would be m
better off and would reduce food consumption b" selling the food stamps on the
mar!et.
DIGJ?C 6.6b – lac! mar!et where food

stamps are sold for fift" cents on the dollar
/ther Goods higher utilit"
Sell food stamps for other

goods on blac! mar!et
A ! U 1
U 0

D
!ood "tamp
%uarantee Dood
Master your
>.
#areto e$$icient redistribution is a reallocation of income that increases 9or doe
decrease< the utilit" of all consumers. ,ith these Read Free
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consumers 
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increases as Sherr"#s utilit" increases. (hus it ma"
 be possible
Useful  Notto reallocate
useful income
Farsha to Sherr" and raise both of their utilit". ,ith Cancel
anytime.
Sherr"#s initial utilit" functi
JS:133S  her utilit" with 7133 of income is J S:13397133<1=% or JS:1333.
1=%
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&hapter ) + E0penditure Programs %or the Poor
1. a. Bote that the figure below shows the correct shape of the budget constraint
the numbers themselves are outdated. ,ith a wage rate of 713 per
Cli&abeth earns 7133. ecause the deduction in )alifornia is 7%%2 none
earnings are counted against the 742 welfare benefit. (hus her total incom
762 9:7133K742<.
b. (he actual welfare benefits collected b" a person equals :G*t9Carnings*0<
:actual benefits G:welfare grant t:ta- rate on earned income and 0:stan
Master your semester with Scribd deduction. (hus 9Carnings*0< is the net earnings that are ta-ed awa"
Days
 in the
& The New York Times of reduced benefits. ,hen benefits equal &ero 9:3< the e-pression  bec
 Useful
3:G*t9Carnings*0< which collapses toA Carnings:G=tK0.  Not useful
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“brea!even formula.” In the )alifornia conte-t here the e-pression bec
Carnings:742=3.2 K %%2 or Carnings:71212. ,ith a wage rate of 713 per
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but the" ma" also e-plain participation in the program. (he econometric strateg" s
be chosen carefull" to account for this.
+. a. ,ithout the program in effect $ois#s budget constraint is the line '0. ,
program in effect her budget constraint is ')0. (he grant is reduced to &e
$ois wor!s %3 hours per month since her hourl" wage rate is 713.
Income
'
713(
 )
7%33
0
( * %3 ( $eisure ours
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b. Sign
Fan" low*wage earners would be better off up to vote
wor!ing on
&ero title with this !in
hours
& The New York program
Timesin place as shown in Digure 1+.4. Useful  Not useful  Cancel anytime.
c. If the implicit marginal ta- rate on the grant is 44.46 percent then $ois ca
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Income
'
713(
 )
7%33
0
( * +3 ( * %3 ( $eisure ours

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d. In the graph below the highest indifference curve corresponds to the pro
with a 44.46 percent marginal ta- rate the middle indifference curve to
program with a 133 percent marginal ta- rate and the lowest indifference cu
no program. ours wor!ed fall to &ero with the 133 percent marginal ta-
while hours wor!ed fall some but not all the wa" to &ero with the 44.46 per
marginal ta- rate. (here is insufficient information to predict how man" h
$ois will wor! in each case. In general the lower marginal ta- rate strengt
wor! incentives as illustrated in Digures 1+* and 1+*4.
Income
'
713(
7%33
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. e participates in the public housing program as long as #  # 'ca>ce$ .
2. 's illustrated below the budget constraint with food stamps has a “notch” in it sim
the anal"sis of Fedicaid in Digure 1+.8 of the te-tboo!. 't the notch the margin
You're
rate is greater than 133Y. /ne !e"Reading a Preview
difference from the figure in the te-tboo! is
marginal ta- rate on earned Unlock
income for Fedicaid is 3Y until the “Fedicaid notch”
full access with a free trial.
the marginal ta- rate on earned income for food stamps is %Y until the “food s
notch.” (he reason the food stamp notch e-ists at all is that there is a “gross in
test” where a recipient is Download
ineligible Withif Free Trial is higher than the limit.
income
characteri&ation in the te-tboo! that “at some point near the povert" line food st
worth about 71%23 are suddenl" lost” implicitl" assumes that childcare costs are
high. (his is li!el" to be true for man" households. In the "ear %33 this mo
9annual< gross income limit was 7188 per month 
Sign 97%+8%>
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& The New York Times four while the monthl" guarantee was 761 97242%Useful
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earnings at the limit of 7188 of earnings during the Cancel
per "ear<. Not
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month
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and after appl"ing a
earnings deduction and a 71+ monthl" standard deduction the household would re
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stamp notch.” (his notch would be even higher if the household qualified for a chil
deduction child support deduction or shelter deduction. (he childcare deduction r
between 7162 and 7%33 per child per month. 'ssuming this famil" of four consisted
mother and three children each with 7162 of monthl" childcare costs then :G*t9C
0*)<:61*.+9.>;188*1+*2%2<:761*7%>3.>4:7183.1 which is then rounded dow
7183. (he modification here is that ):childcare costs. (his amount corresponds
annual food stamp benefit of 7%%>3. (he figure below draws the budget constraint
annual levels for the food stamp program using %33 rules and assumes no child
e-penses.
(he food stamp “notch” with %Y ta- rate

on earned income
/ther Goods or
'nnual Income
Dood stamp notchH eligibilit"

determined separatel" from
benefits. Botch : 7+>
You're Reading a Preview Statutor" food stamp

ma-imum : 7242%
7%+8%> Unlock full access with a free trial.

