Practice Problem Solutions PAI 897 Professor David Popp Fall 2024

1. The following questions ask you to consider the domestic market for gasoline. Use a
supply and demand diagram to analyze each of the following scenarios. Explain
briefly. Be sure to show how both the equilibrium price and quantity change in
each case.

a) As the economy becomes better, both business and holiday travel increases.
b) Geopolitical instability in major oil producing countries in the Middle East
reduces the amount of oil available to import from these countries.
c) In response to increasing minimum fuel economy requirements from the
government, the automobile industry has continuously made technological
progress improving the average fuel economy of vehicles sold in the U.S.
market.

The purpose of this problem is to get you thinking about how demand and supply
curves are affected by outside influences, and to help you distinguish between
shifts of a curve versus a movement along a curve.

a)
P
S

P1
P0

D’
D

Q0 Q1 Q
As travel increases, more drivers will need gasoline. As a result, demand shifts up
and to the right. The equilibrium quantity and price both increase.
 p. 2 of 52

b) The reduction in oil from the Middle East means less oil is available to refine
into gasoline. As a result, supply shifts up and to the left. The price of gasoline
increases and the equilibrium quantity falls.

S’
P
S

P1
P0

Q1 Q0 Q
c) Improved fuel efficiency means that people now need less gasoline to drive
the same distance that they did before. This will reduce the demand for
gasoline, causing the demand curve to shift down to the left. Both the
equilibrium price and quantity fall.

P
S

P0
P1

D
D’

Q1 Q0 Q

Note that while the question asks about a technological improvement, it is a

technological improvement to a compliment for gasoline – that is, for a product
that uses gasoline. Thus, the improvement in fuel efficiency of vehicles does
not affect the supply of gasoline, but rather the demand for gasoline.
 p. 3 of 52

2. Suppose the market for AquaDoodles (once a popular toy) has a supply curve of P =
10 + Q, and a demand curve of P = 150 – 6Q. Assume that the market is perfectly
competitive.
a) What will the equilibrium price and quantity of AquaDoodles be?
b) Calculate the producer and consumer surplus associated with the equilibrium
found in part (a). Illustrate on a graph.
c) Now, suppose the government levies a tax of $7 per Aquadoodle sold, to be
paid by consumers. What is the quantity of Aquadoodles sold? What price do
consumers pay? What price do producers receive? Illustrate on a graph.
d) What do the new prices tell you about the price elasticities of supply and
demand for Aquadoodles? Which is more elastic? How do you know this?
e) Find the new producer and consumer surplus associated with your answer to
part (c).
f) How much revenue does the government raise from the tax?
g) How does the sum of consumer surplus, producer surplus, and revenue after
the tax (your answers to (d) and (e)) compare to the sum of producer and
consumer surplus found before the tax (your answer to (b))? What does the
difference between the two represent?

a) The equilibrium price and quantity are:

10 + Q = 150 – 6Q
7Q =140
Q = 140/7
Q = 20

Substitute this into either supply or demand to get:

P = 30
 p. 4 of 52

b)
P
150

30

10 D

20 Q

Consumer surplus is the triangle above the price and below demand. It has a height
of 120 (= 150 – 30) and a base of 20. Its area = 0.5(120)(20) = $1200.

Producer surplus is the triangle below price and above supply. It has a height of 20
(= 30 – 10) and a base of 20. Its area = 0.5(20)(20) = $200.
 p. 5 of 52

c) The result of the tax is to shift either the supply curve or demand curve in. Note that
while your results will be the same no matter which one you choose, the question says
that the tax is imposed on consumers, so I shift the demand curve below. The demand
curve shifts down by the amount of the tax. The new demand curve represents the
demand curve faced by suppliers. If P is the price consumers pay, suppliers get P - 7,
with $7 going to the government. Algebraically, P = 150 – 6Q becomes P = 143 – 6Q.
Graphically, note that the y-intercept of the graph has shifted down by the amount of
the tax.
P
150

143

S
36
30
29

10 D
D’
19 20 Q
We begin by finding the new equilibrium. Equate the new supply curve with the old
demand curve.

10 + Q =143 – 6Q
133 = 7Q
Q = 133/7
Q = 19

We plug this quantity into the original supply and demand curves to get the post-tax
prices. With a quantity of 19, suppliers receive:

PS = 10 + 19 = $29 (from the original supply curve)

Consumers must pay $7 more than this, or $36. Note that we can verify this using
the original demand curve, where we get PC = 150 – 6(19) = 150 – 114 = $36.
 p. 6 of 52

d) Most of the tax is paid by consumers – their price increases by $6, while producers
only receive $1 less. Since inelastic parties bear the larger burden of a tax, this tells
us that demand is more inelastic than supply.

e) Note that we use the original supply and demand, at the new prices and quantities, to
find consumer and producer surplus.
P
150

143
A B
E S
36 C D
30 F G H
29
I

10 D
D’
19 20 Q
Areas A & B in the above graph represents consumer surplus. This is a triangle with
a height of 114 (= 150-36) and a base of 19. Its area = 0.5(114)(19) = $1083.

Area I in the above graph represents producer surplus. This is a triangle with a height
of 19 (= 29-10) and a base of 19. Its area = 0.5(19)(19) = $180.5.

f) Revenue is simply the tax times the quantity sold.

$7 x 19 = $133.

On the above graph, revenue is the rectangle represented by areas CDFG.

g) Before the tax, the sum of consumer and producer surplus was $1400. Afterwards,
the sum of consumer surplus, producer surplus, and revenue is $1396.5. The
difference is $3.5. Graphically, this is the area of triangles E & H.

This difference is the deadweight loss. It is the value of lost opportunities, because
some potentially beneficial transactions do not occur after the tax. For the quantities
between 19 and 20, demand is above supply. This tells us that consumers are willing
to pay more than the marginal cost of producing the good. However, because of the
tax, these units are not sold. The potential producer or consumer lost because of this
is the deadweight loss.
 p. 7 of 52

3. To encourage increased growth of grasslands in the Animal Kingdom, their leader,

Simba, is considering a subsidy for production of grasslands. Suppose that the market
for grasslands can be represented by the following equations:

Demand: P = 200 – 1.5Q

Supply: P = 50 + Q

where P is the price per acre, and Q represents quantity of grasslands, represented in
acres consumed per week.

a) Calculate the equilibrium price and quantity of grasslands before the subsidy.
b) To encourage grassland production, Simba announces a price floor of $140 per
acre. With this new price floor, what will be the new quantity of grassland
consumed in the Animal Kingdom?
c) Illustrate your answers to (a) and (b) on a graph. Using this graph, calculate the
consumer surplus and producer surplus at the initial equilibrium price and
quantity from part (a).
d) Calculate the new consumer surplus and producer surplus with the price floor
of $140 per acre (part b).
e) How does the total consumer and producer surplus in part (c) compare to the
total consumer and producer surplus in part (d)? What explains the difference
in these two figures?
f) Suppose that the government supports the $140 per acre price by purchasing
any excess grassland that producers make available but are unable to sell to
other animals. How many acres of grassland must the government buy?

a) The equilibrium occurs where supply equals demand:

200 – 1.5Q = 50 + Q
150 = 2.5Q
Q = 150/2.5
Q = 60 acres

To find the price, we substitute the equilibrium quantity into either the demand or supply
equation:

Either:
P = 200 – 1.5(60) = $110

Or:
P = 50 +(60) = $110
 p. 8 of 52

b) The minimum price is above the equilibrium price. Thus, there will be an excess supply
of grasslands – more animals will want to sell grasslands than will be willing to buy
grasslands. The new quantity sold will be limited by the number of animals willing to
purchase grasslands at this higher price. We find this by substituting $140 for P in the
demand equation, and then solving for Q:

140 = 200 – 1.5Q

60 = 1.5Q
Q = 60/1.5
Q = 40 acres

c) To draw the graph, we begin by drawing the supply and demand curves. Note that the
equations are already solved for P. Thus, we know that the y-intercept (on the price
axis) for demand is $200. Similarly, by setting P = 0, we find that Q = 133.33 when P
= 0 (because 200 – 1.5(133.33) = 0).

For supply, we know that the y-intercept is 50, and intersects demand at a quantity of
60 and a price of $110.
P
200
S
A
140
B
C E
110
D
90
F
50
D

40 60 90 Q

With a price floor of $140, note that there will be excess supply, so the quantity
demanded at $140 determines the quantity sold. As we found in part (b), this is 40
acres of grasslands.

Consumer surplus is everything above the price and below the demand curve. Before
the price floor, this is areas A, B and C above. This is a triangle with a height of 90 (=
200-110) and a base of 60. Its area = 0.5(90)(60) = $2700.

Producer surplus is everything below the price and above the supply curve. Without
the price floor, this is areas D, E, and F. This is a triangle with a height of 60 (= 110-
50) and a base of 60. Its area = 0.5(60)(60) = $1800.
 p. 9 of 52

d) With the price floor, consumer surplus is everything below demand and above the price
of $140. This is area A above. This is a triangle with a height of 60 (=200-140) and a
base of 40. Its area = 0.5(60)(40) = $1200.

