Public Economics

Homework 1

1. In an article on how exercise improves health, the New York Times reported on
an observational study that found that each hour spent running added two hours
to a person’s life expectancy. A week later, a letter to the editor questioned
whether the results really proved anything about the impact of exercise on
health, and suggested that the study could just as well be showing that “those
with a strong heart and good health are otherwise more likely to enjoy running
and do it more regularly.”

a. How does this challenge to the exercise study relate to the common
problems faced by economists trying to assess the causal effects of
economic policy?

Answer:
 We need to find causal vs. correlation to make smart policy
 This is important because policies based on correlations could
be a waste of money (if no effect) and even hurt people
(negative effect)
 Yet, often using observational data

b. How could you design an experimental study to estimate the impact of

running on life expectancy?

Answer:
 You need a group of people who are willing to participate
 Assign them randomly to T and C groups, where T are told to run
according to a schedule and C are told to refrain from running
Considerations:
 Ideal length: the longer the study, the better “life
expectancy” results you get, BUT the longer the study the
more attrition you get and non-compliance of the T and C
groups as well.
 Measure attributes that are proven to relate to life
expectancy
2. In the 1970s, researchers at RAND Corporation conducted a famous social
experiment to investigate the relationship between health insurance coverage
and health care utilization. In this experiment, samples of individuals were
induced to trade their normal insurance policies for new RAND policies that
offered different rates at which the insurance would reimburse the individual for
health care expenses. In 1993, the Clinton administration used the results of the
RAND experiment to predict how health care utilization would increase if
insurance coverage were made universal. What problems might arise in using the
social experimentation results to predict the impact of universal coverage?

Answer:

This is a small-scale study that finds strong internal validity, but NOT external
validity in this case (generalizability). You cannot assume that a group of
people who are being offered temporary better rates than they have in a
normally expensive private system would behave the same in a system
providing universal care (not the same thing)
 Hawthorne effect: the policy was temporary and more generous than
current available options
 Many other things, like prices (doctor’s compensation, concentration
of practices, …) overall would change in a universal program (partial
vs. general equilibrium)
 There will likely be many other differences between the plans offered
in this case and under a universal system
 Fundamentally different groups of people would be covered if we
included everyone

3. Your airplane crashes in the Pacific Ocean. You land on a deserted island with
one other passenger. A box containing 100 little bags of peanuts also washes up
on the island. The peanuts are the only thing to eat.

a. In this economy with two people, one commodity and no production,

represent the possible allocations in a diagram, and explain why every
allocation in Pareto efficient. Is every allocation fair?

Answer:
 All of the peanuts are grabbed up
 Since there is only one good, both have a clear preference for
more peanuts (no differences in relative liking of the two goods)
 No matter what initial allocation arises between the two people,
20-80, 40-60, …, you cannot make one person better off without
making another worse off.
 This is Pareto Efficient
 Possible graph:

You Other guy

0___________ |_______________________________________100
100___________|_____________________________________________0
(20,80)

b. Now, a second box washes up with 100 little bags of pretzels. Draw in a
separate diagram (now with two goods) a case where the allocation is
relatively fair, but is not initially efficient. Why do you expect the
allocations to be efficient in the end?

Relatively Fair Allocation:

But because of preferences, this allocation is not the desired allocation (must add
indifference curves). You want relatively more peanuts and the other guy wants
relatively more pretzels. (below)
You will therefore trade to make yourselves both better off
4. Consider an economy with two people, Victoria and Albert, and two
commodities, tea and sandwiches. Currently, both Victoria and Albert would be
willing to substitute two cups of tea for one sandwich. Further, if the economy
were to produce one less cup of tea, the resources released from tea production
could be used to produce three more sandwiches. Is the allocation of resources
in this economy Pareto efficient? In this economy, should there be (i) the same
amount of sandwiches and tea, (ii) more tea or (iii) more sandwiches?

Answer:
 MRS for both people are exactly the SAME (Victoria and Albert both
would trade 2 cups tea for 1 sandwich – cant gain from each other),
therefore no trade GIVEN allocations (YES - Pareto Efficient)
 BUT, resources are not being allocated efficiently in production (not
Production Efficient).

Story:
o Production Possibility: In the economy ↓ 1 cup of tea → ↑ 3 sandwiches
o Imagine: Victoria and Albert give back 1 cup of tea. They value this cup
of tea at ½ sandwich, BUT they get 3 sandwiches by making this
production switch → better off using the same resources
o Answer: less tea, more sandwiches
 5. Which of the following goods do you consider pure public goods? Private goods?
Explain.

Discussion – to think about it (no single correct answer)

Those who found this a bit TRICKY are likely on the right track…

a. Wilderness areas
Most are closer to Pure Public Good – BUT depends on characteristics

Rival: if large relative to population, then non-rival (MOST non-rival

because quite large)
However, even Yellowstone can get crowded (rival because there is a
single route past the most popular geothermal sites)

Excludable: This depends on access points (MOST are non-excludable)

Example: a mountain range with tons of hiking trails, all equally liked
– non-excludable
Yellowstone with one route past geothermal sites and only two
entrances to this road (with a gate) – excludable

b. Medical school education

Clear: Purely private good
Rival: Yes, one person taking a seat fills it for others. Not like internet
courses – one cadaver being used, is one less for others
Excludable – Yes

c. Public television programs

This is a pure public good
Excludable – No, only b/c of legal access
Rival – No, one person watching doesn’t diminish other´s use

d. Automated teller machines (ATM) – bank cash machines

Pure private good
Rival – yes, one person using it takes it up for another to use it at the
same time
Excludable – yes, a bank can require codes, only certain cards that you
have to pay for, …
6. Tomas and Charles are neighbors. During the winter, it is impossible for a
snowplow to clear the street in front of Tomas’ house without clearing the front
of Charles’ house. Tomas’ marginal benefit from snowplowing services is 12-Z,
where Z is the number of times the street is plowed. Charles’ marginal benefit
is 8-2Z. The marginal cost of getting the street plowed is €16.
a. Sketch the two marginal benefit schedules and the aggregate marginal
benefit schedule.

MBT = 12-Z, MBC = 8-2Z, MC=16

MB=0, Z=12 MB=0, Z=4

Z=0, MB=12 Z=0, MB=8

Aggregate => Public Good (both use at same time)

Therefore for each Q, add up MB:
MSB(Z) = MBT(Z) + MBC(Z)
MSB(Z) = 12-Z + 8-2Z = 20-3Z
 MSB = 20-3Z

MSB=0, Z=6.6
Z=0, MSB=20

b. Draw in the marginal cost schedule

c. Find and label the efficient level of provision for snowplowing services

Efficient: MC=MSB
16=20-3Z
Z=1.3
Note: If we consider that snowplows are all or nothing, then only 1 is efficient
(MBT=11, MBC=6, MSB=17 > MC)
7. Define an externality and give 1 example of a positive externality and 1 example
of a negative externality. (Note: be specific in your examples. The same thing
can be an externality in one situation and not be an externality in an only slightly
different situation).

Many possible examples from class…

Example that is easy to see how it depends on the situation:

I plant a flower bed in my yard…
 This is a positive externality if my neighbors like it and it increases the
beauty of the neighborhood
 This is a negative externality if my neighbors suffer from allergies
related to the plants or if they are wild spreading ones that they do not
want in their yards