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4. Dor an individual who is not wor!ing while on welfare in this case the hi
indifference curve touches the budget constraint on the right vertical a-is. Bote th
marginal rate of substitution 9F?S< does not necessaril" equal the after*ta- wage ra
the time endowment – rather it is possible that the person would want to consume
leisure than the time endowment but is obviousl" constrained from doing so.
Individual is on welfare and does not wor!

at all
/ther Goods
Statutor" ('BD
benefit
U 0
MRS>(1-t)w

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6. 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 th
of housing then the suppl" curve is perfectl" inelastic e.g. vertical.
0emand curve shifts outward perfectl"

inelastic suppl"
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"
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P3
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b. If there is no increase in the price of housing but there is an increase in the s
of housing then the suppl" curve is perfectl" elastic e.g. hori&ontal.
DIGJ?C >.6b – 0emand curve shifts

outward perfectl" elastic suppl"
# )+",-%
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c. If there is an increase in both the price and quantit" of housing then the
curve slopes upward.
DIGJ?C >.6c – 0emand curve shifts outward

upward sloping suppl" curve
# )+",-%
"
P1
P3
D
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'ccording to Sinai and ,aldfogel there is partial crowding out consistent with c
above. 'lthough the underl"ing housing stoc! itself is probabl" quite inelastic i
short*run the number of rental homes can be more elastic as 9potential< landlords co

vacation homes or vacant homes into rental units. Read Free
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,hen Cleanor#s hours 9earnings< go from 3 to 1333 973 to 7>333< she q
for an additional earned income ta- credit 9CI()< worth 7+%33 9:3.;>33
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in the te-tboo! she receives the ma-imum subsid" of 7%3 until her earn
e-ceed 716+3. Dor the marginal earnings between 716+3 and 714333
CI() is reduced at a %1.34Y ta- rate. (hus her CI() falls b" 7%46.4
7%3 to 7+8+4.2 9:%3*3.%134;914333*16+3<<. er income rise
714%3 to 7188+4.2.
8. Since Peter does not have to pa" Social Securit" and Fedicare pa"roll ta-
unemplo"ment benefits appro-imatel" 22 percent of his after*ta- income is replace
unemplo"ment insurance. (he e-istence of JI ma" ma!e wor!ers more li!el" to
emplo"ment in industries where the probabilit" of future la"offs is great. JI ma"
induce the unemplo"ed to spend more time loo!ing for wor! than the" would
otherwise. (hese moral ha&ard problems are li!el" to be more serious as the afte
replacement rate rises.

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&hapter ) + a0ation and Income 'istribution
1. a. (he wor!er#s assertion is correct if the demand for her services is perfectl"
elastic. (his assumption is not realistic. (he demand for these servic
would be perfectl" elastic if there were perfect substitutes available and
differentiation which is unli!el".
b. (he statutor" incidence of a ta- does not determine its economic incidence.
$ev"ing the ta- on patrons would not ma!e a difference.
%. 's shown in the graph the subsid" acts to increase the demand for prescription dru
the price rises. owever consumers pa" P% – subsid" so the elderl" benefit b" pa"in
less for prescription drugs and consuming more.
P%
P1
P% * subsid"
0 K Subsid"
0

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+.
. /ne e-pects that those factors that are used intensivel" in tobacco production wi
the burden of the ta-. 'ssuming for e-ample
You're Reading a Previewthat tobacco production is ca
intensive one e-pects owners of all capital 9not @ust those with investments in tobacc
bear some of the burden. Unlock full access with a free trial.
2. a. efore*ta- equilibriumA P : 713With

Download andFree
N : Trial
+33333
'fter*ta- equilibriumA P : 713.43 and N : %>>333

)onsumers pa" 713.43 and producers receive 78.43.
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b. ?evenue : 7%>>333. )onsumers bear 43Read
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percent toofFor
vote 30
theon Days
this
ta- title
burden and
 prod
& The New York bear
Times consumers
3 percent. So 716%>33 comes from Useful and Not 7112%33
useful from Cancel anytime.
producers.
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4. (he equilibrium price can be calculated b" setting the quantit" supplied equa
quantit" demandedA
9i< N0 : a * bP
9ii< NS : c K dP
If N0 : NS then the equilibrium price can be determined as followsA
a − b# = c + d#
a − c = 9b + d < #
a − c
# =
b + d
(he equilibrium output can be determined b" substituting the equilibrium price into e
the suppl" or demand equation.
Substituting into the demand equationA

Q = a − b#
 a − c 
Q = a − b 
 b + d 
Substituting into the suppl" equationA
= c + d#
Q
Download With aFree
− c  Trial
Q = c + d  
 b + d 
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a unit ta- of u dollars is imposed on the commodit"
Read then
Free it doesn#t
For 30this
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it is imposed upon 9the consumer or producer<H the Useful

new equilibrium
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the sam
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−   = −  
a 1 a 1
# =   Q + u
C C0
  Q #
b  b  b  b 
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(he equilibrium that prevails after the imposition of the ta- can be found b" setting
PP or P) : PP( ** in the end both approaches will "ield the same answer. Dirst w
derive the solution setting P)( : PPA
C0
# = # #
a  1 
−   Q + u = 
1  c
  Q −
b  b   d  d
+ + u = 
a c 1 1 
 +  Q
b d  b d 
da + bc + dbu  b + d 
=  Q
db  db 
da + bc + dbu
Q=
b + d
Be-t setting P) : PP(A
# = # #0
C
a  1 
−   Q = 
1  c
  Q − − u
b  b   d  d
a
+
c
+  1 1 
u =  +  Q
Unlock
b full
d access with
 b a free
d  trial.
da + bc + dbu  b + d 
Download =  Trial Q
db With Free  db 
da + bc + dbu
Q=
b + d