The new producer surplus is everything below the price of $140 and above supply.
This consists of the rectangle B and D, as well as the triangle F. To find the area of
the rectangle, we need to know the value of the bottom line. This is the price that
suppliers are willing to make available for 40 acres of grasslands. Plugging 40 into
supply gives us 50 + 40 = 90. Thus, this rectangle has a height of 50 (=140-90) and a
width of 40. Its area = (50)(40) = $2000. The triangle F has a height of 40 (=90 – 40)
and a base of 40. Its area = 0.5(40)(40) = $800. The total producer surplus is the sum
of these two areas, or $2800.

e) The total consumer and producer surplus in part (c) is $4500. The total surplus in part
(d) is $4000. The difference of $500 is the deadweight loss. This is lost surplus
because some of the grassland sales that took place before the introduction of price
supports no longer occur. Note that it is equal to areas C and E on the graph. This is
a triangle with a height of 50 (= 140-90) and a base of 20 (= 60-40), for an area =
0.5(50)(20) = $500.

f) With the price support, there will be an excess supply of grassland. One way for the
government to support prices is to purchase this extra supply. To find this, we need to
know (a) how much suppliers make available at $140 per acre, and (b) how much
consumers purchase at this price. We know from part (b) that consumers purchase 40
acres. To find out how much suppliers make available, plug in the price of $140 to the
supply equation:
140 = 50 + Q
Q = 90

Since suppliers make 90 acres available, and consumers only purchase 40 acres, the
government will need to purchase 50 acres of grasslands at a price of $140 per acre.
 p. 10 of 52

4. Due to concerns about the health of young children, the state of Minnesota proposes
a subsidy for vitamins. You are given the following information:
• Production of vitamins is very competitive and the price is set in a global market.
Thus, the price of vitamins in Minnesota can be considered perfectly elastic.
Currently, a bottle of vitamins sells for $5 in the state.
• 400,000 bottles of vitamins are sold in Minnesota each year.
• The price elasticity of demand for vitamins is -0.15.
• The subsidy would lower the price of vitamins to $3 per bottle.

a) How many more bottles of vitamins would be sold in Minnesota if the proposed
subsidy was approved?
b) Illustrate on a graph. Calculate the change in consumer surplus that would
result from this policy
c) How well does the proposal meet the state’s goal of increasing vitamin
consumption among children? Would you recommend approval of the subsidy?
Please be sure to explain both why the policy does or does not meet the state’s
goal and your recommendation.

a) We can use elasticity here. The formula for elasticity is:

%𝛥𝛥𝛥𝛥
𝜀𝜀 =
%𝛥𝛥𝛥𝛥

Recall that %∆P = ∆P/P0. Thus, the proposed percentage change in price is = -2/5 =
-0.4. Plugging this into our equation along with the elasticity gives us:

%𝛥𝛥𝛥𝛥
−0.15 =
−0.4
%𝛥𝛥𝛥𝛥 = (−0.4)(−0.15) = −0.06

Thus, the quantity demanded increases by 6%. Multiplying by the original quantity of
400,000, we find that just 24,000 additional bottles of vitamins are sold.
 p. 11 of 52

b) Note that you do not need to know the end points of the demand curve to find the
change in consumer surplus. Also note that supply is perfectly elastic, so that the
supply curve is a flat line. The illustration below shows all that you need to find the
change in consumer surplus:

A
5

B C
3

400,000 424,000 Q

With the original price of $5 per bottle, consumer surplus is just area A. When the
price falls to $3 per bottle, consumer surplus increases to areas A, B, & C. Thus, we
can find the increased consumer surplus by calculating areas B & C. Even though we
don’t know the y-intercept of the demand curve, we do know enough to calculate this
area.

B is a rectangle with a height of 2 and a length of 400,000. Thus, its area is $800,000.

C is a triangle with a height of 2 and a base of 24,000 (= 424,000 – 400,000). Its area
is 0.5(2)(24,000) = $24,000

Thus, the increased consumer surplus = 800,000 + 24,000 = $824,000.

 p. 12 of 52

c) While there is no right or wrong recommendation, the key point to notice here is that
the subsidy does not do much to meet the state’s goal of increasing vitamin
consumption. Despite a 40% decrease in price, vitamin consumption increases by
just 6%. That is because demand is inelastic. Consumers are not responsive to
changes in the price of vitamins. Thus, the subsidy does not encourage them to
purchase more vitamins.

Although it wasn’t necessary to answer this question, one way to illustrate this point
is to note how much the government spends to increase vitamin consumption. The
subsidy costs the government $848,000 (= $2 x 424,000). Vitamin consumption goes
up by 24,000 bottles. That comes to $35.33 per additional bottle!

The policy does have a large consumer surplus. However, note that most of the
additional surplus goes to people who would have purchased vitamins anyway (area
B on the graph for part (b)). The subsidy helps people who want vitamins anyway, but
does little to encourage additional people to buy vitamins. Whatever you
recommended, it should take these points into consideration.
 p. 13 of 52

5. Prince Edward Island is considering raising the fare for the ferry connecting the island
to the mainland of Canada by 20%. You have been asked to project whether the fare
increase will lead to an increase or decrease in revenues. You have been given the
following data pertaining to the last time that fares were increased:

before increase after increase

riders per day: 3,000 2,650
fare: $10 $12.50

a) Based on the figures provided, calculate the price elasticity of demand for trips
on Prince Edward Island’s ferry.
b) Based on your calculation above, would you expect revenues to increase or
decrease if the fare rose by another 20 percent? Why?

a) The formula for elasticity is:

%𝛥𝛥𝛥𝛥
𝜀𝜀 =
%𝛥𝛥𝛥𝛥

Recall that %∆Q = ∆Q/Q and %∆P = ∆P/P. Thus, the percentage change in quantity
= -350/3000 = -0.11666, and the percentage change in price is 2.5/10 = 0.25. From
this, we calculate the elasticity to be -0.467:

−0.11666
−0.467 =
0.25

Two common errors here were:

1. Using the new quantity and price, rather than the original quantity and price, to
calculate the percentage change, and
2. Using 20% for the change in price. While the proposed price increase is 20%,
you must use the previously observed data to calculate the elasticity. The
change in quantity that occurred previously was the result of a 25% price
increase. Thus, you must use 25%, not 20%, as the change in price.

b) Revenue will increase. Demand is inelastic. Thus, the decrease in quantity

demanded will be small relative to the increase in revenues from the higher
fare.

Note that simply calculating the new and old revenues only received partial
credit. Simply calculating these revenues shows that revenues increase, but
does not explain why they increased.
 p. 14 of 52

6. Reggie consumes only two goods, chocolate and sausage. Suppose that the price of
both chocolate and sausage doubles. At the same time, Reggie is given a raise at
work, so that his income also doubles. What affect do all of these changes have on
Reggie’s budget constraint? What does this problem tell you about the effect of
inflation that doubles all prices, but in which income also doubles?

Chocolate
I/PC =
2I/2PC
Slope =
PS/PC =
2PS/2PC

I/PS = Sausage
2I/2P

The key to this question is thinking about the interpretation of the x and y intercepts
of the budget constraint. In each case, the intercept is the amount of that good
that you could consume if you only bought that good. It is found by dividing total
income, I, by the price of the good, P. If both the price and income are doubled,
you can still purchase the same amount of the good that you did before. Thus, the
budget constraint does not change at all. The intercepts are the same because
you can purchase the same amount of the good as before, and the slopes have
not changed because relative prices (PS/PC) have not changed. This problem tells
us that if prices increase because of inflation, but income rises at the same rate,
the inflation has no real effect, since purchasing power remains the same.
 p. 15 of 52

7. To encourage communities to spend more on recycling programs, Representative C.

Robin has proposed providing federal aid to communities to help pay for these
programs. There are two proposals:
Proposal A – block grants: This proposal would give each community a block grant
of $250,000. The money could only be spent on recycling programs.
Proposal B – matching grants: This proposal would subsidize spending on
recycling programs. For each dollar spend on recycling programs by local
communities, the federal government would provide $0.50 of aid.

a) Suppose that a typical community has a budget of $1,500,000. Draw a budget

constraint for such a community showing their current choices (pre-policy). Then,
add a second budget constraint depicting the community’s options under proposal
A. Be sure to clearly label all endpoints of each budget constraint.
b) Please reproduce your figure from part (a). Then, add a third budget constraint
depicting the community’s options under proposal B. Once again, please clearly
label all endpoints.
c) Representative Robin is concerned about communities that currently spend little
on recycling programs. Which of the proposals above will these communities
prefer? Please explain the intuition of your answer in a way that Representative
Robin, who has little formal training in economics, would understand.
d) Representative W. Pooh represents a community that spends more than
$750,000 on recycling programs devices. Which proposal makes Representative
Pooh’s community better off? Why? Again, please explain your answer in a way
that would be clear to a non-economist. (Hint: Calculate how much money is left
for other spending under each proposal when a community spends a total of
$750,000 on recycling programs.)
 p. 16 of 52

a) The initial budget constraint allows the community to spend $1,500,000 on

recycling or other goods. With the new policy, if this community spends all of its
own money on other spending, it still has $250,000 to spend on recycling.
Similarly, if it spends all of its money on recycling, it now has $1,7500,000 to
spend.

Other
spending

1,500,000

250,000 1,500,000 1,750,000

Recycling
Programs
 p. 17 of 52

b) The subsidy lowers the price of recycling. For every dollar spent by the community,
the federal government contributes 50 cents. Thus, the price of recycling services
under this program is $0.67, since the community pays 2/3 of the cost for every unit
of recycling services (= $1/$1.50). Under this policy, the community can afford $2.25
million worth of recycling services (= 1,500,000/0.66666).
Other
spending

1,500,000

250,000 1,500,000 2,250,000

1,750,000 Recycling
Programs

c) Communities that prefer little recycling will prefer the block grant. For these
communities, the $250,000 of income given with the block grant is more valuable than
the subsidy. A community would need to spend at least $500,000 on recycling to get
back $250,000 from the government under the subsidy in proposal B.

