Name

Final Exam
Public Finance - 180.365
Fall, 2000
Answers
This exam consists of three parts. You must answer all components of all three parts of the
exam.
Part I (30 Points). Multiple Choice Questions Write the letter corresponding to the
correct answer in the space to the left of the question.
1. c. A dierence between normative and positive analysis is that
(a) only normative analysis is relevant for choosing among policy options.
(b) positive analysis deals with facts and cannot be a source of disagreement.
(c) positive analysis is descriptive whereas normative analysis is evaluative.
(d) normative analysis is ignored by economists because they have no expertise in making
value judgments.
2. b. Which is not true of utilitarianism?
(a) It was espoused by Jeremy Bentham.
(b) It implies that a dollar given to one person is as important as a dollar given to anyone
else.
(c) It assumes that social welfare is determined by the welfare of individuals.
(d) It encourages redistribution when there is diminishing marginal utility of income.
3. c. Which is not true of Rawlsian social welfare functions?
(a) They assume that the welfare of the middle class is unimportant.
(b) They are derived from a concept of justice.
(c) They treat everyone equally.
(d) They focus attention on the least advantaged individual.
4. c. Which is not necessarily true of a public good?
(a) It costs nothing to let an additional person consume it.
(b) It costs a lot to keep an additional person from consuming it.
(c) It is supplied by the public sector.
(d) It can be a negative thing, that is, a public bad.
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5. a. Which is not a potential nancial problem facing the social security system?
(a) The ination rate has been declining.
(b) The number of retirees is increasing.
(c) The ratio of workers to retirees is decreasing.
(d) Life expectancy beyond retirement age has been increasing.
6. d. Social security is nanced in all but which one of the following ways?
(a) A payroll tax on employers
(b) A payroll tax on employees
(c) A tax on one generations workers to support anothers retirees
(d) A general income tax.
7. d. If introducing social security coverage induces people to retire earlier than they otherwise
would have, this may be an example of
(a) deadweight loss.
(b) moral hazard.
(c) excess burden.
(d) all of the above.
8. a. If married women have greater labor supply elasticities than single women, eciency consid-
erations might suggest that an income tax should tax
(a) the married women at lower marginal rates.
(b) the single women at lower marginal rates.
(c) all women at the same marginal rates.
(d) only the married women.
9. c. An ad valorem tax imposed by the United States on vintage French champagne is probably
(a) regressive.
(b) proportional.
(c) progressive.
(d) borne entirely by the importing country.
10. d. Another term sometimes used for excess burden is
(a) welfare cost.
(b) deadweight loss.
(c) eciency cost.
(d) all of the above.
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11. d. A lump-sum tax causes
(a) income and substitution eects that reinforce each other.
(b) income and substitution eects that oset each other.
(c) no income eect.
(d) no substitution eect.
12. d. An optimal tax structure will depend on
(a) elasticities of supply and demand.
(b) the set of available taxes.
(c) the social welfare function.
(d) all of the above.
13. b. A simple Ramsey tax system would tend to tax
(a) high wages more heavily than low wages.
(b) food more heavily than perfume.
(c) trips to Holland more heavily than commuting to work.
(d) all goods equally.
14. b. Which of the following is not true of the deadweight loss from a small commodity tax?
(a) It is zero if the demand curve is completely inelastic.
(b) As the tax rate is increased, the deadweight loss also increases, but at a slower rate.
(c) It measures a loss in revenue relative to a lump-sum tax that causes the same decline in
utility.
(d) It can be represented by a triangle under a demand curve.
15. a. Commodity taxes are most likely to be a useful part of an optimal tax system if there are
major consumption goods that are price
(a) inelastic and income elastic.
(b) elastic and income elastic.
(c) inelastic and income inelastic.
(d) elastic and income inelastic.
16. d. Moral hazard refers to the incentive for
(a) clients to mislead insurance companies with incomplete information.
(b) insurance companies to interpret policies as not covering certain expensive occurrences.
(c) hospitals to refuse high-quality care to the indigent.
(d) people to behave dierently with insurance than without it.
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17. b. Adverse selection in health insurance markets can lead to
(a) individuals choosing to see low quality doctors.
(b) cream skimming among consumers by some insurance companies, leaving a pool of
high-risk, high-cost consumers unable to purchase insurance at a reasonable cost.
(c) doctors choosing to give excess tests and treatments.
(d) individuals choosing excessive insurance coverage and thus overconsuming health care.
18. d. In the US, third parties pay for approximately which fraction of health care expenditures?
(a) 20 percent
(b) 50 percent
(c) 70 percent
(d) 80 percent
19. c. Which of the following is not a condition for adverse selection to occur?
(a) People (buyers or sellers) have dierent risk characteristics.
(b) Buyers have more information than sellers, or vice versa.
(c) The people with more information cannot prove that they are telling the truth to the
other party.
(d) Sellers have some market power.
20. d. Which of the following does not (by itself) cause problems in the eciency of the health care
market?
(a) Adverse selection.
(b) Moral hazard.
(c) Tax distortions.