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(herefore approaches lead to the same outcome.
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6. a. ' part*time wor!er with annual income of 78333 pa"s no ta-es since ev
gets a 713333 deduction.
b. ' retail salesperson with annual income of 72333 has ta-able incom
7+2333 and pa"s 71623 in ta-es 92 percent of ta-able income<. 's a percen
of income the average ta- rate is +.>8Y 971623 is +.>8Y of 72333<. )om
to the part*time wor!er the salesperson has 7+4333 more in income and
71623 more in ta-es so the marginal ta- rate is .>4Y.
c. 'n advertising e-ecutive with annual income of 7433333 pa"s 7%233 in t

since no ta- is levied above 723333 in ta-able income. 's a percenta
income the average ta- rate is 3.%Y. )ompared to the salesperso
e-ecutive has 7222333 more in income and pa"s 7623 more in ta-es so
marginal ta- rate is 3.1Y.
>. (he equation 0123(((4.', is somewhat similar to the e-ercise in (able 1.1.
follow the te-t and define progressivit" with respect to a5erage ta- rates rather
marginal ta- rates then the average ta- rate equal A0R1623(((7,84.' for an" in
level. )learl" this average ta- rate converges to '(?:%3Y as income gets large a
lower for lower income levels. ?eplicating (able 1.1 for the ta- s"stem given her
getA
,ncome 0a 9iability A5erage 0a Rate Marginal 0a Rate
7%333 7*+433 *1.>3 3.%
+333 7*+33 *1.1+ 3.%
2333 7*+333 *3.43 3.%
13333 7*%333 *3.%3 3.%
+3333 7%333 3.344 3.%
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'fter Bew or! )it" increased the ta- from Free
73.3> For 30this
Days
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Times  
quantit" demanded went down and revenues
 Usefulwent up.Not 0efine
useful 0R as the
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revenue after the ta- and 0R( as the total revenue before the ta-. (hen 0R
and 0R16Q2dQ86#4d#81Q#4Qd#2#dQ2dQd#. Ignore the last term
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13. (he imposition of a pa"roll ta- has no effect on emplo"ment when the suppl" of la
perfectl" inelastic as shown below. If on the other hand the suppl" of labor is upw
sloping the imposition of a pa"roll ta- would cause equilibrium emplo"ment to fall
cutting the ta- would then have a positive effect on hiring as suggested b" the edito
It is realistic to assume that although labor suppl" is inelastic it is not perfectl" inela
,age
?ate per S$
hour
,1
,%
0$
0#$
$1 : $% ours per "ear

Master your(he
ne-t graph shows an upward*sloping suppl" and illustrates how the ta- red
equilibrium emplo"ment. )utting the ta- would cause the demand curve 
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the right toward the original demand curve and cause equilibrium emplo"ment  to m
bac! toward $ . 1
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,age
?ate per S$
hour
,1
,%
0$
0#$
$% $1 ours per "ear

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&hapter )/ + a0ation and E%%iciency
1. a. (he suppl" of land is fi-ed or perfectl" inelastic so there is no e-cess b

because the lower price that sellers receive does not cause quantit" supplie
fall.
b. If consumers purchase cell phones in other states in order to avoid the ta-
e-cess burden will be quite large.
c. It is possible that companies could identif" themselves as high*tech in or

receive the subsid". (hus the suppl" is quite elastic and there will be subst
e-cess burden.
d. )onsumers and sellers will li!el" agree to avoid cups and glasses in order to
the ta-. ' ta- that is easil" avoided does not have much of an impact e-ce
create some inconvenience and does not raise revenue.
e. ' ta- on all computer software will have a smaller e-cess burden 9rela
revenues collected< than a ta- on one particular t"pe of software li!e the C
spreadsheet. (his is because it is easier to substitute awa" from one t"p
software than software in general.
f. (here are man" good substitutes for blueberries. (herefore their demand i
elastic and a ta- onUnlock
themfull access with a free trial.
will have a substantial e-cess burden relative to
si&e of revenues collected.
%. Cquation 12.+ relates e-cess burden to elasticit" price quantit" and the ta
?eplacing a general sales ta- with a ta- on a few products would require a higher ta-
which increases e-cess burden other things equal. (he equation indicates that it is
to ta- man" commodities at a lower rate than to ta- a few commodities at a 
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more $4.99/month. is that when the ta- increases the e-cess burden increases wi
(hus when the ta- doubles the e-cess burden quadruples.
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4. (he hori&ontal distance //# measures the total amount of capital available in
'n" point along //# represents some allocation of capital between the manufact
sector and the non*manufacturing sector. 'ssume that firms allocate capital betwee
two sectors to ma-imi&e total incomes. It follows that the value of the marginal pr
of capital is the same in both sectors. In the graph below equilibrium occurs where
units of capital are devoted to the non*manufacturing sector and /#T; units of capit
devoted to the manufacturing sector.
Bow assume that a subsid" is available for the purchase of capital goods
manufacturing sector but not in the non*manufacturing sector. (he subsid" raises
rate of return on capital in the manufacturing sector to 91Ks<LFP F'BJ and cause
increase in the allocation of capital to the manufacturing sector to /#T S along w
decrease in the allocation of capital to the non*manufacturing sector to /T S. (he
burden is equal to the shaded triangle in the graph.
7 7
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6. a. (he value of the marginal product of capital in the corporate sector is gi

VM# c1((2> c and the value of the marginal product of capital i
noncorporate sector is given b" VM# n1?(2'> n. ,ith 23 units of c
altogether in societ" 9 > c4> n1@(8 and no ta-ation capital should be all
so that the values of the marginal products in each sector are equali&ed.
setting VM# c1VM# n gives ((2> c1?(2'> n and substituting in the constrain
23 units gives ((2@(4> n1?(2'> n or > n1(. (his implies that > c13(.
illustrated belowA
'llocation of capital to the corporate and

non*corporate sectors
VM# CR#RA0 VM# --CR#RA0
133
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VM# - 1?(2'> - VM# C 1((2> C
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DIGJ?C 1+.6b – ?eallocation after per*

unit ta- on corporate capital
VM# CR#RA0 VM# --CR#RA0
133
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(hus E>1' and the ta- wedge is t1F  so the e-cess burden is R9%<974<:74.