While I was looking for an intuitive answer, we can see this on the graph above. If the
level of spending on recycling is low, the community will be to the left of the intersection
of the two budget constraints. In this area, the block grant budget constraint is highest.

d) If a community purchases more than $750,000 on recycling programs, it will get back
more than $250,000 from the government. To see this, note that to get $750,000 worth
of recycling services, the community spends $500,000 under each proposal. Under
proposal A, the $250,000 block grant makes up the difference to get to $750,000, and
under proposal B, the 50 cent subsidy provides the additional $250,000. Thus,
Representative Pooh’s community gets more from the government under the matching
grant (proposal B). Again, while it wasn’t what I was looking for in this answer, you can
also see this on the graph, as Representative Pooh’s community is to the right of the
intersection of the two budget constraints. In this area, the matching grant budget
constraint is highest.
 p. 18 of 52

8. Concerned about the unhealthy diet of many American youth, United for Skinny
Adolescents (USA), a health advocacy group, proposes a junk food tax. Unhealthy
foods such as soda, salty snacks, and high-fat baked goods would be taxed. Because
new taxes are unpopular, USA proposes that the policy be revenue neutral. That is,
all of the revenue raised from the tax will be given back to taxpayers. For simplicity, in
this question we’ll assume that all revenues are returned as a lump-sum income tax
rebate. That is, each household’s income will rise by the amount of revenue raised per
household by the new junk food tax.

This question asks you to analyze the effect of this policy on a typical American
household. Suppose that, without the policy, the typical American household has
$3000 to spend for month. They can spend this money on junk food and other goods.
Suppose that, before the tax, a unit of junk food costs $2. 1 At that price, the typical
household purchases 200 units of junk food per month.

a) Using an indifference curve and budget constraint, sketch this initial condition
below, with other consumption on the y-axis, and units of junk food on the x-
axis.
b) As a result of the proposed tax, the price of junk food will rise to $3/unit. At this
new price, the typical household is expected to consume 150 units of junk food
per month. Redraw the above graph, and illustrate the effect of the price change
on the graph. Be sure to show how much the household spends on other
consumption when it chooses 150 units of junk food at the new prices. (Note:
for this part of the question, do not consider the effect of the tax rebate. That
will come in the next part of the question.)
c) Recognizing that new taxes are unpopular, USA proposes returning the income
raised by the tax to consumers. Suppose that this is done through a lump-sum
income tax rebate. Redraw your graph from part (b). Add a new budget
constraint for the typical household after receiving the rebate. For simplicity,
assume that consumers bear the burden of the tax, so that the government
collects $1 per unit of junk food sold. (Hint: Think about how much other
consumption a household could afford if they purchased 150 units of junk food,
as in part (b), but prices hadn’t risen as a result of the tax.)
• How will the amount of junk food consumed now compared to what
households chose before the tax (part a)? How do you know this?
• How will the utility of consumers after the rebate compare to the utility they
had in part (a), before the junk food tax was put in place. Explain intuitively
why these are different.

1 You could think of a “unit” of junk food as representing a bag of chips or bottle of soda, for example.
 p. 19 of 52

a) To draw the budget constraint, note that consumers can buy up to 1500 units of junk
food (= $3,000/$2), or $3,000 worth of other goods. Note that these endpoints are
what we need for the budget constraint – we want to show what is possible, not just
what the consumers actually do. Consumers actually choose 200 units of junk food
per month. Since each unit costs $2, this leaves them $2600 to spend on other
consumption. This is shown by drawing an indifference curve tangent to the budget
constraint at 200 units of junk food. This is the highest possible indifference curve
given the budget constraint.

Other
Consumption
3000

2600

200 1500 Junk Food

 p. 20 of 52

b) The price increase rotates the budget constraint in. Now, the most junk food that
consumers can afford is 1000 units. Given that the household chooses 150 units of
junk food, the family can afford to purchase $2550 worth of other goods (= $3000 –
3(150)). The new indifference curve, tangent to the new budget constraint, is lower
than the original indifference curve. Utility has fallen.

Other
Consumption
3000

2600
2550

150200 1500 Junk Food

 p. 21 of 52

c) The key to this problem is the hint. The difference between the two budget constraints
is due to the tax. Thus, for any quantity, the difference between the two constraints is
the amount of money paid to the government. In this case, the family consumes 150
units of junk food after the tax. They have 2550 left to spend. If they had purchased
150 before the tax, they would have had 2700 to spend. The difference (2700-2550)
is the tax revenue (which, it should be noted, equals $150, since the tax is $1 per unit
of junk food). Thus, the new budget constraint has a steep slope, parallel to the one
drawn in part (b), and goes through the original budget constraint at a quantity of 150
units of junk food. I have made this new line blue to highlight its position.

Other
Consumption
3000

2700
2600
2550

150200 1500 Junk Food

Note that the blue budget constraint is below the original budget constraint. It is also
steeper than the original budget constraint. As a result, households will choose less
junk food, even after the rebate. That is because of the substitution effect. Higher
prices make junk food less appealing. Even if we had given households enough
income to get them back to their original utility curve, they would choose less junk
food.

As I’ve drawn the curves above, consumers are worse off with the tax and rebate
plan. Although the rebate helps compensate them, it is not enough to get them back
to their original indifference curve. Note that the original indifference curve is
infeasible with the blue budget constraint. The reason is that the compensation is
only equal to the amount of revenue raised by the tax. As junk food prices rise,
consumers substitute away from junk food and purchase more of other goods.
Because of this substitution effect, the revenue that is raised is not sufficient to get
consumers back to their original indifference curve.
 p. 22 of 52

The key here is that the new indifference curve goes through the original budget
constraint. The old indifference curve only touches that constraint in one place.
Thus, it is unlikely for the new line to go through the old budget constraint. However,
depending on the scale of your graph, it is possible. If you drew the curves so that
there was little change in junk food consumption, the revenue raised may be sufficient
to compensate consumers for their lost welfare. As long as your answer to this
question was consistent with your drawing in part (c), either answer is acceptable.

The intuition here is that there is a substitution effect – people consume less junk
food after the tax, which reduces government revenue – and an income effect – using
the revenue to lower income taxes allows consumers to increase their welfare. One
makes consumers better off, and the other makes consumers worse off. For
consumers to be better off, the income effect has to dominate the substitution effect.
 p. 23 of 52

9. You manage one department in a large corporation. Two years ago, you had 20
workers and produced 40,000 units. The company allocated 10 more workers to your
department last year, and output increased to 45,000. You just received a memo from
your boss indicating that he is very concerned about the 500-unit fall in the average
productivity of your workers. How can you defend yourself?

Defend yourself by noting that you were only given additional labor. Because of
diminishing returns to inputs, the marginal productivity of the additional labor was
less than before. Since marginal product was falling, average product must fall.

The problem is likely one of capacity constraints. If you were also given more
capital to work with, the productivity of the labor could be maintained.

10. Suppose that the state of California is debating proposals to increase access to
affordable housing. Among the proposed options is offering tax credits to developers
of new apartment buildings that reserve 25% of the apartments in new building to be
rented at below market rates. A supporter of this proposal argues that this is the best
option for California because it will not cost the state government any money. Is this
argument correct? Please use arguments from this section of the course to support
your answer.

This supporter is ignoring opportunity costs. While it is true that the government
will not be spending public money on housing under this proposal, the tax credit
will reduce the taxes paid by developers. As a result, the government will bring in
less revenue from taxes. The net effect on the budget is no different than if the
government kept taxes at their original rates and spent the value of the tax credit
to build public housing.

Policy analysts refer to support programs provided through the tax code as tax
expenditures. While the government does not spend its own money through such
programs, it costs the government money through lost revenue. Common
examples in the U.S. include the mortgage interest deduction and the deduction
for charitable donations.

One common mistake was to argue that the policy would reduce the supply of
other types of housing. Note that the policy only applies to new buildings. It does
not apply to existing buildings, so supply will not decrease.
 p. 24 of 52

11. CSI, Community Services, Inc., uses a combination of high school students and
professional staff to provide services to low-income families in the community. High
school students are able to serve 4 families per day, whereas professional staff can
serve 20 families per day. Students are paid $40 per day, whereas professionals are
paid $100 per day. Their accountant argues that CSI could lower costs by using more
students and fewer professionals, while still serving the same number of families.
Given the data above, do you agree with this assessment? Why or why not?

The accountant’s assessment is incorrect. To minimize costs, CSI should consider

how much it costs per family served – the marginal product per dollar spent on
each type of worker. We are given information on the marginal product for each
type of worker, as well as the cost per day for each. Comparing the two, we see:

𝑀𝑀𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑀𝑀𝑃𝑃𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
?
𝑤𝑤𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑤𝑤𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
20 4
?
100 40

0.2 > 0.1

Thus, we see that, given the current allocation, professionals serve more families
per dollar spent than high school students. Thus, CSI could actually lower costs
by using more professionals and fewer students.

Alternatively, some of you did the inverse:

𝑤𝑤𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑤𝑤𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
?
𝑀𝑀𝑀𝑀𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑀𝑀𝑀𝑀𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
100 40
?
20 4

5 < 10

As long as you interpret this result correctly, your answer will be the same. In this
case, rather than calculating the number of families served per dollar spent, you
are calculating the cost per family served. The cost per family served is lower for
professionals, so more professional staff should be used.
 p. 25 of 52

12. Tom’s Terrific Turkeys is getting ready for the Thanksgiving rush. Turkeys sell for
$30 each, and the market is perfectly competitive. Tom has prepared the following
data for his firm:
Q TC MC ATC AVC
0 $10 -- -- --
1 $20 $10 $20 $10
2 $35 $15 $17.5 $12.5
3 $55 $20 $18.33 $15
4 $80 $25 $20 $17.5
5 $110 $30 $22 $20
6 $145 $35 $24.17 $22.5

a) What are the fixed costs for Tom’s firm? How do you know this?