(d) Technological innovation.
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Part II (30 points). True/False/Uncertain Questions Decide whether the following
statements are True, False, or Uncertain. Explain your reasoning. Your score will be based not
just on whether you get the True, False, Uncertain part right but also heavily on the quality of
your explanation.
1. The fact that cigarette sales do not change much when cigarette taxes are increased allows
us to conclude that cigarette companies bear most of the burden of the cigarette tax.
Answer:
False. The fact that cigarette sales do not change much implies that either
supply or demand is inelastic. If supply is inelastic, then the cigarette companies
bear most of the burden. If demand is inelastic then smokers bear most of the
burden of the tax.
2. Social Security is a regressive program because you only have to pay Social Security taxes on
income up to a maximum cap amount per year.
Answer:
It is true that, examined on a yearly basis, Social Security taxes are regressive,
for the reason stated in the question. But on a lifetime basis, Social Security is
a progressive program, because low-lifetime-income households get a much higher
return on their contributions than do high-lifetime-income households.
3. Eliminating the marriage penalty by allowing individual members of a couple to le their
taxes separately would provide a tax incentive in favor of the traditional family where one
spouse works and the other stays at home.
Answer:
False. Eliminating the marriage penalty would create a tax system where a
couple with two earners will pay lower taxes than a couple with a single earner at
the same level of household income. Thus eliminating the marriage penalty provides
a tax incentive in favor of the two-earner couple.
4. Most public nance economists think gasoline taxes are good because the excess burden of
such taxes is low since consumption of gasoline does not change much when the gas tax rises.
Answer:
While it is true that most PF economists think gasoline taxes are good, the
reason is because burning gasoline creates a negative externality in the form of
pollution. The gasoline tax helps correct the externality, which has nothing to do
with excess burden.
5. The economic theory of property taxation states that when a new (and permanent) property
tax is imposed, only future owners of the property bear the burden of the tax.
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Answer: False. The theory of property taxation says that the taxes get capitalized
into the price of the property. This means that the person who owned it when the
tax was imposed bears the full burden of the tax. Future owners of the property
bear none of the burden, because they will have paid a price for the property that
is lower by an amount that should exactly compensate them for the annual tax
payments.
6. In evaluating the economic eciency of various commodity taxes, it is not safe to assume
that the excess burden of a tax is measured well by the total amount of tax revenue raised
by that tax.
Answer: True. A tax can impose a large excess burden even if it raises no revenue.
Think of the example of the cable TV tax again.
7. Recently, some tax analysts have proposed a tax break that would allow people to save
unlimited amounts of money in retirement saving plans where interest income is allowed to
accumulate tax free. The eect of such a plan would be to raise the saving rate.
Answer: Uncertain. Whether an increase in the after-tax rate of return increases
or reduces the saving rate depends on the interest elasticity of saving. Theory says
that the interest elasticity could be positive or negative, so we dont know whether
reducing taxation on interest will increase or reduce the saving rate.
8. Because monopoly prots are simply an income distribution issue, the conditions for the
Fundamental Theorem of Welfare Economics are satised in an economy with some oods
provided by monopolies.
Answer: False. The FTWE requires perfect competition, because without per-
fect competition the price of a good will dier from its marginal cost, making the
economys marginal rate of transformation dierent from its marginal rate of sub-
stitution.
9. The theory of welfare economics suggests that the government should pay for development
costs for new drugs.
Answer: True. Once an eective drug is invented, it produces maximum social
benet if its price is equal to the cost of production. If the drug is invented by
the government, the government can give away the formula and allow perfectly
competitive drug rms to compete to manufacture it at the lowest price. If the
drug is invented by a drug company who gets a patent on it, the drug company
will almost certainly charge a price far in excess of marginal cost. Thus society is
(in principle) better o if the government develops the drug.
10. The nancial condition of a Pay As You Go Social Security system is improved by the birth
of an unexpectedly large Baby Boom generation.
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Answer: True - so long as the Baby Boom generation has the same number of kids
per person as previous generations did. The problems of the US Social Security
system are caused not by the large size of the Baby Boom but by the smaller size
of the subsequent generations.
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Part III (40 points). Longer Questions.
1. (10 pt) Consider the market for widgets. Assume that the supply is perfectly elastic at a price of
$10. Suppose an ad valorem sales tax of 60 percent is imposed on consumers of widgets.
(a) How would you compute the excess burden of the tax? (Give either a formula or a
geometric answer, and dene all terms used in your answer).
Answer:
The formula we derived in class was B = (1/2)epqt
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where e is the elasticity
of demand, p and q are the pre-tax price and quantity, and t is the ad valorem
tax rate. Alternatively, a geometric approach is to say that excess burden
corresponds to the triangular area between the demand curve and the supply
curve between the original and the after-tax quantities.
(b) Assume that the demand function for widgets is D = 70P where P is the price paid by
consumers and D is the quantity demanded. Compute the excess burden of the widget
tax.
Answer:
Plugging into the formula e = 1/6, p = 10, q = 60, t = 0.6 gives B = 18.
