Public Economics

General information
Each exercise set contains selected Discussion Questions from the textbook and Ad-
ditional Exercises.
Unless speci…ed otherwise, the discussion in the tutorials only covers the Additional
Exercises. You can do the questions from the textbook by yourself; solutions are
provided. If you have questions, you can ask your tutorial teacher.
Some exercise sets contain more Additional Exercises than can be discussed during
the tutorial. At the start of the tutorial, you can tell the tutorial teacher which
exercises you would like to discuss.

Practicum 1

Discussion Questions Rosen:

8th edition 9th & 10th editions

Chapter 3 4, 9, 10 6, 12, 14
Chapter 4 1 1

Additional Exercises:

1.1 Two independent villages, Tinytown and Smallville, are located on opposite
sides of a river. Currently, there is no bridge connecting the two villages. The
villages decide independently on whether to (help) …nance a bridge. Building a
bridge would cost 100. If both villages help to …nance the bridge, they both pay
50; if only one village …nances the construction, it has to pay 100. The bene…t
of a bridge to Tinytown is 60, and to Smallville 75.

(a) Is it socially e¢ cient to build the bridge? Suppose the two villages decide
independently whether to build the bridge. Will the bridge be constructed
(determine the Nash equilibrium)?

Now suppose that the bene…t of the bridge to Smallville rises to 125.

(b) Suppose the two villages decide independently whether to build the bridge.
Will the bridge be constructed? Which village is best o¤?

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1.2 Thelma and Louise are neighbours. During the winter, a snowplow can clear the
street in front of their houses. Thelma’s marginal utility (= marginal bene…t)
from snowplowing services is 12 Z euro, where Z is the number of times the
street is plowed. Louise’s marginal utility is 8 2Z euro. The market price per
hour equals 16 euro, which is also equal to the marginal cost of snowplowing.

(a) Sketch the marginal utility curves and the aggregate willingness to pay.
Find the e¢ cient level of snowplowing.
(b) Suppose Thelma and Louise decide independently how many hours of snow-
plowing to pay for (of course taking the presence of the other into account).
What is the Nash-equilibrium outcome?
(c) How large is the di¤erence in welfare between the e¢ cient outcome and the
outcome under private provision (the outcome under b)?

Now suppose that the price of snowplowing drops to 8 euro.

(d) What would happen if the marginal cost of plowing suddenly drops below
8?

1.3 Adam and Britt derive utility from a public good. Adam’s total utility derived
from consuming Q units of the public good, measured in euro, is given by

UA = ln Q

Britt’s total utility derived from consuming Q units of the public good, measured
in euro, is given by
UB = ln Q
Total production cost of the public good are given by T = cQ. The market
price per unit of the public good is c. Both Adam and Britt maximise their
utility, and they decide independently from each other how many units of the
public good to buy. Assume that > > 0 and c > 0.

(a) Derive the socially e¢ cient level of public good provision.

(b) In the Nash-equilibrium, how many units of the public good does Britt
buy? How many units does she consume?

Suppose the government provides the public good, and covers the cost by taxing
Adam and Britt such that they both pay half of the total cost of providing the
public good. However, the government does not know the preferences of Adam
and Britt. The government makes the following proposal: Adam and Britt

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 (independently) state how many units of the public good they prefer. The
government then provides the average number of units (and adjusts the tax
accordingly). In other words, if Adams states to prefer QA units and Britt
states to prefer QB units, the government provides 12 (QA + QB ) units and both
pay a tax of 21 c 21 (QA + QB )

(c) Determine the Nash equilibrium of statements QA and QB .

(d) Compare the outcome of c) to both the socially e¢ cient level (part a) and
the outcome in case of private provision (part b). What does this exercise
illustrate?

1.4 Consider a (very) small village, where only two families live: family Adams and
family Besley. The size of the available land around the village is 5 acres. This
land must be divided into space for agriculture, which creates sandwiches s, and
a park of size z acres. The park is a pure public good. Each acre agricultural
land yields 50 sandwiches.

(a) Find the production possibilities frontier. What is the Marginal Rate of
Transformation between sandwiches and park size?

The two families derive utility from the number of sandwiches and from the size
of the park. The utility of Adams and Besley is given by, respectively:

UA = sA + 20z
1 p
UB = sB + 30 z
2
(b) Derive the Marginal Rate of Substitution between sandwiches and park
size for both families. (Hint: MRS is the slope of an indi¤erence curve,
which is equal to the ratio of the marginal utilities of z and s.)
(c) What is the socially e¢ cient size of the park?
(d) How large would the park be if the two families decide independently about
their contribution to park size (assume that they both own half of the land
around the village)?