Tom’s fixed costs are $10. We know this because he has to pay $10 even
if he does not produce any turkeys.

b) Given the current market price of $30, at what quantity would Tom maximize
profits? Explain the economic intuition behind your answer.

Since the turkey market is perfect competition, Tom is a price taker, and
can sell as many turkeys as he can at $30. Thus, Tom’s marginal revenue
is $30. To maximize profit, Tom should equate marginal revenue to
marginal cost. This occurs when Tom sells 5 turkeys. At this quantity, the
amount of extra money he makes by selling a turkey is the same as the
additional cost of producing another turkey.

c) Is a price of $30 a long-run equilibrium for the turkey industry? Why or

why not?

No. Tom makes a profit of $40 when he sells 5 turkeys at $30 each. (Total
revenue = 5 x $30 = $150, and total cost = $110). In long-run equilibrium,
firms must make 0 profits. Because there are profits available, firms will
enter the turkey industry until the price falls enough so that no more profits
are available.

d) Suppose the price fell to $15? How many turkeys would Tom sell now? Would
he make a profit? Should Tom continue to operate in the short run? Why or
why not?

Tom would sell 2 turkeys. He would lose $5. He should continue to operate,
however, since he is at least covering his variable costs, and has some
money left to pay some of his fixed costs. If he decided to shut down, he
would lose $10 (his fixed costs). Obviously, this is worse than losing $5.
 p. 26 of 52

13. This question asks you to consider the market for cab rides in Metropolis. The city is
currently served by several cab companies, each who own multiple cabs and hire
drivers to operate them. The number of cab companies is sufficiently high to consider
the market perfectly competitive.

a) The industry is currently in long-run equilibrium. Using two diagrams, one to

represent the market for cab rides, and a second to represent the costs of a
typical cab company, illustrate the current price, quantity and profits of a typical
cab company. Explain why you have drawn the curves as you did.
b) To reduce traffic in Metropolis, city managers have reduced the number of
parking spaces in the city. This has reduced the number of people who bring
their own cars into the city, and increased demand for cab rides. Show how this
affects the market equilibrium, price, and profits immediately after the policy
takes affect. Using one diagram for the cab ride market and a second for a
typical cab company, illustrate below.
c) Will the scenario you have described in part (b) be a stable long-run equilibrium?
Why or why not? Once again using separate diagrams for both the industry and
a typical cab company, illustrate the long run equilibrium for cab rides in
Metropolis.
d) To avoid the possibility you discuss in (c), cab companies lobby for licensing
rules that prohibit new entry. They argue that, to avoid new congestion
problems, only drivers approved by the city should be allowed to operate cabs.
Moreover, they argue that the number of approved drivers should equal to the
number of drivers operating before the number of parking spaces was reduced.
How would that change your answer to part (c)? Why?
e) Economists often call such lobbying efforts “rent seeking” behavior. Why do you
think this is? What is the most that the industry would be willing to spend on
such lobbying?

a) In long-run equilibrium, firms are making zero economic profits. The price must be
equal to the marginal cost at the point where MC intersects the AC curve.
Market Typical company
P S $
MC AC

P0 P0 = MR = AR

D
Q0 Q q0 q
 p. 27 of 52

b) The new policy increases demand for cab rides, so demand shifts to the right. In the
short run, increased demand leads to a higher equilibrium price and quantity. Each
cab company provides more rides than it did before, and earns positive economic
profits.

Market Typical company

P $ Profits
S
MC AC
P1 P1 = MR = AR
P0

D1
D0
Q0 Q1 Q q0 q1 q
c) No, it will not be a stable long-run equilibrium. Since cab companies are making
positive economic profits, more companies will enter the market, shifting supply out.
As a result, the price of cab rides will fall. This will occur until the price returns to its
original level, with cab companies making zero economic profit.

Market Typical company

P $ Profits
S
MC AC
S1
P1 = MR = AR
P0

D1
D0
Q0 Q1 Q Q q0=q2 q1 q
2
 p. 28 of 52

d) By restricting the number of drivers, supply would not be able to shift out. The result
of part (b) would remain in place, and current cab companies would earn positive
economic profits.

e) The positive profits earned in part (d) are an example of economic rent. Intuitively,
the extra value from the restriction is now capitalized into the “price” of a cab company.
If the owner of a cab company making long-run economic profits decided to sell the
company, she would be able to sell for a higher price than for a cab company making
zero economic profits.

Since the policies that result from this lobbying result in economic rent, economists
often refer to such behavior as “rent seeking.” The most an industry would be willing
to spend on rent seeking is the total value of the profits to the industry.

14. To reduce reliance on their local electric utility, the city of Mount Washington has
decided to build their own municipal power plant. They must now decide what price
to charge consumers. After some careful research, you estimate the following
demand curve for electricity:
P = 400 – 3Q
where Q represents the quantity of electricity used per month, measured in megawatt
hours (MWh). The marginal costs of electricity generation are $40 per MWh. The fixed
costs of running the power plant come to $5,000 per month.

a) Because the municipal power plant is the only source of electricity for local
residents, the city can act like a monopolist provider of electricity. Councilman
Alexander argues that acting as a monopolist and maximizing profits from the
power plant will bring in needed revenue to the city. Find the amount of
electricity purchased per month, along with the price per month, if the city
maximizes profits as a monopolist. Illustrate on a graph.
b) How much profit does the city make if it acts as a monopoly?
d) Councilwoman Eliza believes that the city is providing a vital public service, and
so should provide electricity without any deadweight loss. To completely
eliminate the deadweight loss, what should the price of electricity be? How
much electricity will citizens purchase at that price? Will the city make money,
break even, or lose money at that price? Explain.
d) Redraw your graph from part (a). On it, please show the consumer surplus that
consumers receive and the deadweight loss from this pricing strategy.
Compare this result to the consumer and producer surplus associated with
Councilwoman Eliza’s pricing strategy. What does the difference represent?
e) Councilman Aaron is not happy with either plan. He does not like the
deadweight loss and large profit from monopoly pricing, but is also not happy
with the outcome of part (d). Can you suggest a compromise pricing strategy
that could reconcile these concerns? (Note: you do not need to calculate any
numbers here. Just give a general explanation of an alternative pricing strategy
that could work.)
 p. 29 of 52

a) Profits are maximized where MR=MC. If the city acts as a monopolist, the marginal
revenue curve will bisect the demand curve. Thus, MR = 400 – 6Q.

MR = 400 – 6Q = 40 = MC
360 = 6Q
Q = 360/6 = 60

To get the price, we need to look at the demand curve, to see how much citizens are
willing to pay for 60 MWh of electricity. We get:

P = 400 – 3(60)
P = $220

The graph for this market is shown below. Note that the equilibrium quantity is found
where MC=MR, and the price is found from the demand curve. The price charged is
how much consumers are willing to pay for 60 MWh of electricity.
P
400

220

MC
40
D
60 Q
MR

b) To calculate the profit, note that we need to consider the fixed cost. Thus, profit is not
just the producer surplus from the graph. Rather, we must calculate profit as total
revenue minus total cost. Total costs include the per unit costs (= 60 MWh at $40/per
MWh) plus the fixed costs:

profit = TR – TC
profit = PxQ – TC
profit = (220)(60) – 40(60) – 5000
profit = $5,800
 p. 30 of 52

c) To completely eliminate this deadweight loss, the city should set the price equal to
marginal cost. We find the new quantity by equating marginal cost and demand:

400 – 3Q= 40
360 = 3Q
Q = 120
P = 40

Unfortunately, at this price, the city will lose money, because of the fixed costs:

profit = TR – TC
profit = PxQ – TC
profit = (40)(120) – 40(120) – 5000
profit = -$5,000

d) Consumer surplus is the area above the price and below demand. With monopoly
pricing it is equal to areas A and B. This is a triangle with base of 60, and a height of
180 (= 400-220). Thus, consumer surplus = 0.5(60)(180) = $5,400.

The producer surplus under a monopoly is areas C and D. This is a rectangle with a
length of 60 and a width of 180 (= 220-40). It’s area = (60)(180) = $10,800. Note that
this is equivalent to the profits made relative to variable cots (e.g. ignoring the fixed
costs).

There is no producer surplus in the case of marginal cost pricing. The consumer
surplus with marginal cost pricing includes areas A, B, C, D, and E. This triangle has
a base of 120 and a height of 360 (= 400 - 40). Its area = 0.5(120)(360) = $21,600.

The sum of consumer and producer surplus with monopoly pricing is $16,200. The
difference between the consumer surplus with marginal cost pricing and this sum is
$5,400. This represents the deadweight loss, which is area E on the graph. This area
is a triangle with base of 60 (= 120-60) and a height of 180 (= 220-40). Thus, the
deadweight loss = 0.5(60)(180) = $5,400.
P
400

A B
220
D
C
E
MC
40
D
60 120 Q
MR
 p. 31 of 52

e) The problem with marginal cost pricing is that it does not cover the fixed costs of
providing electricity in Mount Washington. One solution would be average cost
pricing, where the price equals the average cost of each MWh of electricity provided.
This way, the price covers both the marginal cost of $40 per MWh and each person’s
share of the fixed costs, allowing the city to break even. While there is some
deadweight loss associated with average cost pricing, the deadweight loss will be less
than with monopoly pricing.

