Economics 321: Public Economics Prof. Marika Cabral TA: Katherine Keisler Fall 2017 UT Austin Problem Set 1 (Due Monday Sept 18th) 1. (Ch1) Consider the four basic questions of public finance listed in the chapter. Which of these questions are positive—questions that can be proved or disproved—and which are normative—questions of opinion? Explain your answer. The four basic questions of public finance: 1. When should the government intervene in the economy? The word “should” suggests that this is a question about which opinion will vary, so it is normative. 2. How might the government intervene? This question is positive. It asks: How does the government actually intervene now, and how might it intervene in the future? One can check whether a government might intervene in a particular way directly by examining the behavior of existing and future governments. 3. What is the effect of those interventions on economic outcomes? Economic effects can be measured and thus are not a matter of opinion, so this question is positive. 4. Why do governments choose to intervene in the way they do? This is a factual (positive) question. It may be difficult to directly observe the answer, but one can potentially learn about the motivations behind a government’s interventions by looking at patterns of behavior over time. 2. (Ch1) In order to make college more affordable for students from families with fewer resources, a government has proposed allowing the student of any family with less than $50,000in savings to attend public universities for free. Discuss the direct and possible indirect effects of such a policy. This policy would make college cheaper for students from families with less than$50,000 in savings. There would be two direct effects of this policy. First, it would make the families of students who already intended to attend college better off if the families that were saving had less than $50,000 in savings. Second, it would probably encourage additional students from low-savings families to attend college. A potential indirect effect of this policy would be to reduce the savings of other families—families that were saving money for a college education but would stop doing so when they could anticipate getting a free ride if they don’t save. 3. (Ch1) Proper hygiene, such as regular hand-washing, can greatly limit the spread of many diseases. How might this suggest a role for public interventions? What kinds of public interventions might be possible? Suggest three distinct types of possible interventions. Individuals tend to ignore the external costs they impose on others by failing to wash their hands frequently enough (or by failing to employ other sorts of hygienic practices).This suggests that they tend to wash their hands less than optimally and that there may there-fore be a role for public interventions. One possible intervention would be a requirement that individuals wash their hands after using restrooms. (Such regulations are imposed for employees at businesses, for example.) A second possible intervention is public provision of hand-washing facilities. This would reduce the cost of hand-washing, thereby encouraging individuals to engage in that activity more frequently. A third possibility would be an advertising campaign to encourage hand-washing.4. (Ch2) You have $100 to spend on food and clothing. The price of food is $5 and the price of clothing is $10. a. Graph your budget constraint. The food intercept (y in the accompanying figure) is 20 units. If you spend the entire$100 on food, at $5 per unit you can afford to purchase 100/5 = 20 units. Similarly, the clothing intercept (x) is 100/10 = 10. The slope, when food is graphed on the vertical axis, will be –2. b. Suppose that the government subsidizes clothing such that each unit of clothing is half-price, up to the first 5 units of clothing. Graph your budget constraint in this circumstance. This budget constraint will have two different slopes. At quantities of clothing less than or equal to 5, the slope will be –1 because 1 unit of food costs the same as 1 unit of clothing ($5). At quantities of clothing greater than 5, the slope will be –2 (if graphed with food on the y-axis), parallel to the budget constraint in a. The point where the line kinks, (5, 15), is now feasible. The new x-intercept (clothing intercept) is 12.5: if you purchase 5 units at$5 per unit, you are left with $75 to spend. If you spend it all on clothing at $10 per unit, you can purchase 7.5 units, for a total of 12.5 units. New budget constraint (bold) and original (dashed): 5. (Ch2) Consider an income guarantee program with an income guarantee of $6,000 and a benefit reduction rate of 50%. A person can work up to 2,000 hours per year at $8 per hour. a. Draw the person’s budget constraint with the income guarantee. A person will no longer be eligible for benefits when he or she works 1,500 hours and earns $12,000 (guarantee of $6,000/50%)(b) Suppose that the income guarantee rises to $9,000 but with a 75% reduction rate. Draw the new budget constraint. Benefits will end under these conditions when earned income is $9,000/.75 =$12,000, just as shown in a. The difference is that the all-leisure income is higher, but the slope of the line segment from 500 hours of leisure to 2,000 hours of leisure is flatter. (c) Which of these two income guarantee programs is more likely to discourage work? Explain. A higher income guarantee with a higher reduction rate is more likely to discourage work for two reasons. First, not working at all yields a higher income. Second, a person who works less than 1,500 hours will be allowed to keep much less of his or her earned income when the effective tax rate is 75%. With a 75% benefit reduction rate, the effective hourly wage is only $2 per hour (25% of $8). 6. (Ch2) Governments offer both cash assistance and in-kind benefits, such as payments that must be spent on food or housing. Will recipients be indifferent between receiving cash versus in-kind benefits with the same monetary values? Using indifference curves, show the circumstances in which individuals would be indifferent and situations in which the form of the benefits would make a difference to them. Generally recipients can attain a higher level of utility (they can choose a consumption bundle on a higher indifference curve) when they are given cash rather than a specific good. People