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>. a. efore*ta- equilibriumA P : 713 and N : +33333
'fter*ta- equilibriumA P : 713.43 and N : %>>333

)onsumers pa" 713.43 and producers receive 78.43.
C-cess urden : R91%333<973.43< K R91%333<973.3< : 74333.
#
ta- revenue
"
713.43 e-cess burden
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the negative e-ternal cost were equal 
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71 per gallon then a 71 ta- Cancel anytime.
achieve an efficient allocation and would create no e-cess burden.
negative e-ternal cost of 73.23 per gallon there is still an e
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&hapter )1 + E%%icient and E9uitable a0ation
1. 'ssuming that all other commodities 9e-cept for cable and satellite television
unta-ed then optimal ta- polic" suggests the commodities should be ta-ed accordi
the inverse elasticit" rule. Goolsbee and Petrin 9%33< find that the elasticit" of de
for basic cable service is *3.21 and the demand for direct broadcast satellites is *
'ppl"ing the inverse elasticit" rule would impl" thatA
6t BA",C 7t "A099,0 816G"A099,0 7G BA",C 816H.3(7(.@813.@
(hus ta- rates on basic cable should be 1.2 times higher than ta- rates on sat
television because basic cable is inelasticall" demanded while demand for
television is highl" elastic. 'mong the assumptions that go into the inverse elasticit"
are that goods are neither complements nor substitutes and that the elasticities ar
ic!sian compensated elasticities rather than the Farshallian uncompensated elastic
In this case it is li!el" that the first of these assumptions is false – basic cable
satellite television are li!el" substitutes for each other. (he ic!sian and Farsh
demand elasticities are li!el" to be close to each other because the income effec
li!el" to be small for this commodit".
%. 'lthough the ta- schedule You're

is progressive
Reading a the incidence is not clear at all.
Preview
determined b" the relative demand and suppl" elasticities for e-pensive cars. /ne
argue that behavior will beUnlock full access
distorted onl"with
atathe
free margin
trial. and hence demanders la
bear the burden. owever administration of this ta- would not be straightforwardA
Download
could imagine methods of evasion suchWith Free Trial
as misrepresenting invoices or selling the c
parts[
+. (he beard ta- was progressive because it was a function of social position. It#s h
!now about the efficienc" consequences unless one !nows more about the price
Days
 elas
of demand for the privilege of having a beard. If the elasticit" was small then  it w
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be an efficient ta-. owever conventional notions of Cancel  Not useful
hori&ontal
anytime. equit" suggest th
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2. 'n unregulated profit*ma-imi&ing natural monopolist will produce N1 units of o

and charge a price per unit equal to P1. Since price is greater than marginal cos
monopolist#s output is inefficient. (he efficient level of output is N; where price e
marginal cost. C-cess burden is the area between the demand curve and the mar
cost curve between output levels N1 and N;.
If the firm is required b" law to charge average cost then price will be P % and the
can brea! even b" producing N% units of output. N% is below N; so although av
cost pricing leads to more output than at the profit*ma-imi&ing level it still falls sho
the efficient amount and there is still an e-cess burden measured as the area betwee
demand curve and the marginal cost curve between output levels N% and N;.
P1

P% ')
F)
F? 0

N 1
N% N;
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4. (he marginal benefit of underreporting is equal to the ta-es saved which is simp
person#s marginal ta- (he e-pected marginal cost of underreporti
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6. (he problem with a one*time ta- on profits is that the government has an ince
renege on its promise. (he time inconsistenc" of optimal polic" occurs whe
government cannot implement an optimal ta- polic" because the stated pol
inconsistent with the government#s incentives over time. Since pharmace
companies !now that government has an incentive to impose a ta- on profits more
once their behavior will be affected b" the ta- creating an e-cess burden.
>. a. It is true that a proportional ta- on all commodities 9including leisu

equivalent to a lump sum ta-. (o illustrate consider the simplest e-ample w
there are onl" two goodsA consumption goods and leisure. (he budget const
is equal toA pC C4w91,  where p) and w are the prices of consumption goods
leisure ) and $ are the quantities of consumption and leisure and I is inco
(hen a proportional ta- on all goods changes the budget constraint
K8pC C462K8w91,  or rearranging pC C4w91,/  where ,/1,762K8=, . (
proportional ta- on all goods does not change relative prices and is equivale
ta!ing awa" income. So it is equivalent to a lump sum ta-.
b. It is 9usuall"< false that efficienc" is ma-imi&ed when all commodities are ta-
the same rateH this will not be true if leisure is unta-ed. Imagine
complicated budget constraintA pC C4p ! !4w91, . If leisure cannot be ta-ed
a ta- on commodities leads to a budget constraint of 62K8p C C462K8p ! !4w
which does changeYou're the Reading
relative apricePreview of leisure compared with fo
consumption goods. (hus it is not a lump sum ta-. Instead the inverse elas
rule given in equation 914.8< would suggest that the ratio of the ta- rate
inversel" related to the ratio of the compensated demand elasticities
commodities that canDownload
be ta-ed. With(hatFree
is 6t CTrial
7t 816G ! 7GC 8.
!
c. It is true that average cost pricing for a natural monopol" allows the enterp
Master your semester with Scribd brea! even but the outcome is inefficient. Digure 14.+ in the te-tboo! show
t"pical natural monopol" problem with anRead initial fi-ed cost and 
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above the marginal cost curve. Setting #1AC results in an output level of
&ero economic profits. (he figure illustrates however that the marginal b
of more output e-ceeds the marginal cost so the efficient level of produ
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and the ta-es should not affect the utilit" ordering. /ne implication of the
de$inition is that an" e-isting ta- structure does not violate the no
hori&ontal equit" if individuals are free to choose their activities and e-pendi
If (om and err" have free choice between the two different @obs 9and iden
preferences< then the net after*ta- rewards 9including amenities< must
same at both @obsH otherwise there would be migration. In this case the be
ta- wage on (om#s @ob ad@usts for the fact that there is a fringe benefit.