Another possibility is to consider price discrimination. For example, low income users
could be charged the marginal cost of electricity generation, and higher income users
could be charged a higher price. This second price simply needs to be high enough
so that it covers the fixed costs as well as the marginal costs of the municipal power
plant. Another price discrimination idea suggested by several students is to vary the
price by time of day. Users could be charged more to use electricity during peak
demand periods, such as hot summer days. Not only does this pricing scheme bring
in more money when demand is high, it also discourages households from using
electricity when the power plant is under stress from heavy demand.

Finally, tiered pricing is another option. Each MWh could be priced at marginal cost,
but users could also be charged an annual connection fee. The connection fee could
be set based on the number of households to cover the fixed costs of the municipal
power plant.
 p. 32 of 52

15. The Department of Transportation in Boston has been asked to evaluate the price
that it charges riders on its subway system. Because of your background in
economics, you have been asked by the city to advise their deliberations.

The fixed costs of operating the system are $26,000. In addition, the marginal costs
of operation are $1 per rider. Having researched the demand for public transportation
in Boston, the city has come up with the following table with price, quantity, marginal
revenue, and various costs filled in: 2

P Q (riders MR AC MC
per day)
15 0 -- -- --
14 2,000 13 14.00 1
13 4,000 11 7.50 1
12 6,000 9 5.33 1
11 8,000 7 4.25 1
10 10,000 5 3.60 1
9 12,000 3 3.17 1
8 14,000 1 2.86 1
7 16,000 -1 2.63 1
6 18,000 -3 2.44 1
5 20,000 -5 2.30 1
4 22,000 -7 2.18 1
3 24,000 -9 2.08 1
2 26,000 -11 2.00 1
1 28,000 -13 1.93 1
0 30,000 -15 1.87 1

2 For those that are interested, the table was derived using a demand curve of P = 15 – 0.5Q where Q
represents 1,000 riders per day. Note that you do not need to know this to solve the problem.
 p. 33 of 52

a) Josh, a member of the city council, has taken some economics, and recalls that setting
prices equal to marginal cost is efficient. Thus, he asks you to consider what the
effects of setting the price equal to marginal cost will be. How many riders will use the
subway at this price? How much revenue will these riders generate? What will be the
total costs of serving these riders? Will the subway make money, lose money, or
break even?

Since the marginal cost is $1, this requires setting the price at $1. From the table,
we see that at this price there will be 28,000 riders. 3

These riders will generate $28,000 of revenue (= $1 x 28,000).

The total cost of providing this service is $54,000. You could find this in one of two
ways. First, you could multiply the marginal cost per rider of $1 by the quantity,
and then add the $26,000 fixed cost (= $1 x 28,000 + $26,000). Second, you could
simply multiply average costs by quantity (=$1.93 x 28,000). The second method
will not be exact, since the average cost figures presented have been rounded off.

Since the total costs are greater than the total revenues, the city will lose money.
Boston loses $26,000 operating its subway using marginal cost pricing. Intuitively,
since the marginal cost is constant, marginal cost pricing covers all of the variable
costs, but does not provide any money to cover fixed costs.

b) Manny, a second council member, suggests that Boston should take advantage of its
market power. He asks you to determine the price at which the city, which has a
monopoly as the only subway operator, would maximize its profit from the subway.
What price would that be? How many riders would use the subway? Please calculate
the total revenue and total costs, as well as the profit generated by these riders.

To maximize profits, we must find the point where marginal revenue equals
marginal costs. Since the marginal cost is $1, we find the quantity where marginal
revenue equals $1, which occurs with 14,000 subway riders. The price for this
quantity is $8. 4

These riders will provide $112,000 of revenue (= $8 x 14,000).

The total cost of providing this service is $40,000. Again, you could find this in one
of two ways. First, you could multiply the marginal cost per rider of $1 by the
quantity, and then add the $26,000 fixed cost (= $1 x 14,000 + $26,000). Second,

3 Note that you could also get this answer by setting the demand curve equal to marginal cost: 15 – 0.5Q

= 1 implies that Q = 28. However, since I gave you the information in the tables, such calculations were
not necessary.
4 Again, you could use the bisection rule and then find this algebraically. Given the demand curve of 15 –

0.5Q , we know that MR = 15 – Q. Setting this equal to 1 gives us 15 – Q = 1, which simplifies to Q = 14.
We get the price by plugging this quantity into the original demand curve.
 p. 34 of 52

you could simply multiply average costs by quantity (=$2.86 x 14,000). Because
of rounding, this second method will not be exact.

Finally, we find the profit by subtracting total costs from total revenue. The city
makes $72,000 of profit at this price.

c) A third member of the council, Jonathan, is concerned about consumers, and does
not want the city to maximize its profits. However, it is important to Jonathan that the
city covers its costs, so that Boston does not lose money operating the subway. Based
on the numbers above, what price should the city set to meet Jonathan’s goal? How
do you know this?

At this price, how many riders will use the subway? How much revenue will they
generate? What will be the total costs of serving these riders? What profit, if any,
does the city make from these riders?

For the city of Boston to just cover its costs, the profits should equal zero. The
trick here is to remember what holds when the profits are equal to zero. When
profits equal zero, total costs and total revenue are equal. Thus, average revenue
and average cost are also equal. Since average revenue is just the price, we
need to find the price and quantity sold when average costs and price are equal.
This is the intuition of average cost pricing that we discussed as a potential policy
solution for natural monopolies.

Referring to the table, we see that average costs and price are equal two places:
at a price of $14 or a price of $2. While I gave students that chose a price of $14
partial credit for recognizing the P=AC relationship, given Jonathan’s goals, the
better choice is a price of $2. At this price, 26,000 people ride the subway.
Because Jonathan is concerned about consumers, it makes more sense to
choose the lower price, and thus the higher number of riders. Moreover, choosing
a price of $14 would results in a higher price, lower ridership (2,000 riders), and
lower profits than the profit maximizing strategy in part (b). Thus, neither the city
nor consumers are better off choosing $14 instead of the profit-maximizing price
of $8.

These riders generate $52,000 of revenue (= $2 x 26,000).

The total cost of providing this service is also $52,000. You could find this in one
of two ways. First, you could multiply the marginal cost per rider of $1 by the
quantity, and then add the $26,000 fixed cost (= $1 x 26,000 + $26,000). Second,
you could simply multiply average costs by quantity (=$2 x 26,000).

As expected, Boston makes no profit in this case. It just breaks even. Thus, it
satisfies the goal of serving as many people as possible without losing money.
 p. 35 of 52

16. Evaluate the following statement:

“The First Theorem of Welfare Economics states that as long as producers and
consumers act as perfect competitors, and there are no other market failures, a
Pareto efficient allocation of resources emerges. Thus, if market failure is not
evident, there is no justification for government intervention in the economy.”

This statement assumes that the only justification for government

intervention is market failure. However, the First Theorem of Welfare
Economics only states that, in the absence of market failure, an efficient
solution results. It does not say anything about the desirability of efficiency.
Recall from class that an efficient solution could nonetheless involve a very
inequitable distribution of income. Some people may find this objectionable,
and argue that government intervention is needed to promote more equality.

17. For each of the policy proposals below, identify who the potential beneficiaries and
losers (if any) are. Then, state whether the change is likely to be:
1) a Pareto improvement
2) an improvement in social welfare using a Rawlsian social welfare criterion.
Explain briefly.

a) Providing free health care to low-income families, financed by increasing

income taxes

The potential beneficiaries are those receiving free health services. These
will all be low income families.

The losers are those who are pay higher income taxes but do not receive
additional health services. Since low-income families pay little or no
income tax, most taxpayers will be losers in this scenario.

Because one group benefits at the expense of another, this policy is not a
Pareto improvement.

However, because it benefits the least well-off members of society, it is an

improvement in social welfare using a Rawlsian social welfare criterion.
 p. 36 of 52

b) Providing free public wi-fi, financed by an increase in sales taxes

The potential beneficiaries are those who would use the free public wi-fi.
Presumably, one will need to use a cell phone or laptop to access these
services.

Losers in this scenario are those who pay higher sales taxes but receive
little or no benefit from free public wi-fi. For instance, those who don’t use
a cell phone would not benefit.

Since not everyone owns a cell phone, there will be some consumers who
pay more in sales taxes but do not enjoy the benefits of free public wi-fi.
Thus, the policy is not a Pareto improvement.

To be an improvement in welfare under a Rawlsian social welfare criterion,

the policy must improve the welfare of the least well-off people in the
community. Since the poorest people in the community are unlikely to own
a cellphone, this policy is likely not a welfare improvement under a Rawlsian
social welfare function.

c) Providing free public wi-fi, financed by a tax on cell phone users.

The potential beneficiaries are those who would use the free public wi-fi.
Presumably, one will need to use a cell phone or laptop to access these
services. Thus, the beneficiaries are also the ones paying the cost of free
public wi-fi. Thus, there are not clearly identified losers in this scenario. (A
possibility is someone who only uses their phone to make phone calls, and
thus doesn’t care about free public wi-fi.)

While it is not necessarily the case, it is possible that this policy could be a
Pareto improvement. If cell phone users value free public wi-fi service at
least as much as the cost of the tax increase, it is a Pareto improvement.

However, the policy is not an improvement in welfare under a Rawlsian

social welfare criterion, since it does nothing to improve the welfare of those
who are so poor that they do not use a cell phone.