1.5 Suppose there are two individuals, Anne and Ben, who both derive utility from
the consumption of a public good and from the consumption of a private good.
Anne’s utiliity function is given by

UA = ln(xA ) + ln(GA + GB )

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 where xA is the number of units of private goods Anne consumes, GA is the
number of units of the public good bought by Anne, and GB is the number of
units of the public good bought by Ben. Ben’s utility function is given by

UB = ln(xB ) + ln(GA + GB )

where xB is the number of units of the private good that Ben consumes.

Marginal production cost of both goods are constant and equal to their price on the
market. The price of the public good equals pG . The price of the private goods equals
px = 1. As a result, the marginal rate of transformation between the public good and
the private good equals pG . Anne and Ben have the same level of income y, which
they spend fully on the two goods. Given px = 1, this implies that xA = y pG GA
and xB = y pG GB . Both individuals maximise their own utility.

(a) Consider the assumptions of this exercise. How can you see in this exercise that
the public good is non-rival while the private good is rival?

(b) Derive that for Anne and Ben, the marginal rate of substitution between the
public good and the private good are given by
xA xB
M RSA = and M RSB = , respectively.
GA + GB GA + GB

(c) Determine the socially e¢ cient level of units of the public good GA + GB .

Suppose that the public good is provided by the market. Anne and Ben decide
independently how many units of the public good to buy (of course taking the presence
of the other into account).

(d) Determine the Nash-equilibrium that arises on the market (in terms of provision
of the public good by Anne and by Ben).

(e) Explain why the answers to c) and d) are di¤erent.

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Answers to exercises week 1

The solutions on the Discussion Questions (DQ) in Rosen & Gayer are numbered as
follows: Rosen [number DQ in 8th edition] / [number DQ in 9th & 10th editions].
So, Rosen 3.4 / 3.6 gives the solution to DQ 3.4 in the 8th edition and to DQ 3.6 in
the 9th & 10th editions of the textbook.

Rosen 3.4 / 3.6:

a) The social indi¤erence curves are straight lines with slope of –1. As far as
society is concerned, the “util”to Augustus is equivalent to the “util”to Livia.
b) Social indi¤erence curves are straight lines with slope of –2. This re‡ects the
fact that society values a “util”to Augustus twice as much as a “util”to Livia.
c) See the …gure.

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 Figure 3.4

Rosen 3.9 / 3.12

Although Victoria’s marginal rate of substitution is equal to Albert’s, these are not
equal to the marginal rate of transformation and the allocation is, therefore, Pareto
ine¢ cient. Both people would give up 2 cups of tea for 1 crumpet but, according to
the production function, could actually get 6 crumpets by giving up 2 cups of tea. By
giving up tea and getting crumpets through the production function, both utilities
are raised.

Rosen 3.10 / 3.14

a) False. As shown on page 41 of the text, equality of the marginal rates of
substitution is a necessary, but not su¢ cient, condition. The MRS for each individual
must also equal the Marginal Rate of Transformation.
b) True. As long as the allocation is an interior solution in the Edgeworth box,
the marginal rates of substitution must be equal across individuals. This need not be
true, however, at the corners where one consumer has all the goods in the economy.
c) False. If a policy is a Pareto-improvement, it also increases social welfare, but
the other way around is not always true. Social welfare may increase by, for instance,
redistributing money from rich to poor. Clearly, this is not a pareto-improvement.
d, 8th edition) False. Smokers, especially those without children, are worse o¤ if
the tax on cigarettes is raised in order to fund education. Social welfare may improve
though, through better education and reduced externalities from smoking.
d, 10th edition) False. See Figure 3.10: a move from point q to point p3 increases
e¢ ciency, but reduces the utility of Eve. Hence, it is not a Pareto-improvement. Note
that given an allocation within the UPC, there exists an allocation on the UPC that
yields a Pareto-improvement.

Rosen 4.1 / 4.1:

a) Wilderness area is an impure public good – at some point, consumption
becomes rival; it is, however, nonexcludable.
b) These television signals are nonrival in consumption. Producers may be able
to choose to make the signal either excludable or non-excludable.
c) Medical school education is a private good.
d) Television programs are potentially excludable (Pay-tv etc.) and non-rival
(given that you have su¢ cient tv-sets).
e, 8th edition) An Internet site is nonrival in consumption (unless there is a lot
of tra¢ c), and is in principle excludable.
e, 9th & 10th edition) An ATM machine is excludable. It is non-rival (everyone
can use it), unless it is very busy (in which case you may have to wait).