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&hapter )2 + he Personal Income a0
1. (he aig*Simons definition of income is the net change in the individual#s po

consume during a given period. (his criterion suggests the inclusion of all sourc
potential increases in consumption and also implies that an" decreases in an individ
power to consume should be subtracted in determining income. /verall it reflec
broadest possible base of income. 'llowing capital losses of 72333 to be dedu
against other forms of income rather than the current 7+333 would move the ta- s"
more in the direction of the aig*Simons criterion.
%. Personal fitness e-penses should be counted as income according to the aig*S

definition since the" represent a net increase in the individuals power to consum
would be difficult to devise a consistent s"stem for determining whether such ben
should be ta-able since the availabilit" of personal fitness equipment does not prove
the individual used the equipment. It would also be difficult to accuratel" meas
value of such consumption.
+. Suppose ones bu"s the oil stoc! for 71333 at the start of period 3. 't the st
period 1 he has two options.
a. old the oil stoc! one more period then sell.

b. Sell the oil stoc! bu" the gold stoc! and hold it for one period.
In both cases it is assumed that all assets are sold and an" ta-es paid at the e
period %. ,hat are the returns to option a<X 't a 13 percent rate of apprecia
the oil stoc! is worthDownload
71%13 after With Free %
period Trial
the capital gain is 7%13 and assu
a %8 percent rate applies to capital gains the capital gains ta- is %> perce
7%13 or 72>.>3. (hus ones is left with 71%13 * 72>.>3 or 71121.%3 after
Master your semester withstrateg"

If ones follows Scribd b< the value of the oil stoc! at the start of
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Times the capital gain is 7133 and the ta- 7%>. (hus ones has 7146%  lef
to proceeds 9L< from selling the gold stoc! at the end of period 1. Cancel anytime.
: : l % ld t 6 t
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. If same*se- couples were allowed to legall" marr" the" would be sub@ect to the ma
penalt" resulting in an increase in income ta- revenues.
2. Dor an itemi&er a 7233 ta- deduction lowers the ta- bill b" t*deduction . (hus
itemi&er with a +3Y marginal ta- rate the ta- bill is lowered b" +3Y;7233 or 712
9refundable< ta- credit on the other hand directl" lowers the ta- bill b" that amou
this case 7233.
4. a. ,ith a ta- rate of t1(. and a nominal interest rate of i1(. the nominal
ta- rate of interest is 62t8i162(.8(.1(.(. ,ith an e-pected inflation ra
O1(.(? the real after*ta- rate of interest is 62t8i2O162(.8(.2(.(?1(.
(.(?1(.(.
b. If the e-pected inflation rate increased b" + percentage points to O1(. an
nominal interest rate also increases b" + percentage points to i1(.  then th
after*ta- rate of interest is now 62t8i2O162(.8(.2(.1(.'2(.1(.('.
real after*ta- rate of return falls from 1.1Y to 3.%Y. (his is because th
s"stem ta-es nominal  not real returns.
c. In general consider two rates of inflation O ]O/ . (he !e" question is when
are present b" how much must the nominal interest rate increase in order to
the same real rate ofYou're
return.Reading
(his isa Preview
calculated b" equating real rates of r
under different inflation rates 9holding constant ta-es<A 62t8i2O162t8i/2O/.
can rearrange this equationA 6O/2O8162t86i/2i8  or 6i/2i81 6O/2O8762t8 . (his
turn be e-pressed asA Ei1EO762t8. Intuitivel" the left*hand side of thi
equation is the changeDownload
in nominal With Free Trial
interest rates that !eeps the real after*ta- ra
interest unchanged. It is equal to the change in the e-pected inflation rate
b" 91*t<. (hus returning to part b for a + percentage point change i
Master your semester with Scribd inflation rate and a marginal ta- rate of t1(.( nominal interest rates would
to increase b" appro-imatel" .+ percentage Read points.
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6. Fuch of the public debate concerning the marriage ta- focuses on whether it is f
ta- individuals or families. eliefs concerning the choice of the fairest ta-able un
influenced b" value @udgments and b" attitudes toward the role of the famil" in so
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8. a. i. ' famil" of four would receive four e-emptions that totaled 7

9;7++33< in %334.
ii. Ignoring other features li!e the e-emption phaseout an increase in i

of 7%233 leads to an increase in ta-es of 7>62 with a marginal ta- ra
+2Y 97>62:7%233;+2Y<.
iii. Personal e-emptions are reduced b" % percentage points for each 7
increase in 'GI. (hus the e-emption falls from 71+%33 to 8>Y;71+
and ta-able income goes up b" %Y;71+%33 or 7%4.
iv. (he additional increase in ta-able income of 7%4 increases

liabilit" b" +2Y;7%4 or 78%.3.
v. (he total change in ta- liabilit" the effective ta- rate is 97>62K78
7%233 or +>.484Y.
b. i. ,ith an e-tra 7133 in income the famil" would owe an additional
+2Y;7133 or 7+2 in ta-es.
ii. /therwise allowable itemi&ed deductions are reduced b" % percent o