In answering these questions, note that a Rawlsian social welfare criterion

does not necessarily imply competition among different classes – it is just
that if focuses on the well-being of those who are the worst off. For
example, some students said that the tax on cell phone users is an
improvement with a Rawslain social welfare criterion, because it makes
laptop users better off at the expense of cell phone users. That is incorrect.
The key question is whether the policy makes the worst off people in society
better off.
 p. 37 of 52

18. Using theories discussed in this class, what rationale can you provide (if any) for
government intervention in the following areas? Your answer should both clearly state
whether or not you think the proposed service makes sense, and should use economic
logic to defend your answer.
a) Prohibiting smoking in public buildings

Because of the dangers of second-hand smoke, smoking creates negative

externalities to those nearby. Thus, prohibiting smoking in public buildings
can be justified by reducing the harm from second-hand smoke, and thus
reducing a negative externality.

b) Food stamps

Providing food stamps cannot be justified as correcting a market failure.

Rather, support for food stamps depends on concerns about equity and
redistribution. For example, if market forces leave some families with
insufficient food for sustenance, we may support food stamp programs as a
way to provide a minimum level of food consumption for everyone.

c) Public transportation

There are several possible justifications that could be offered for public
transportation. First, public transportation reduces traffic congestion and
the pollution that comes from traffic. Thus, the use of public transportation
helps reduce negative externalities. One could also support public
transportation for equity reasons. For example, public transportation can
be used by low-income citizens that cannot afford their own vehicle.
Government provision of a natural monopoly is another possible answer. It
would not be sensible to duplicate the infrastructure (particularly for things
such as subway tunnels) to allow multiple companies to compete on public
transit routes. Thus, a single operator makes sense. Having the
government as this operator prevents a for-profit firm from abusing
monopoly power over public transport.

One justification that does not work here is public transportation as a public
good. Public transportation has neither of the features of a public good. It
is excludable – you cannot use the service without paying. Moreover, as
anyone who has rode public transportation in a large city at rush hour can
attest, it is also rival.
 p. 38 of 52

19. Golf balls are hand crafted by artisans in Scotland. Demand for golf balls can be
represented by the curve P = 105-2Q, where Q represents boxes of golf balls. The
marginal cost per box of golf balls equals 0.5Q. However, to produce dimples on golf
balls, the artisans must chip away at the surface of the balls, creating small waste
particles that pollute the local environment. The damage done to the local
environmental is given by the following marginal damage curve: MD = Q.

a) Assume that the market for golf balls is perfectly competitive. How many boxes
of golf balls will be produced if nothing is done to regulate the pollution? At
what price will they be sold? Use a graph to illustrate your answer.
b) What is the socially efficient level of golf ball production? What should the price
be? Use a graph to illustrate your answer.
c) To bring about the level of production you found in part (b), the government
proposes using a Pigouvian tax. At what level should they set the tax? How
do you know this?

a) In a competitive market, we use marginal cost to get the supply curve. Thus,
we set demand equal to the marginal private costs to find the quantity sold.
Note that, since nothing is done about pollution in this question, we ignore the
damages caused by pollution. In this case, marginal private costs equal 0.5Q.

21 MPC

42 Q

105 – 2Q = 0.5Q
105 = 2.5Q
Q = 105/2.5
Q = 42
To find the price, plug this quantity into either supply or demand to get P =
$21:
P = 105 – 2(42) = $21
or
P = 0.5(42) = $21
 p. 39 of 52

b) To find the efficient level of production, we equate the social marginal cost and
demand. Social marginal cost is the sum of private marginal costs (0.5Q) and
marginal damages (Q). Thus, social marginal costs equal 1.5Q.
P

MSC = MPC + MD

MD
45

MPC
21
D

30 42 Q

We get:
SMC = 1.5Q = 105 – 2Q = demand
3.5Q = 105
Q = 105/3.5
Q = 30
To get the price, plug the quantity of 30 into demand:
P = 105 – 2(30) = $45.

c) The tax should make producers to incorporate the cost of pollution into their
decisions. Thus, the tax should equal to the marginal damage at a quantity of
30. Since MD = Q, the tax equals $30.

Note that the price does not increase by the full $30. That is because the
producer price falls – both consumers and producers bear the burden of the
tax. At a quantity of 30, the marginal private cost equals $15. As marginal
private cost represents the original supply curve in a competitive market, this is
the price that suppliers will receive after the tax. When the price received by
producers falls from $21 to $15, the difference between the consumer price
($45) and producer price ($15) equals the Pigouvian tax of $30.

A common mistake was to use the difference between $45 and $21 as the tax.
This equals $24. However, this tax will not be sufficient to reduce the
equilibrium quantity to 30, as shown below, here I add the tax to the marginal
private cost curve:
105 – 2Q = 0.5Q + 24
81 = 2.5Q
Q = 32.4
 p. 40 of 52

20. Lake Poisson is being poisoned by two chemical firms on its shores. The wastewater
released into the lake by these firms, Acme Acids and Barry’s Bases, are killing the
fish in Lake Poisson. Each firm is currently emitting 10 gallons of pollution into the
lake. Scientists estimate that to neutralize the effect of this pollution, 12 gallons of
waste from these plants will need to be eliminated. The marginal costs of reduction
for each firm are as follows:

Abatement Acme Acids Barry’s Bases

1 $5 $10
2 $10 $20
3 $15 $30
4 $20 $40
5 $25 $50
6 $30 $60
7 $35 $70
8 $40 $80
9 $45 $90
10 $50 $100

a) The government’s goal is to reduce 12 gallons of emissions. To do this, they

require each firm to abate 6 gallons. What is the total cost of abatement for
Acme Acids? For Barry’s Bases? What is the combined total for both firms?
b) Is this the cheapest way to reduce 12 gallons of total emissions? If not, can
you suggest a better strategy? How many tons should Acme Acids clean up to
minimize clean up costs? How many gallons should Barry’s Bases clean up to
minimize clean up costs? Please explain how you found your answer.
c) Can you suggest a policy that will lead the firms to clean up the amounts you
propose in part (b)? Explain how the policy works to bring about the efficient
solution.

a) To find the total costs of abatement for each firm, we add up the marginal
abatement costs for each gallon.

For Acme Acids, the total cost of abatement = $5 + $10 + $15 + $20 +
$25 + $30 = $105.
For Barry’s Bases, the total cost of abatement = $10 + $20 + $30 + $40
+ $50 + $60 = $210.

The combined total is $315.

 p. 41 of 52

b) This is not the cheapest way to reduce 12 gallons of pollution. To see this, note
that marginal abatement costs of the last gallon reduced are not equal.
Eliminating the 6th gallon of pollution only costs Acme Acids $30. In contrast,
eliminating the 6th gallon costs Barry’s Bases $60. If Barry’s Bases did not have
to eliminate this 6th gallon, they would save $60. At the same time, suppose
we ask Acme Acids to remove one additional gallon (so that total abatement
remains at 12 gallons). This would only cost Acme $35. Thus, we could still
reduce 12 gallons of pollution, but save $25 (= 60-35).

Such savings are possible any time the two marginal abatement costs aren’t
equal. Thus, we can continue making such trades until the marginal abatement
costs are equal. This occurs when Acme Acids removes 8 gallons of pollution,
and Barry’s Bases removes 4 gallons of pollution. Here, the marginal
abatement cost of each firm equals $40.

Note that the total abatement costs have now fallen. Acme Acid’s cleanup
costs rise slightly, to $180. However, Barry’s Bases now spends only $100 on
pollution abatement. The total abatement cost of $280 is $35 lower than in part
(a).

c) There are a couple of policy options that could achieve an efficient allocation
of abatement responsibility. One is an emissions fee. Consider an emissions
fee set just above $40 (e.g. $40.01). For Acme Acids, they will not choose to
pollute and pay the fee until they have removed 8 gallons of pollution, since the
marginal abatement cost for the first 8 gallons is less than the fee. In contrast,
Barry’s Bases will only remove 4 gallons of pollution. After that, it is cheaper to
pay the fee than to pollute less.

An alternative policy with the same effect would be to give each firm tradable
pollution permits. We could begin by giving each firm enough permits to cover
one-half of their pollution. Thus, the starting point is similar to the current policy.
However, if firms are allowed to buy and sell permits, Barry’s Bases will buy
permits from Acme Acids until their two marginal abatement costs are equal.
At that point, no more beneficial trades are possible. For example, beginning
with the initial allocation, Acme and Barry could negotiate a permit price
anywhere between $35 and $60. At this price, Acme could sell one permit to
Barry. Since Acme’s marginal abatement cost for the 7th gallon is $35, any
price above $35 allows them to cover the clean-up costs and save the
remainder as profit. Similarly, by reducing one less gallon of pollution, Barry’s
Bases saves $60. Thus, they are willing to pay any price up to $60 to avoid the
clean-up cost.
 p. 42 of 52

21. Canterbury and Midland are remote regions in the country of Amazonia separated by
a large mountain range. To travel from one region to the other, drivers must either
take a series of narrow, windy roads over the mountains or drive around the mountain
range. Either route takes 3 hours to complete.

The leader of Amazonia proposes building a tunnel through the mountains. This
tunnel will provide a direct route connecting Canterbury and Midland, and reduce the
travel time between these regions to just 45 minutes. Because the tunnel will reduce
travel times, reduce congestion on narrow mountain roads, and stimulate economic
development in these regions, he argues that the tunnel is a public good.

Do you agree? Using theories discussed in class, should the tunnel be considered a
public good?

