2 LM-56

Università di Roma “Tor Vergata”

Public Sector Economics and Management
MSc in Economics (LM-56)
Exercises: will be corrected in class on 9 and 16 October
1. An individual can work and earn $12 per hour. In the appropriate cartesian
diagram, draw the budget constraint in the presence of these alternative
policies

(a) Each individual is guaranteed a basic income of $600 per month, paid
by the state. If an individual works and receives income, the value of
the benefit paid by the state is reduced correspondingly ($1 of income
implies reduction of the benefit of $1).
(b) The state guarantees a basic income of $300 per month. If an individual
works and receives income, the value of the benefit paid by the state
is reduced by $1 for every $3 earned income.
(c) The state guarantees a basic income of $900 per month. If an individual
works and receives income, the value of the benefit paid by the state is
reduced by $1 of income for every $2 earned, but every citizen receives
at least $300 a month (ie the reduction of the benefit ends when the
benefit is $300). This more expensive policy is financed with a tax of
$1 for every $10 of gross income.
Suppose that people differ in their trade-off between leisure and con-
sumption: illustrate the choices made by various individuals as this
trade-off varies. Which of these choices would be preferred by people
with different trade-offs?

2. A new socially concerned government is elected and decides to provide help

to single mothers, such as Jane. Jane’s utility function has, as arguments,
two (groups of) goods: (a) goods for the baby (nappies, milk, toys, baby
clothes, etc) and (b) goods for adult women (cigarettes, fry-ups, white wine,
make-up, etc). Assume that the quantities of the various goods in each
group is consumed by Jane in fixed proportions, and that the amount of
the goods is measured in such a way that a unit of each cost e1. Jane’s
preferences can be described by a Cobb-Douglas utility function, where the
coefficient of baby goods is equal to α times the coefficient of adult goods.
α therefore measures how much Jane cares for her baby. Jane’s income is
e10 per week.
The welfare minister in the new government decides that babies need at least
e20 of baby food a week.

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(a) Explain how the minister could ensure her aim with a food voucher
scheme (Jane is given vouchers, which she can use only to buy baby
goods), and calculate the cost of this scheme to the taxpayer when
α = 1. Explain your answer [20%]
(b) Still assuming that α = 1, calculate the cost to the tax payer of ob-
taining the same objective of ensuring that Jane baby’s consumption
of baby’s goods is 20, but this time giving Jane cash (which she can
spend as she wants). Explain your answer. Is Jane batter off in with
case? Is her baby? [30]%.
(c) Now let α vary. What are the values of α such that the government
can ensure, at the same cost to the taxpayer of the voucher scheme,
that Jane’s baby has enough baby goods (that is 20 units), when Jane
receives cash rather then vouchers [30%]
(d) Finally, suppose again α = 1. Suppose the government decides to
subsidise the cost of baby goods instead of giving a voucher or a subsidy
to Jane. Calculate the subsidy that ensures that Jane’s baby has enough
baby goods in this case. [20%]

3. Consider a model of optimal income taxation, where there are two types of
workers, equal in numbers. Type 1, the high productivity workers, can earn
w1 per hour, and type 2, the low productivity workers, can earn w2 per hour:
w2 < w1 .
The government observes the earned income of an individual, but not the
number of hours she work. The government has a fiscal instrument given
by the relation between income earned and tax paid. There are no costs of
collecting tax.
The government needs to raise a total income R through tax, to pay for,
say, defence.
The utility function of the individuals is
1
U (C, L) = C − L2
2
where C is the amount of consumption (all post tax income is spent on
consumption) and L is the number of hours worked.
The government has a welfare function which gives double weight to low
productivity workers.

(a) Set up the model as a Mirrlees optimal income tax problem.

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(b) Determine the optimal income tax income schedule (that is, the tax on
each type of individual) (Hint: derive the total tax paid by each type
of individual from (1) the government budget constraint and (2) the
incentive compatibility constraint for the productive type).
w2
!2
1− 2
2
w1
(c) Show that this tax schedule can be written as T2 = 12 R−2w1 2
w2
,
4− 2
w1
2
w2
!2
1− 2
w1
and T1 = 21 R + 2w1 2
w2
, and argue therefore that as the pro-
4− 2
w1

ductivity of the two types of workers tends to be the same they end up
working the same number of hours and paying the same level of tax,
even though the government would like to favour the second group.

4. The town of Tadcaster has three families, each with one child, and each of
which earns £40,000 per year (pre-tax). Each family is taxed £4,000 per
year to finance the state school in the town, which any child can then attend
at no cost. The quality of education is determined by the teacher/student
ratio, expenditure on equipment, and so on, and can be measured by expen-
diture, so that one unit of quality costs £1,000. The three families differ
in their preferences for education. Though Alice Atherton and Bhupinder
Banerjii both go to the state school, the Banerjii family places a greater
value on education than the Atherton family. The Cappleman family places
the greatest relative value on education and sends young Charles to a private
school, where any level of education can be purchased at a cost of £1,000
per unit of quality.

(a) Determine the quality of the education in the state school in the town.
Which of the children receive the highest quality of education?
(b) In appropriately labelled cartesian diagrams, draw the budget constraint
facing the three families and draw a possible indifference curve which
could correspond to the choice each family makes.
(c) The town council is considering replacing its current system with a
voucher system. Under the new system, each family would receive a
£6,000 voucher for education, and families would still be able to send
their children to the same state school. The voucher however could
be used to supplement a private school tuition fees (but no change
can be given: a family would not be able to purchase £4,000 worth of
education, pay with the voucher and receive £2,000 change). Calculate
the new tax needed to finance the scheme.

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(d) Draw the budget constraint the families would face under this system.
(e) Suppose that, if the new system were introduced, only Bhupinder
Banerjii would change school. The council sub-committee which takes
the decision on the proposed new scheme has three members, Ms Ather-
ton, Mrs Banerjii and Capt Cappleman. Carefully explain, using dia-
grams if necessary, how each family would be affected by the scheme.
Assume each member votes only according to their preferences, do you
expect the proposed scheme to be approved?

5. Consider the following model: a consumer lives for two periods, period 1
and period 2. In period 1 she supplies a fixed amount of labour (normalised
to 1) and receives income w per unit supplied. In the second period, she
does not work. Her utility function is such that she must consume in both
periods. Write down an example of a functional form satisfying this property.
Argue that she must save during her first period and consume her savings
in her second period. There is no uncertainty. Explain the effect of a tax on
the interest from saving which is used to finance a lump sum transfer (with
balanced budget) to the elderly.

6. Adam owns a 10 acre apple orchard. His neighbour, Eve, runs an apiary
(she keeps bees to make honey). Each hive of bees can pollinate 1/2 acre
of apples, thereby raising the value of Adam’s apple production by $10. The
honey produced by one hive is worth $100 and Eve’s marginal costs are
given by M C = 10 + 5q, where q is the number of hives she chooses to
use. Assume that both Adam and Eve are operating in perfectly competitive
industries. No one else is affected by Eve’s bees.

(a) What is the equilibrium number of hives that Eve will employ?
(b) Why is this amount not efficient?
(c) At the equilibrium quantity, what is the maximum that Adam would be
willing to pay to induce Eve to employ 1 extra hive?
(d) What is the minimum that Eve would be willing to accept to increase
her employment of hives by 1?
(e) What is the efficient number of hives? Remember that Adam has a 10
acre farm.
(f) What does the Coase Theorem say about Adam and Eve’s problem?

MSc Economics End