You're
amount b" which 'GIReading
e-ceedsa Preview
7123233. owever the reduction c
be more than >3 percent of the total of itemi&ed deductions. 'n addi
7133 in 'GI ma" reduce itemi&ed deductions b" 7% if 'GI e-c
7123233. (his would mean an increase in ta-able income of 713%.
iii. 'ssuming the additional income caused allowable itemi&ed deduc
fall b" 7% the famil"#s ta- liabilit" increased b" +2Y;713
Master your7+2.63.
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iv. (he effective ta- rate is 97+2.63<=7133:+2.6Y. 
13. /f the 7333 of earnings that Sam has he is able to invest 91*tI<;earnings in the ma
or 91*3.%2<;7333:7+333. 'ssume that when he saves the mone" in a ta-able acc
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&hapter )3 + Personal a0ation and 4ehavior
1. (he suppl" of labor 9and other factors< in and out of a cit" is more elastic than the s
of factors to the nation as a whole. (herefore an income ta- reduction at the cit" le
li!el" to lose less revenue than such a reduction at the federal level ceteris paribus.
as one can thin! of “welfare*induced” migration for poor households one can thi
“ta-*induced” migration for businesses and possibl" wor!ers. If the cit" lowers ta-
9and other cities do not respond accordingly8  then one imagines that a numb
businesses will enter that state and spur economic activit".
%.

If individuals view their loss in the labor income ta-es as offset b" the benefits of p
services labor suppl" falls Unlock
b" 'fullhours.
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(his is the compensated change in hours
respect to a change in the net wage rate.
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. (he effect of the change in the highest marginal ta- rate on the individual#s b
constraint is demonstrated belowA
Income
$eisure
(he resulting change in the ta- rate moves part of the budget line out to the new d
budget constraint. (his polic" has an effect on labor suppl" analogous to the effect
increase in an individual#s wage rate on labor suppl"A it is theoreticall" ambiguous.
reason for this ambiguit" is that there are two competing effects ** a substitution e
which acts to decrease leisure and an income effect which increases leisure.
decrease in the ta- rate ma!es leisure more e-pensive so the substitution effect dic
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that less of it is to be consumed. Reading there
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is e-tra income provided b" this ta
and the income effect ma!es the individual want to consume more leisure. (hes
competing effects ma!e the overall change in labor suppl" ambiguous. C-
empirical wor! suggests that for prime age males the income and substitution ef
more or less cancel each other Download
out. DorWith Free Trial
wor!ing wives the substitution effect domin
meaning that the reduction in marginal ta- rates would tend to increase their labor su
Master your(he
effect on savings can be demonstrated using a diagram illustrating the change i
intertemporal budget constraint that results from this 
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savings will be ambiguous since there are again competing income and substit
effects. (he e-tra income gained from the ta- cut will ma!e this individual want t
for more consumption in both periods 9now and in the future< so this will cause sav
to increase 9intuitivel" the individual will consume some of her e-tra income now
some in the ne-t period<. owever the ta- cut will also change the slope of the b
line. (his causes a substitution affect which ma!es consuming in the current period
e-pensive 9so savings will increase< but it causes income to rise which ma!es
individual want to consumer more in the current period. (he counteracting effect
it difficult for us to sa" what will happen to overall savings. Cconometric wor! sug
that changes in marginal ta- rates have little effect on individual saving.
$astl" the effect on ta- revenues will be negative 9a decrease in the ta- rate will ha
direct effect in this case<. owever this decrease will not be as pronounced as we m
thin!. Dirst to the e-tent that some individuals wor! more ta-able income will incr
Fore importantl" individuals will opt for more ta-able income instead of nonta
income as the ta- rate falls. Dor instance since fringe benefits are li!e non*ta
income an individual will prefer them to cash pa"ments 9which are ta-able< when th
rate is high. owever the opposite is true when the ta- rate falls. (hus although
lower ta- rate less revenue is collected from a given ta- base this decrease is some
counteracted b" the increase in the base itself. (hat said there is no evidence th
increase in the base would be large enough to ma!e the ta- self*financing.
2. (he interest rate cut ma" be successful at stimulating consumer spending. ?edu
rate of return on savings reduces the opportunit" cost of current consumption w
tends to increase current consumption and lower saving 9the substitution effect<.
other hand the fact that theDownload
interest rate With Free Trial
is lower ma!es it harder for a saver to ach
an" future consumption goal 9the income effect< so the effect ma" be to increase sa
and reduce current consumption. (he polic" will have the desired results
substitution effect dominates the income effect.
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4. Increasing ta- rates will not increase ta- revenue if Curopean ta- rates are on  the
hand side of the $affer )urve 9Digure 1>.4< where the ta- rate e-ceeds t . '
' r io l per n will i vi s in re ti du d int

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8. a. (he suppl" curve is given b" S : *133 K %33wn. (he gross wage is w : 13
the net wage is wn : 91*t<w : 91*t<13. (he difference then between the gros
net wage for an" ta- rate is w * wn : 13t. (his is the ta- collected per hou
wor!.
(he ta- revenue for an" given hours of wor! is then the product of the
collected per hour of wor! and the labor suppl" curveA
ta- revenue : 13t;9*133K%3391*t<13<

: *1333t K %3333t *%3333t%
: 18333t * %3333t%
(he ta- rate t : 3.6 is be"ond the revenue ma-imi&ing point 9this can be show
computing ta- revenue for a slightl" lower ta- rate li!e t:3.48.
b. (a!ing the derivativeA
d0a Re5enue7dt1(
"ields 18333*3333t:3 or
You're Reading
t : 918333=3333< or a Preview

t : 3.62 as the revenue ma-imi&ing ta- rate.