A public good has two features: it is non-rival, meaning that many people can use
the good at the same time, and it is non-excludable, meaning that we cannot
prevent people from using the good, making it difficult to collect a fee for usage.
Neither applies here. Thus, while the tunnel may be beneficial to Amazonia, the
tunnel is not a public good.

As the tunnel becomes more crowded, travel times will fall. Thus, congestion is a
possibility. While it may be non-rival for low levels of traffic, at some point it will
become rival. A few people pointed out that, since congestion is only a problem
for high traffic levels, the tunnel has characteristics of a club good.

Similarly, although Amazonia may choose to not charge a toll for using the tunnel,
the decision to finance the tunnel by other means is a choice. It is not a feature of
the tunnel. Since there are limited entry points, it would be possible to charge a toll
to drivers using the tunnel. Thus, excluding people who don’t pay would be
feasible.

22. Some national parks do not charge entrance fees during the winter, except on
weekends. Is this an efficient pricing policy?

This is an efficient pricing solution. In the winter, national parks are rarely crowded
during the week. As a result, the parks are non-rival. The marginal cost of
additional visitors is zero, and so it is inefficient to charge an admission fee.

Some students argued that the pricing solution is efficient because it is a use of
peak-pricing. That is also an acceptable answer. I was looking to connect this
question with our discussion of public goods, but the logic is the same – the park
is only rival during periods of peak use.
 p. 43 of 52

23. Three neighbors – Tyrone, Tasha, and Pablo – will be voting on expansion of a
neighborhood park. The expansion will cost $6,000. All three will share the cost of
the expansion – that is, each person will contribute $2,000 to the installation. The
expansion is worth $2,500 to Tyrone, $2,250 to Tasha, and $1,000 to Pablo.

a) Explain why the park expansion is a public good.

b) Is the proposed park expansion efficient? Why or why not?
c) Suppose a majority rule vote is held to determine whether the expansion should
take place. What will the result of the vote be? Explain any differences
between this result and your answer in part (b).

a) The park expansion is both non-rival and non-excludable. It is usually

impossible to keep anyone from enjoying the benefits of a neighborhood park,
as unlimited access is usually desired. In addition, it is non-rival. Unless the
park becomes very crowded (again, unlikely in a small neighborhood park),
more people using the park will not reduce its benefits.

b) It is not efficient to proceed with the park expansion. Since this is a public good,
we need to compare the social marginal benefit – that is, the sum of individual
marginal benefits – to the marginal cost. The sum of marginal benefits equals
$5,750. This does not justify the cost of $6,000 to expand the park.

c) If the expansion is approved, each voter will pay $2,000. To determine whether
an individual will vote yes or no, compare the voter’s individual benefit to their
share of the cost:

Tyrone = 2,500 – 2,000 = $500

Tasha = 2,250 – 2,000 = $250
Pablo = 1,000 –2,000 = -$1,000.

Since two of the three voters have positive net benefits, the park expansion will
be approved. Both Tyrone and Tasha will vote for the expansion. The problem
here is that the yes/no referendum does not reflect the intensity of an
individual’s preferences. The two who vote for the expansion have only a small
positive net benefit. Pablo, the only one who opposes the expansion, has large
negative net benefits. However, his no vote has only as much weight as one
of the two yes votes.
 p. 44 of 52

24. Consider the price of an automobile insurance policy that replaces the car in case it is
destroyed in an accident. For simplicity, assume all cars are worth exactly $20,000
and all accidents require that the car be replaced. Also, assume there are just two
types of drivers:

• Safe drivers, who have a have a 1% chance of being in an accident

• Speedsters, who have a have a 5% chance of being in an accident

a) If a driver is in an accident, the insurance policy will replace the vehicle with a
new one of equal value. Given this, what is the actuarially fair price for an
insurance policy that only covers safe drivers? That is, what is the expected
value of the damages that safe drivers have?
b) What is the actuarially fair price for an insurance policy that only covers
speedsters? That is, what is the expected value of the damages that speedsters
have?
c) Suppose that one-half of all drivers are safe drivers, and the other half are
speedsters. If the insurance company must offer a policy with the same price to
all drivers, what would that price be? That is, what price covers the expected
value of payouts to all drivers?
d) At this price, will safe drivers wish to buy insurance? Why or why not? What
type of market failure does this illustrate?

a) Actuarially fair insurance is when the premium equals the expected payout.
Here, there is a 1% chance of an accident that will lead to a $20,000 payout.
Thus, the expected payout is 0.01 X $20,000 = $200.

While the calculation above is all you needed to answer this question, note how
this relates to the example we did in class. Either with or without insurance,
this driver would have the same expected income:

• EV(with insurance) = 100%($20,000 - $200) = $19,800

• EV(no insurance) = 0.99($20,000) + 0.01($0) = $19,800

b) Here, there is a 5% chance of an accident that will lead to a $20,000 payout.

Thus, the expected payout is 0.05 X $20,000 = $1,000.

While the calculation above is all you needed to answer this question, note
again how this relates to the example we did in class. Either with or without
insurance, this driver would have the same expected income:

• EV(with insurance) = 100%($20,000 - $1,000) = $19,000

• EV(no insurance) = 0.95($20,000) + 0.05($0) = $19,000

c) The insurance company needs the price to cover its expected payouts. If one-
half of drivers have a 1% chance of an accident, and one-half have a 5% risk,
the average risk is 3%. Thus, the expected payout is 0.03 X $20,000 = $600.
 p. 45 of 52

d) At a price of $600, safe drivers will choose not to buy insurance. Their expected
income is higher without it:

• EV(with insurance) = 100%($20,000 - $600) = $19,400

• EV(no insurance) = 0.99($20,000) + 0.01($0) = $19,800

This is an example of adverse selection. Adverse selection occurs because

insurance is more attractive to people with a high probability of suffering a loss.
If the insurance company is unable to identify which drivers are safe, or if
government regulations do not allow them to charge higher prices to riskier
drivers, the resulting price will be based on average risk. Such a price
discourages low-risk drivers from buying insurance.

A common error here was to say this is an example of moral hazard. While
moral hazard is relevant for insurance, that is not what this example shows.
Moral hazard is when a person takes unnecessary risks because they are not
responsible for the full cost of their actions. Even if the insurance company
could charge a higher price to Speedsters, those drivers could still take greater
risks because insurance will pay the costs if an accident occurs.

25. Characterize each of the following as an example of (i) adverse selection, (ii) moral
hazard, or (iii) principal-agent problem. Explain briefly.
a) A savings and loan association, with federally insured funds, makes risky
investments.
b) A physician prescribes tests that are relatively expensive and ineffective for
treating a patient’s illness.
c) An employee signs up for disability insurance, aware of having an illness that
is likely to be disabling.

a) This is an example of moral hazard. Because the bank is insured, it can take
greater risks, because it will not pay the full cost of a negative outcome.

b) This is an example of a principal-agent problem. The doctor is compensated

for the tests provided, whether or not the patient gets better. Prescribing more
tests rewards the doctor, but does not help the patient.

c) This is an example of adverse selection. Those most likely to benefit from

insurance are more likely to purchase it.
 p. 46 of 52

26. Concerned about trash in neighborhood parks, the city of Urbana has decided to
undertake a beautification project. As a result of cleaner, more attractive parks, they
expect that park attendance will increase by 10%. They also project that property
values of homes near the park will increase by $5,000 per home. There are 1,000
homes that are considered “near” local parks.
a) What are the benefits of the beautification project?
b) How would you measure these benefits?

a) The benefits of the beautification project are the increased recreation

opportunities due to a cleaner, more attractive park. The city estimates that
these opportunities will increase by 10%, and that residents of 1,000 homes will
take advantage of these opportunities.

b) We can use the increase in property values to place a dollar value on the
increased recreation opportunities. Homes near the park will be worth $5,000
more after the beautification project. That is, people are willing to pay an extra
$5,000 to be in a location where they can enjoy the cleaner park. 1,000 homes
are near the parks. Thus, the total value is $5,000,000 (=$5,000 x 1000).

Note that, in doing a cost-benefit analysis, you could simply list the benefits as
the 10% increase in recreational opportunities, or you could value these benefits
at $5,000,000. However, including a $5,000,000 benefit plus 10% additional
recreational opportunities would be double counting, as it is increased
opportunities from cleaner parks that cause the property values to rise.
 p. 47 of 52

27. We Like Sports (WLS) is a group of citizens lobbying for a new sports stadium for the
local baseball team. They argue that the new stadium would have several benefits:
• Currently, the team attracts 1 million spectators a year. WLS projects that with
the new stadium, 1.5 million fans will attend games. Each fan spends $30 at
the game, which generates $3 in taxes. This will create additional revenue for
the city.
• In addition to spending money on the games, WLS argues that these fans will
bring more revenue to the city. They project that one-half of these fans will eat
at restaurants near the stadium, either before or after the game, providing a
needed boost to the struggling neighborhood around the stadium.
• Finally, WLS projects that 10% of these fans will travel from a town more than
two hours away, and will choose to stay in a local hotel after the game.

You have been hired by the city to provide an impartial analysis of the proposed
stadium. As part of this analysis, you have been asked to critique the claims of WLS.
Do you agree with the potential benefits? In preparing a cost-benefit analysis, should
these benefits be considered? Please explain your answer.

