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PRELIM 2- ECON 3350 - Cornell University - J. Wissink – Fall 2012 – Nov 1
Directions: Write legibly, concisely, & coherently. Label all axes, functions, & variables you use. READ
QUESTIONS CAREFULLY. Draw pictures whenever possible. MAKE SURE YOU TRY ALL PARTS
OF EACH QUESTION. Total time for the test is 75 minutes. Total points on exam = 100, each question is
worth 20 points.
Good luck.
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1. Consider the "market failure" for a situation in which there is a negative consumption externality.
Assume a typically shaped demand curve and supply curve in the market that creates the externality.
Assume that the marginal social impact of the externality created in this market is constant. Assume
there is no externality present on the production side of the market.
a) Identify and explain ONE example of this type of externality in the real world.
b) IN A GRAPH THAT IS BIG ENOUGH… Diagrammatically illustrate the market equilibrium if the
externality is ignored.
c) In your diagram identify and label the Pareto Efficient allocation and identify the dead-weight-loss to
society when the market allocates this good ignoring the impact of the externality.
d) Suppose demanders in this market have the property right to ignore the externality and consume at the
market equilibrium. Now assume trade in this property right is possible. On your diagram
geometrically indicate why (assuming trade can take place) there are gains from trade from an
incremental reduction in the number of units traded from the original market allocation.
e) INSTEAD of property rights and trade, suppose the government decides to use its ability to tax and/or
subsidize transactions in this market to alter the allocation. What would you have the government do?
As completely as you can, demonstrate the impact of your policy selection on the diagram you drew.
ANSWER SPACE:
2
ANSWER SPACE:
3
2. Suppose your BEST GUESS of the marginal cost of pollution reduction is MCBG = 2R where R is
pollution reduction. Suppose the marginal social benefit of pollution reduction is MSB = 100 – 1/2R.
Suppose you can use either a policy that sets R and then allows cap and trade on the pollution permits
consistent with R OR you can set a policy that charges people a fee to pollute based on R.
a) Based on this information, what is the value of R that would drive the “cap on pollution”?
b) Based on this information, what is the pollution fee you should set?
c) Now suppose the marginal cost of reduction turns out to actually be MCactual = 4.5R. After the fact,
which policy “looks” better? Show your analysis with equations and numbers and present a reasonably
accurate diagram of the situation.
ANSWER SPACE:
4
ANSWER SPACE:
5
3. You are preparing a benefit cost analysis for the mayor of Ithaca. The city wants to start a math-tutoring
program for all the 4th graders. The tutoring program will last a month. Labor is traded in an Ithaca
labor market where there is a local and preexisting per unit tax on labor. Here are all the important
facts:
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The local market demand curve for labor hours is typically shaped.
The local market supply curve for labor hours is completely elastic.
Current demand wage = $8.00/hr
Current supply wage = $6.00/hr
Current monthly level of employment in Ithaca = 1,500,000 hours.
The city of Ithaca will completely inelastically demand 30,000 hours of labor the month they tutor.
a) How much is the preexisting tax?
b) Sketch a graph of the situation reflecting the facts stated in this problem. Show the situation both before
and after the government enters the market with its demand.
c) Determine the “shadow wage” for Ithaca’s tutoring needs.
d) What total value for “cost of tutoring” should Ithaca use in its benefit cost analysis for the program?
e) Suppose upon further investigation you realize that the local supply curve for labor is much more wage
insensitive than you presumed. Will this make Ithaca’s project look more or less attractive and why do
you think so?
ANSWER SPACE:
6
ANSWER SPACE:
7
4. Consider a project X that "lives" for 3 years from this day forward: 2012, 2013, 2014. The table below
gives information about the projects anticipated benefits and costs in each year.
$benefits
$costs
2012
$400
$1,500
2013
$200
$200
2014
$2,000
$570
a) Suppose the market interest rate is 0%. Should the project be undertaken?
b) Suppose I tell you that the project's internal rate of return is very near 14.5% (and that I am correct).
What exactly does that mean? (A formula or just well-chosen words or a picture are all equally
acceptable here.)
c) Given what I told you in part (b), if the market rate of interest is 10%, should the project be undertaken?
Briefly defend your position.
d) How about if the market rate of return is 19%? Briefly defend your position.
e) Suppose I tell you that there is an alternative project Y being considered with a “Benefit/Cost Ratio” that
is higher than that of project X’s. The two projects are mutually exclusive. Which project, X or Y, is
better? Briefly defend your position.
f) Assume there is uncertainty over the benefits of the project in the third year, and that, in fact, the
benefits could be $3,000 with probability ½ and $1,000 with probability ½. How will this uncertainty
affect the benefit-cost calculations and the attractiveness of the project?
g) Suppose some of the benefits in the third year are due to a reduction in highway fatalities. What two
methodologies have been suggested for valuing a human life and which one would you recommend
using, assuming you want the project to get a “thumbs up” (that is a “yes!”)?
h) Suppose you realize that benefits and costs in the third year have been reported as anticipated nominal
amounts based on “third year” dollar values using an expectation of 3% inflation each year. How will
knowing this affect/inform your benefit-cost calculations?
ANSWER SPACE:
8
ANSWER SPACE:
9
5. Suppose there are two states of the world: good and bad.
In the good state of the world your income is $250,000.
In the bad state of the world your income is $40,000.
The good state occurs with probability good =0.25 and the bad state occurs with probably bad = 0.75.
Suppose your utility function is: u(M) = 50•M1/2 where M = money income.
a) What would an “income insurance” contract look like if it took away all your income risk and left you
indifferent between buying the insurance and taking the income gamble? Show your work.
b) What is the insurance company’s expected profit on this contract?
c) Graphically illustrate the values of expected utility, utility of the expected value, expected value and the
certainty equivalent.
d) How would your answers change if we changed the utility function to one where u(M) = 50•M?
ANSWER SPACE:
10
ANSWER SPACE:
11