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)hapter 18 – (he )orporation (a-
1. ' corporation ma" use retained earnings to increase dividends but shareholde
additional income ta-es as a result. Cven though the franchises weren#t parti
profitable it ma" have been in the shareholders# best interest to purchase them inste
pa"ing additional dividends.
%. a. (he real value of depreciation allowances Ψ of equation 918.1< falls.
b. ,hen Ψ falls the user cost of capital increases.
c. Inde- appreciation allowances.
+. If the 7%3 million is e-pensed the firm gets a deduction of 7%3 million in the cu
"ear. If the 7%3 million is depreciated the deductions are spread over time 9in a wa
depends on the specifics of the depreciation schedule<. (he present value of the f
flow of deductions is less than 7%3 million. ecause the pac!age design will
benefits that e-tend over a period of time it would seem sensible to view it as a
e-penditure. If so depreciation is appropriate and the I?S was right.
. (he user cost of capital ) in Cquation 18. isA

) : 9r K δ<=V91 * θ<-91 – t<Wfull access with a free trial.
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,here t is the individual ta-Download

rate on dividend income.
With Free Trial Suppose $ee Cnterprises can
their mone" out and receive an after*ta- rate of return of 13 percent. 'ssume tha
could also bu" a new printing press that would e-perience economic depreciation
percent annuall". Ignoring ta-es the printing press would have to generate a 1% pe
return to cover depreciation. If the corporate ta- rate is +2 percent and themargina
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percent to %1.6 percent therefore ma!ing it more li!el" that the purchase of
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4. ' retroactive rebate of the alternative minimum ta- for corporations would simp
lump sum transfer. (hus according to neoclassical theor" such a rebate would not
an effect on investment because it does not affect the user cost of capital. (he use
of capital depends on current individual and corporate ta- rates after*ta- rates of
in the capital mar!et economic depreciation depreciation allowances and investme
credits. Bone of these is affected b" the 'F( rebate described in the te-t. Fore
because the firms involved in the 'F( rebate were ver" large it is hard to imagine
the rebate would rela- liquidit" constraints either.
6. /#Beill#s statement that as chief e-ecutive of 'lcoa he “never made an inv

decision based on the ta- code” is problematic for the shareholders of 'lcoa. It m
no sense to ignore ta- incentives when ma!ing business decisionsH that is afte
returns are what matter. /#Beill#s lac! of ta- sophistication li!el" lowered the val
'lcoa relative to what it would have been had he ta!en account of the ta- s"stem.
>. (he FIPS financial instrument which could interchangeabl" be called debt or
would be attractive to a corporation because firms would want ta- authorities to view
instrument as debt because the interest paid is ta- deductible. /n the other hand
want potential investors to view the instrument as equit" because more debt ma!e
firm a ris!ier investment. 'lthough the ta- law might be forced to view thi
instrument as debt there is no reason wh" investors in the mar!et 9or credit ra
agencies< would then viewYou're
it as Reading a Preview In principle investors and
equit" however.
agencies should be able to see through such accounting gimmic!s though in practic
accounting scandals showed that this was not the case.
8. (he user cost of capitalDownload With Free Trial

9ignoring depreciation allowances and investment ta-
credits< is given b" equation 916.< in the te-tboo! ):9rK^<=V91*_<91*t<W where r:after ta- ra
return in the capital mar!et ^:economic depreciation _:corporate ta- rate and t:individua
rate. Substituting the numbers from the problem into the formula gives the user costA
):9.3>K.31<=V9.42<;9.6<W:.186>. Since the pro@ect#s return +3Y 
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&hapter *7 + 'e%icit Finance
1. a. (he government borrowing to finance a Femorial 0a" parade increas

national debt. In designing an accounting s"stem for the government
borrowing in this case should in fact increase the national debt.
b. (he sale of the Statue of $ibert" to private entrepreneurs would decreas
national debt under current measurement. In the discussion on capital spen
the e-ercise here is similar to the sale of nondefense federal buildings in %33
designing an accounting s"stem this transaction is simpl" an e-change of a
and should have no effect on the debt rather than decreasing the deb
current s"stem ignores tangible assets.
c. (he law promising free 9future< medical care to children under five affect
spending not current spending. 's such it does not affect the
measurement of the debt. (his is similar to the discussion of the im
legislative promises about Social Securit". In designing an accounting s"
the present value of the entitlement should be counted as a current e-pense s
debt should increase. (he current s"stem ignores implicit obligations.
d. (he 7133 ta- would reduce the si&e of the national debt. (he implicit pro
pa" $"nne bac! 7132 You're
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not increase the si&e of the debt assu
this is similar to the implicit promise to pa" Social Securit" in the future
designing an accounting s"stem again this implicit promise should be cou
'ssuming the present discounted value of the of the 7132 paid bac! ne-t
Download
equals the 7133 ta- this "ear thenWiththeFree Trial on the debt should be &ero r
impact
than to decrease it.
e. (he 7133 bond would increase the si&e of the national debt. (he present
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these pa"ments the amount b" which the bond contributes to 
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%. Ge "# nt o st ible a ets i ludi old. Selling th ld mig
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2. ,hether or not the burden of the debt is borne b" future generations is contro
/ne view is that an internal debt creates no net burden for future generations because
simpl" an intragenerational transfer. owever in an overlapping generations model
finance can produce a real burden on future generations. (he burden of the deb
depends on whether debt finance crowds out private investment. If it does f
generations have a smaller capital stoc! and hence lower real incomes all other t
equal. In a ?icardian model voluntar" transfers across generations undo the effe
debt polic" so crowding out does not occur.
4. (he benefits*received principle which states that the beneficiaries of a pa

government spending program should pa" for it suggests that deficit fina
appropriate for war if the benefits are received b" future generations. 'n eff
standpoint would sa" that debt is appropriate if the e-penditure is temporar" and
are not ma@or pre*e-isting distortions in capital mar!ets.