We Like Sports (WLS) is being overly generous by attributing all these benefits to
the stadium. First, consider the claim that additional tax revenues will be raised
from increased attendance. Here, WLS has ignored the distinction between
benefits and transfers. For these revenues to truly be a benefit, they must be new
resources coming into the city (assuming that the analysis is being done at the
scale of the city). For any new fans that are from the city, this is simply a transfer
of money from their pockets to the city’s revenues. Moreover, for fans coming from
outside the city, this tax revenue is only a benefit if these people would not have
visited the city anyway. If increased attendance at baseball games means lower
attendance at local theaters, museums, etc., then this is also a transfer. In this
case, the baseball team benefits at the expense of other local attractions, and
revenues for the city as a whole do not increase (here, I’m assuming that fewer
visitors at other attractions means less tax revenue from those places). Similar
logic holds for the other claims. While there may be more business at restaurants
near the stadium, at least some of this business will come at the expense of other
restaurants in the city.

The most likely benefit is the 10 percent that come from more than two hours away.
Again, what matters here is whether these people would have visited the city
anyway, or whether it is the baseball game that makes them want to come. If they
would not come without the new stadium, the revenues brought in by these new
fans, both through taxes and through their purchases at local businesses, are a
legitimate benefit in the eyes of the city.
 p. 48 of 52

28. Emerald City is connected to its suburbs by two highways, one privately owned and
one public. Because the public highway has no toll, it has much traffic, so that it takes
75 minutes to complete a journey to Emerald City. The Yellow Brick Highway is a
privately run toll road. A journey on the Yellow Brick Highway costs $5. Because of
the tolls, the highway is less congested, so that commuters using the Yellow Brick
Highway can reach Emerald City in 60 minutes.

After careful study, you have determined that the demand curve for the Yellow Brick
Highway is:
P = 10 – 0.05Q
where Q represents the number of drivers on the toll road per hour.

a) At the current toll of $5, how many drivers will use the Yellow Brick Highway
each hour? Illustrate on a graph.
b) What is the total willingness to pay for the number of journeys on the Yellow
Brick Highway that you found in part (a)?
c) How much time does a driver save by using the Yellow Brick Highway rather
than the public highway? Using this information and the total willingness to pay
found in part (b), calculate the value of one hour of time to a typical user of the
Yellow Brick Highway (Hint: First use the number of drivers found in part (a) and
your answer in part (b) to find the willingness to pay per person for the amount
of time saved).

a) To find the number of drivers using the Yellow Brick Highway each hour, simply
replace P with $5 and solve for Q:

5 = 10 – 0.05Q
5 = 0.05Q
Q = 5/0.05
Q = 100

The graph is shown on the next page, along with the areas necessary to find
willingness to pay in part (b).
 p. 49 of 52

10

A
5

B
D

100 Q

b) The willingness to pay for 100 trips on the highway equals the total expenditure
on tolls (area B) plus consumer surplus (area A). The value of each is:

area A = consumer surplus = 0.5(10 - 5)(100) = $250

area B = expenditure = (5)(100) = $500
Willingness to Pay = A + B = $750

c) Since it takes 60 minutes to get to Emerald City using the Yellow Brick Highway,
rather than 75 minutes using the public highway, each driver on the Yellow Brick
Highway saves 15 minutes. Since there are 100 drivers, this is a total of 1,500
minutes saved.

The community as a whole is willing to pay $750 to save 1,500 minutes. This
comes to $0.50 per minute (= 750/1500). Multiplying this by 60 minutes gives
us a value of $30 per hour.

Alternatively, you could solve this by saying each of the 100 drivers using the
Yellow Brick Highway places a value of $7.50 on their time saved (= $750/100).
Each driver saves 15 minutes, which is ¼ of an hour. Thus, multiplying $7.50
by 4 gives the total value of $30 per hour.
 p. 50 of 52

29. Consider two projects. The first has a large setup costs, but provides larger benefits
afterwards. The second involves no set up, but provides only minimal net befits each
year. The net benefits of each project in each year are listed below:

Project Year 0 Year 1 Year 2 Year 3

A -$200 $100 $100 $100
B $100 $100 $100 -$250

You may assume that all values are presented as real dollars.
a) Suppose that the real discount rate is 3%. Which project is preferable? Why?
b) Suppose that the real discount rate is 7%? Which project is preferable? Why?
c) Explain intuitively why the results differ in parts (a) and (b).

a) In each case, we need to calculate the net present value of each project. For each
discount rate, we will select the project with the highest net present value. We use the
following formula to calculate the net present value. Note that costs or benefits that
occur in year 0 are not discounted. Future benefits and costs are discounted as
appropriate. In each case, we are given net benefits for a given year, and discount
that value as appropriate. Thus:
FV1 FV2 FV3
NPV = FV0 + + 2
+
(1 + r ) (1 + r ) (1 + r )3
where FVt is the future value of the net benefit in year t.

We begin by using the above formulas with a discount rate of 3%:

100 100 100

PVA = −200 + + 2
+ = −200 + 97.09 + 94.26 + 91.51 = $82.86
(1.03) (1.03) (1.03)3

100 100 250

PVB = 100 + + 2
− = 100 + 97.09 + 94.26 − 228.79 = $62.56
(1.03) (1.03) (1.03)3

The net present value is higher for option A than for option B. Given this option A is
preferable.

b) We repeat the calculations with a discount rate of 7%:

100 100 100

PVA = −200 + + 2
+ = −200 + 93.46 + 87.34 + 81.63 = $62.43
(1.07) (1.07) (1.07)3

100 100 250

PVB = 100 + + 2
− = 100 + 93.46 + 87.34 − 204.07 = $76.73
(1.07) (1.07) (1.07)3
The net present value is higher for option B than for option A. Given this option B is
preferable.
 p. 51 of 52

c) A higher discount rate means that people place less importance on future outcomes.
In option A, the costs are paid up-front, but the benefits come later. With a high
discount rate (part b), these benefits are less important. In contrast, the future benefits
receive more weight in part a.

Recall that the discount rate relates to interest rates. In part a, with a lower discount
rate, the opportunity cost of having money now, rather than in the future, is lower.
Thus, paying the up-front cost is not costly. In contrast, if alternative investments could
earn a 7% return, paying the costs up-front, rather than investing them elsewhere, is
costly.

30. Bill rides the subway at a cost of 75 cents per trip, but currently would switch if the
price were any higher. His only alternative is a bus that takes five minutes longer, but
costs only 50 cents. He makes 10 trips per year.

The city is considering renovations of the subway system that would reduce the trip by
10 minutes. Fares would rise by 40 cents per trip to cover the costs of the renovation.

The fare increase and benefits of reduced travel time are both projected to be in effect
forever. Alternative investments made by the city currently earn a 7% nominal rate of
return. Inflation is 2%.

a) Use the information on Bill’s travel decisions to calculate the value he places
on a minute of his time.
b) Based on this information, what is the present value of the project’s benefits
and costs to Bill?
c) The city’s population consists of 55,000 middle-class people, all of whom are
identical to Bill, and 5,000 poor people. The poor people are either unemployed
or work close to home, so they do not use any form of public transportation.
What are the total benefits and costs of the project for the city as a whole? What
is the net present value of the project? Is the project worth doing?
d) Suppose that, instead of raising fares, the city decided to pay for the
renovations by increasing taxes to cover the cost. This leads to a tax increase
of $3.67 per person. All families, whether or not they ride the subway, must
pay the higher taxes. How, if at all, does this change your answer to part (c)?
 p. 52 of 52

a) Bill is willing to pay no more than 75 cents to ride the subway. By riding the
subway, rather than the bus, he saves 5 minutes per trip. The bus costs 50 cents.
Thus, he spends 25 cents to save 5 minutes per trip. Each minute saved is worth
5 cents to Bill.

b) To calculate the present value of costs and benefits, we first need to find the
appropriate discount rate. The nominal rate of return on alternative investments
is 7%. This is the opportunity cost of investing in this project, rather than another
project. The rate of inflation is 2%. To find the real discount rate, we subtract
inflation from the nominal rate of return, to get a real discount rate of 5%.

Let’s first calculate the present value of benefits. The renovations would reduce
travel time by ten minutes. Since each minute is worth 5 cents to Bill, this has a
value of 50 cents per trip. He makes 10 trips per year, so receives $5 of benefit
per year. The present value of $5 per year forever is:
PV = $5/r = $5/0.05 = $100
The cost of renovations to Bill is the increased fare. Each trip would cost 40 cents
more. Since he takes 10 trips per year, his total costs increase by $4. The present
value of $4 per year forever is:
PV = $4/r = $4/0.05 = $80
c) Since the poor families work close to home, we only consider the benefits and
costs to the middle class residents who will be riding the subway. We get the total
present values of benefits and costs by multiplying the answers to part (b) by
55,000:
total PV benefits = $5,500,000
total PV costs = $4,400,000
The total net benefit of this project is the difference of the total benefits and total
costs. This is $1.1 million. Based on the cost-benefit test, this project is
worthwhile.

d) Using taxes, rather than a fare increase, to fund the project does not change the
net present vale, as costs and benefits are the same. However, this does change
the distribution of benefits and costs. Subway riders save $0.33. Their total costs
are just the $3.67 tax increase, rather than the $4 fare increase. The PV of this
cost is $73.40 per person (= 3.67/0.05), for a total cost to riders of $4,037,000.
Thus, riders are better off using taxes to fund the renovations. The net benefit to
riders is $1,463,000.

However, the renovations now affect poor families, as their taxes increase. Since
they receive no benefits, only their costs matter. The present value of costs to
these families is $367,000 (= ($3.67/0.05) x 5,000).

Thus, the net benefits are still positive. Whether or not the project is desirable,
however, depends on a value judgment. Is it worthwhile to impose a cost of
$367,000 on poor families in the city in order to provide $1,463,000 of benefits to
middle-class subway riders?