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Exercise 1.1
a) It is e¢ cient to build the bridge, as total bene…t is 135 > 100 (= total cost).
Both villages decide not to …nance the construction however. Consider this payo¤
matrix, where the …rst entry in a cell is the payo¤ to Tinytown, and the second entry
the payo¤ to Smallville:

S
build not build
T build 10; 25 40; 75
not build 60; 25 0; 0

For both villages, regardless of what the other village decides, it is always best to
choose not build. (Recall from Micro: this is a prisoners’dilemma game, ‘not build’
is here a dominant strategy and the equilibrium (not build, not build) is called a
Nash-equilibrium). Note that both villages would be better o¤ if some third party,
for instance the government, forced them to contribute both towards the construction
of the bridge.
b) Now, Smallville will build the bridge alone. Tinytown is best o¤. The payo¤
matrix changes to:
S
build not build
T build 10; 75 40; 125
not build 60; 25 0; 0
For Tinytown, not build is still the best option, regardless of Smallville’s choice (dom-
inant strategy). It follows that Smallville optimally chooses to build.

Exercise 1.2
a) Thelma’s marginal bene…t is M BT HELM A = 12 Z, and Louise’s is M BLOU ISE =
8 2Z. The marginal bene…t for society as a whole is the sum of the two marginal
bene…ts, or M B = 20 3Z (for Z 4), and is equal to Thelma’s marginal bene…t
schedule afterwards (for Z > 4). The marginal cost is constant at M C = 16. Setting
M B = M C along the …rst segment gives 20 3Z = 16, or Z = 34 , which is the
e¢ cient level of snowplowing.

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b) Both Thelma and Louise would not pay for snowplowing: Z = 0. Marginal
cost is higher than marginal bene…t at Z = 0 for both.
c) With constant marginal cost, producer surplus is 0. Hence, we have to com-
pute the di¤erence in (total) Consumer Surplus. Under b), CS is 0. Under a),
total CS equals the area between the aggregate demand curve and the price. Hence,
CSa = 12 (20 16) 34 = 83 . Alternative way of calculating is to add the bene…ts
to Thelma and Louise of Z = 43 (area below MB-curves) and subtract the cost:
R4 R4 3 4 2
0
3
(M BT + M BL M C) = 03 (4 3Z) = 4 43 2 3
= 83 .
d) For M C 8, it is possible for Louise to credibly free ride, while Thelma
provides the e¢ cient allocation. This occurs because if Thelma believes that Louise
will free ride, Thelma chooses the amount of Z that maximises her own utility. With
M C 8, this gives Z 4. Yet, for Z 4, Louise’s marginal bene…t is zero, implying
that the social MB equals Thelma’s MB, see the …gure. Hence, if M C 8, Louise
free-rides and Thelma pays for Z 4, which is socially e¢ cient.
Beyond the question: Note that it depends on the speci…cs of the exercise that de-
spite free-riding, the outcome is socially e¢ cient. For instance, suppose Louise would

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have marginal utility of snowplowing equal to 8 Z (rather than 8 2Z), and that
marginal cost would be equal to 6. Optimal provision would have Z = 7 (As for
Z 8, social marginal bene…t would be 20 2Z). However, if Thelma and Louise
decide independently, the only Nash equilibrium is where Thelma pays for Z = 6 and
Louise contributes nothing. Similar reasoning as above shows that this is indeed a
Nash equilibrium: Given that Thelma pays for Z = 6, marginal cost are higher than
marginal bene…t for Louise, so that she optimally contributes nothing. And given
that Louise does not contribute, it is optimal for Thelma to pay for Z = 6. Hence,
the outcome is not socially e¢ cient!
Note that the case where Louise pays for Z = 2 and Thelma does not contribute
is not a Nash equilibrium: If Thelma would not contribute, Louise optimally pays
for Z = 2. However, if Louise pays for Z = 2, marginal bene…ts to Thelma are
larger than marginal cost (10 > 6) so Thelma would contribute something. But then
Louise would want to reduce her contributions, etc. Hence, the only Nash equilibrium
is where Thelma pays for Z = 6 and Louise contributes nothing.

Exercise 1.3
a) M UA + M UB = M C gives Q + Q = c ! Q = +c . You can also maximise
UA + UB cQ with respect to Q.
b). The only Nash equilibrium is where Adam buys Q = c and Britt Q = 0. Hence,
both Adam and Britt consume Q = c (note: at Q = c , we have M UB = =c = c,
which is smaller than c by > . Hence, if Adam buys c units, Britt prefers to buy
0 units).
c) The only Nash equilibrium is where QA = 4 c and QB = 0. As a result, the outcome
is Q = 2 c You can show this by (i) maximising utility of A and B and infering that
> implies you end up in a corner solution, or by (ii) intuitively arguing that for
any Q, the marginal cost are the same for A and B, but the marginal bene…ts are
always higher for A (as > ). Hence, if A is content with a particular Q, B prefers
a lower level and, hence, sets a lower QB . In turn, A sets a higher level.
d) As > , the outcome under c) is higher than the socially e¢ cient outcome. This
illustrates that where private provision of public goods tends to yield underprovision
(market failure), public provision tends to yield overprovision (government failure).
Which of these two is more e¢ cient depends on and .
Note 1: Observe that the di¤erence in stated preferences QA and QB is much larger
than the ‘true’di¤erence in preferred levels of Q.
Note 2: This exercise assumes people have no problem with lying about their prefer-
ences. Of course, if all people would be honest about their preferences (even if this
a¤ects their price or tax levels), outcomes would be more e¢ cient.