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&hapter *) + Fundamental a0 Re%orm8 a0es on &onsumption and Cealth
1. a. (he income ta- is 23 percent so Mach pa"s 23Y;713333 : 72333 in i

ta-es in the first period. In the second period he earns 7233 in interest 913
savings : 13Y;72333 : 7233< so he pa"s ta-es on interest of 23Y;7233 :
(he present value of Mach#s lifetime ta- pa"ments equals 72333 K V7%23=91.1
72%%6.%6.
b. In the second period Mach has savings and interest equal to 72233. e
consume 7+446 in period % and must then pa" 23Y;7+446 : 71>++.
consumption ta-es. (he present value of Mach#s lifetime ta- pa"ments is
equal to 72333 K V71>++.23=91.1<W : 74446.
(hese calculations demonstrate the transitional problem in moving

consumption ta- because Mach had to pa" high ta-es during period 1 whe
earned most of his income and then had to pa" high ta-es during period %
he did his consuming.
%. (he burden of the estate ta- includes the resources used in estate planning and the e
of estate planning. Fan" families ma" alter their behavior in reaction to the estat
and if this results in less efficienc" the estate ta- creates an e-cess burden that i
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amount of ta- revenue collected.
+. (here is a fundamental confusion here. (here is no reason to assume that the in
of a general consumption ta- 9a L'(< will be the same as the incidence of a partial f
ta- 9corporate income ta-<. Download With Free Trial
. a. Dor a fan giving a million*dollar ball to FcGwire or Sosa there would be a

gift ta- liabilit". 0epending on the fan\s circumstances it could reach 71233
Master your semester with Scribd more. (he person receiving the gift owes no ta-.
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become part of his or her estate ta-able after death under the estate ta-.
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2. a. (he e-pression “,hat "ou earn is what "ou !eep” is false because a cons
ta- is equivalent to a ta- on wages. (he two are related b" the e-p
91Kτ<:1=91*t< where τ:consumption ta- rate and t:income ta- rate.
b. (he e-pression “Investment and savings would soar” ma" be true.
consumption ta- raises the return to saving but because of the conflict betw
income and substitution effects one cannot !now whether or not this will inc
saving. Digures 1>.8 and 1>.13 in the te-tboo! illustrate these possibilities.
c. (he statement that “(here is no evading the Dairta-” is false. Cvasion ca

ma@or problem with retail sales ta-es especiall" at high rates.
4. In the simplest possible case the budget constraint is p) : w where p is the pr
consumption ) is units of consumption w is the wage rate and  is hours of w
,ith an income ta- p):91*t<w where t:income ta- rate. ,ith a consumption
91Kτ<p):w where τ:consumption ta- rate. (hus for an" income ta- rate t w
find a consumption ta- rate τ that is equivalent b" solving the e-pressionA 91Kτ<:1=9
6. a. ,e can conclude that an income ta- generates an e-cess burden if it creat

wedge between the amount a borrower pa"s and the amount a lender recei
,ith a %2Y income ta- and an interest rate of >Y lenders receive 91 – t<r : 4
Since interest paid is ta- deductible borrowers pa" 91 – t<r : 4Y. (here
there is no ta- wedgeUnlock
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b. If interest pa"ments are not ta- With

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receive 4Y after ta-es. Since there is a wedge between the two rates the inc
ta- creates an e-cess burden in this case.
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If the income Scribd
ta- rate is t : 3.%2 then 91Kτ< : 1=91*3.%2< : =+ so the
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liabilit". If interest pa"ments are not ta- deductible there is no wedge betw
the rate lenders receive and the rate borrowers pa" so there is no e-cess burd
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>. Jnder an income ta- 'm"\s burden is 71333;t in the first period and .3>97>33<
second period 9e.g. her investment income is ta-ed<. Shirle"\s burden is identical
first period 71333;t but is lower in the second period equal to .3>97633<t.
because Shirle" consumed more in the first period and saved less. (hus 'm"
higher lifetime ta- burden because she has higher investment income. Jn
proportional consumption ta- 'm" and Shirle" have the same lifetime ta-
71333;τ where τ is the consumption ta- rate.

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&hapter ** + Public Finance in a Federal System
1. If there are inter*@urisdictional e-ternalities then gun control is a federal issu

e-ample if la- gun control in one state leads to more crime in another state ther
inter*@urisdictional e-ternalities.
%. Superficiall" it seems a violation of hori&ontal equit" for two people with id

properties to pa" different ta-es on them. owever the phenomenon of capitali&
requires that we distinguish carefull" between the owners at the time the ta- is levied
the current owners. ' propert" with an undul" high ta- rate will sell for a lower p
other things being the same. (hus a high ta- rate does not necessaril" ma!
individual who bu"s the propert" after the ta- is imposed worse off. Indeed equal
assessment ratios could generate a whole new set of hori&ontal inequities.
+.

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c.
. Lirtuall" all studies conclude that a dollar received b" a communit" in the form of a
results in greater public spending than a dollar increase in communit" income.
phenomenon has been dubbed the fl"paper effect because the mone" seems
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happens to spending on education depends on the income elasticit" (he govern
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4. In the figure below the 9constant< marginal cost of hiring a firefighter is C . (he dem
for the two communities are D and D'. Suppose that initiall" the quantit" is set a
'fter decentrali&ation each communit" hires firefighters up to the point whe
marginal benefit equals marginal cost i.e. where their respective demand curves inte
C . (his is at Q for communit" 1 and Q' for communit" %. )ommunit" 1 gains
)ommunit" % gains dbe. )ommunit" 1 gains more because its demand curve is
inelastic.
6. (he “user*fee” view of propert" ta-es regards propert" ta-es as pa"ment for local p
services. (he statement “its presence would raise propert" values and 
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revenues would easil" repa" the construction costs” reflects this view ** that people
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Answer to End of Chapter Solution

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Part 1 – Getting Started

Instructor’s Manual to accompany

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&hapter * + ools o% Positive "nalysis

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&hapter  + ools o% -ormative "nalysis

d. Drom a national standpoint there is a good deal of competition and information

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g. declaring ban!ruptc". (he ban!ruptc" “floor” on costs creates various moral h

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+. If insurers in )alifornia could no longer use location to determine automobile in

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