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Unformatted text preview: Econ 131 - Spring 2010 Professor: Emmanuel Saez GSI: Fran¸cois Gerard, Mark Borgschulte Problem Set 1 Solutions Short Answers: A) Discuss two reasons that government should intervene in the operation of free markets and give two examples of real-world government policies or programs motivated by these reasons. The government should intervene in the face of market failures that prevent markets from de- livering pareto efficient outcomes, such as externalities and public goods. Tradable pollution rights exist to complete the clean air market and address the negative externality caused by pollution. National Parks and the conservation of wilderness are a real world example of government provision of public goods. Governments may also choose to intervene when the market does not deliver the distributional outcome that society desires, by redistributing endowments when possible, or by intervening more directly when that is not possible. For example, the inheritance tax could be seen as an attempt to redistribute initial endowments. B) In plain everyday English, explain the difference between marginal cost and average cost. The marginal cost is the cost of producing an additional unit of a good while the average cost is the total cost divided by the total quantity. The average cost takes into account the cost of all the units produced and includes the fixed costs of production. C) True/False/Uncertain (no points without an explanation): In the presence of 100% crowd- out the government is powerless to correct the under-provision of public goods. False. In the presence of 100% crowd out the government can still choose to provide the optimal quantity of the good (by providing the good itself), there just won’t be any private provision left in the market. Note, the government could even tax the individuals to pay for the provision of the public good. D) True/False/Uncertain (no points without an explanation): Since the Second Welfare Theo- rem tells us that the government can choose any Pareto efficient point in the Edgeworth box, there is no need to sacrifice efficiency for equity. False. The Second Welfare Theorem tells us that the government can implement any Pareto efficient point if it can costlessly redistribute initial endowments. However, many endowments (talents, height of athletes, etc.) cannot be redistributed in practice or would be extremely costly to redistribute. This leads to the equity/efficiency tradeoff. 1 Problems 1.) California College is planning to open a new dorm with capacity r . The college’s total cost function for this endeavor is: C college = 50000 + 2 . 5 r 2 The demand for the dorm rooms is given by: P = 12000- 10 r However, the extra dorm rooms increases the number of people living in a confined area which annoys the non college student neighbors. The cost to the neighbors is given by: C neighbors = 7 . 5 r 2 a) Depict this situation graphically. Clearly label the market equillibrium and the social equilib- rium. Pretend you are talking to someone who has never taken an economics course; explainrium....
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