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Exercise 1.4
a) Each acre land can yield 50 s or 1 z. There are 5 acres land, so the maximum
amount of sandwiches is 250, and each acre park reduces s by 50. Hence, the PPF
equals s = 50(5 z). It follows that the MRT equals 50. (In general, the MRT is the
absolute value of the slope of the PPF, which can be written as M Cz
M Cs
)
@U=@z
b) MRS between s and z is given by . For family Adams, this gives
@U=@s
15
p
20 z 30
M RSA = 1 = 20; for family Besley, this gives M RSB = 1 = p .
2
z
c) Condition for optimal provision of public goods: M RSA + M RSB = M RT .
Substituting gives
30
20 + p = 50
z
Solving for z gives z = 1.
A note: in principle, both MRT and MRS could be de…ned in a reversed manner,
@U=@s @U=@z
so that MRS = rather than . However, this does not work in case of
@U=@z @U=@s p
1
deriving the e¢ cient level of public goods provision ( 20 + 30z 6= 50
1
for z = 1). This is
because we have to add up the marginal utilities of public good consumption across
all individuals, i.e. we want to know how many sandwiches the individuals together
@U=@z M Uz
want to give up for one additional unit of z. With MRS = = , the MRS
@U=@s M Us
is the marginal utility of public good z in terms of utility from consuming private
@U=@s
good s, which is what we want to know. With MRS = , we get how much of
@U=@z
the public good an individual is willing to give up for an additional private good s.
Adding this up over individuals is nonsense, because the additional private good can
only be consumed by one individual.
Note that if all goods are private goods, it does not matter whether MRS is written
@U=@x @U=@y
as or as , as long as the MRT is de…ned in the same way. It follows
@U=@y @U=@x
1
directly from the equilibirum condition: if M RSX = M RSY = M RT , then M RS X
=
1 1
M RSY
= M RT .
d) Regardless of the decision by family Besley, family Adams’marginal value of an
acre Park equals 20 sandwiches, while the marginal cost are equal to 50. Hence, family
Adams does not contribute to the park. Knowing this, family Besley maximises their
own family’s utility with respect to farm size. Hence, they optimally set M RSB =
30
M RT , which gives p = 50. Solving for z gives z = 0:36.
z
Clearly, this is less than optimal (as found under c)). The reason is that neither

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family takes the bene…ts of the park to the other family into account.

a) Non-rivalness implies that units consumed by one person can also be consumed by
other people. In this exercise, each person’s utility does depends on the amount of
the public good provided by the other person, but not on the amount of the private
good provided (=consumed) by the other person.
M UG
b) Using the de…nition of the MRS, we get M RSA = M Ux
. Taking derivatives, we
1
1 1 GA +GB
get that M UG = GA +GB
and M Ux = xA
. Substituting yields M RSA = 1 !
xA
M RSA = GAx+G A
B
. Derivation of M RSB is equivalent.
c) Condition for e¢ ciency: M RSA + M RSB = M RT (see lecture 1 / chapter 4).
Substituting for xA and xB into the expressions for the M RS yields yGAp+G
G GA
B
+ yGAp+G
G GB
B
=
2y pG GA pG GB y
pG ! GA +GB
= pG ! 2y = 2pG (GA + GB ) ! (GA + GB ) = pG .
d) For both persons, it is optimal to set M RS = ppGx . This gives yGAp+G G GA
B
= pG !
y pG GB y pG GB y pG GA
GA = 2pG and GA +GB = pG ! GB = 2pG . These can be seen as best-response
functions. Solving these two equations with two unknowns (via substitution) yields
y pG GA
y pG 1
y+ 1 p G
GA = 2pG
2pG
= 2 2p2 GG A so that GA 1 14 = 4pyG ! GA = 13 pyG which
implies GB = 31 pyG and GA + GB = 23 pyG .
e) Clearly, the Nash-equilibrium yields an ine¢ ciently low level of public goods pro-
vision. The reason is that each person bene…ts from the units of the public good
provided by the other person (non-rivalness) but none of them takes these bene…ts
to the other into account in deciding how many units to provide themselves (non-
excludability). Therefore, total contributions towards the public good are too low.

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