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ECON337 - Assignment One

Due: February 16 in class


Name: ------------------------------------

Student ID -------------------

This file may be updated. Before submitting your work, check the last version to make sure that
you have answered all the questions.
The deadline is February 16th in class. You may submit your assignment earlier. In this case, leave
it in my mailbox in the economics department.
Write down your answers cleanly and clearly in the space given for each part. Do not submit a
separate sheet.
In all graphing questions, be sure to label clearly all axes and curves to avoid marks being
deducted.
You may work in groups, but each student should submit his/her own assignment separately.

Problem #1 (35 marks)


Consider a simple economy with two consumers and two goods. Consumers utility functions and initial
endowments are as follows:
Consumer A:
Consumer B:

!! = 2! ! + !!!
!! = ! ! + 2!!!

eA = (xA, yA) = (10, 9)


eB = (xB, yB) = (40, 1)

where,
MUxA = 2, MUyA = 2yA
MUxB = 1, MUyB = 4yB
a. Calculate MRSxy for each consumer and briefly explain whether the initial allocation of x and y is Pareto
efficient. (6 marks)

b. Using the concept of MRSxy and comparing the two values, briefly explain how trading can improve
consumer utility. (5 marks)

c. Set up the conditions necessary for defining the contract curve. (6 marks)

d. Using the conditions in part c, derive the contract curve. (3 marks)

e. Continuing with parts c and d, set up the conditions necessary for defining the core of the economy. (5
marks)

f.

Draw an Edgeworth box for these consumers and sketch their preferences. Label the following on your
graph: (10 marks) (Note: Put consumer A in the left bottom corner and consumer B in the top right
corner. Goods x and y are on the horizontal and vertical axes, respectively.)
i.
ii.
iii.
iv.
v.

The original endowments for each consumer


Indifference curves given the endowments
Pareto improvement area
The contract curve
The core of the economy

Problem #2 (40 marks)


Suppose that Zo and Marc, the only residents of the city of Upper Hapolonia, need to determine how much
fireworks the city needs. Fireworks satisfy the characteristics of a pure public good. The marginal benefit that
each person receives (in dollar terms) is given by the following equations.
! ! = 7 !!
! ! = 5 0.5!!
where M, Z and !! represent Marc, Zo and fireworks, respectively.
(Do not round the numbers.)
a. Find the social marginal benefit of fireworks. (3 marks)

b. Suppose each unit of fireworks cost $6. Calculate the socially optimal (efficient) amount of fireworks. (2
marks)

Now, suppose that the government pays for fireworks by either collecting a lump-sum tax or an income tax.
Answer the following questions if the government chooses to use a lump-sum tax.
c. Calculate the optimal amount of fireworks. (3 marks)

d. Calculate the total cost to society of the optimal amount of fireworks. (2 marks)

e. Calculate the amount of fireworks that each consumer consumes. Are they different? Why? (5 marks)

Answer the following questions, if the government chooses to use an income tax. Suppose that the marginal cost
of funds (MCF) is 1.75.
f.

Set up the efficiency condition. Calculate the optimal amount of fireworks. (4 marks)

g. Comparing your answers in parts c and f, briefly explain why these two numbers are different. (5 marks)

h. Suppose fireworks generate marginal revenue of $3.9 by selling tickets. How does this affect the optimal
amount of fireworks? (3 marks)

i.

Comparing your results from parts c, f and h, briefly explain why your results in part h differ from parts c
and f. (5 marks)

Assume fireworks could be traded in a private market such that the marginal cost for a private firm is P = 0.5Qf.
j.

Calculate the market demand function. (3 marks)

k. Calculate the optimal market quantity and price. (2 marks)

l.

Calculate how much each person consumes. (3 marks)

Problem #3 (35 marks)


Suppose that a car company is located close to a lake that is surrounded by a residential area. This company
discharges chemicals into the lake. Suppose the market demand for cars is P=100. The private cost of producing
cars is 10+Q. However, pollution generated by the production process creates external harm equal to 0.5Q per
unit on the third party (ie, the level of the negative externality increases with the quantity produced).
a. Draw a graph to show the private market equilibrium and the socially optimal equilibrium. (5 marks)

b. Calculate the private market equilibrium quantity if the externality is not corrected in this market. (Label
the amount on the graph in part a.) (3 marks)

c. Calculate the socially optimal quantity of cars that should be produced. (Label your answer on the graph
in part a.) (3 marks)

d. Calculate the net gain from adjusting production to the socially optimal level. Show the area on your
graph in part a. (5 marks)

e. Suppose that the government wants to achieve the socially optimal quantity by imposing a Pigouvian tax
on producers. Calculate the size of the tax per car. (3 marks)

f.

The economist, Ronald Coase, suggested that by introducing property rights, we can solve the problem
without any further government intervention. Calculate the fee range in the following two situations:
i. The car company owns the lake. (8 marks)

ii. The third party owns the lake. (8 marks)

To be continued