(c) What is the incidence of the tax?
Answer: Because supply is perfectly elastic, consumers of widgets bear the
entire burden of the widget tax.
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2. (20 pt) A recent article in the New York Times reported that drug companies in India have recently
managed to learn the formulas for producing a large number of drugs invented by American
drug companies (including Viagra!). With the formula in hand, it is very cheap to make these
drugs. The Indian drug companies have therefore begun producing these drugs and selling
them at prices as low as one tenth the price charged by the US drug companies.
(a) Discuss the eects of the actions of the Indian drug companies on Pareto eciency. (To
be concrete, analyze the case of a specic drug V , which is sold in the US at a price
of P
U
and in India at a price P
I
< P
U
; assume that the cost of production is the same
in the US and India, C; assume that all industries in the US and India are perfectly
competitive except for the US drug industry; and assume that the prices of goods other
than the drug are the same in the US and India, P
O
. You will not get full credit unless
you correctly use the concepts of the marginal rates of transformation and substitution
in your answer.)
Answer:
The theory of welfare economics says that Pareto optimality requires the
marginal rate of transformation to be equal to the marginal rate of substitution.
Drug customers in the US will purchase V up to the point where the marginal
rate of substitution between V and other goods equals the ratio of their prices,
P
U
/P
O
. But the marginal rate of transformation is given by the ratios of the
costs of production, C/P
O
. Since we know that P
U
> C, we know that the
drug market in the US is not Pareto ecient. In other words, there are people
for whom a dose of V would be worth more than it costs to produce that dose,
but is worth less than the price charged, P
U
. The fact that such people do not
consume V constitutes a Pareto ineciency.
The Indian rms are charging a price that is equal to the cost of production,
so Indian consumers will buy the socially ecient amount of drug V . Without
these Indian drug companies, most or all of the Indian customers would not have
been able too aord drug V , so the activities of the Indian rms do increase
Pareto eciency.
(b) The US drug companies say that they spent billions of dollars to develop their drugs,
and that the Indian companies are stealing their intellectual property. If you were hired
by the US drug companies to make an argument for why it is good for social welfare to
allow them to charge high prices for their drugs, what argument would you make?
Answer:
You could argue that, if drug companies know that they will get more prots
by inventing a new drug, they will devote more research into developing new
drugs. If, on the other hand, they know that as soon as they invent a new drug
and patent it, that drug will be copied and they wont get any prots from
selling it in India, they will be less willing to invest the money to develop new
drugs.
(c) Suppose that the US drug companies are successful in their eorts to use international
law to get the Indian government to shut down the copycat Indian drug companies.
Suppose further that it is true that Indians are much poorer than Americans so that no
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Indians will buy the drug V unless the price is fairly close to the value P
I
that was being
charged by the Indian drug companies. Discuss the prices that the US drug company is
likely to charge in India and in the US for the drug. Also discuss the likely eects on
social welfare of a bill Congress debated earlier this year that would have made it very
dicult for US drug companies to sell their products in other countries at lower prices
than in the US.
Answer:
By assumption, P
I
was equal to the cost of production of the drug, so if they
were to sell the drug in India at price P
I
the US drug companies would make
essentially zero prots. However, the question said that Indian demand would
be low unless the price charged was fairly close to P
I
. This indicates that the
US drug rms could make a modest prot by charging a price slightly above
P
I
in India, and a much higher price P
U
in the US. The extra prots earnable
in India would also make the prospect of inventing new drugs somewhat more
lucrative, and so the drug company would probably increase its investment in
developing new drugs, which would benet Indians and Americans alike.
The Congressional bill described would probably have the eect of preventing
the US drug company from selling its product in India at all. It would also
reduce the prots of the US drug company, and reduce its incentives to invent
new drugs. Thus, the Congressional bill would be a very bad piece of legislation:
It makes Indians, Americans, and the shareholders of the drug companies all
worse o.
(d) The heavy-metal rock band Metallica has complained loudly about tracks of its songs
that are being downloaded and passed around on the Internet for free. Newspapers have
interviewed some of the people who have passed around Metallica tracks, who have said
that nothing they were doing had hurt Metallica because they wouldnt have bought
Metallicas albums anyway. What does this have to do with the case of the Indian drug
companies?
Answer:
The arguments are virtually identical. The MP3 swappers are making ex-
actly the same argument as the Indian drug companies: nobody gets hurt
because we wouldnt have bought the product anyway. Metallica is making
exactly the same argument as the American drug companies: Our intellectual
property is being stolen. The conclusions are the same too: in the short run,
swapping Metallica tracks for free is Pareto improving, but in the long run mak-
ing all music available free on the Internet would greatly reduce the incentives
to produce good music (because no musicians could make any money if their
product is swapped on the Internet for free).
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3. (10 pt) During the Presidential campaign, George Bush said that the best way to provide prescription
drug coverage to Medicare beneciaries was to subsidize the purchase of private insurance.
Suppose a study determines that the average drug bill of Medicare recipients is $200 a month,
and suppose Bush proposes a specic program in which vouchers are given to all Medicare
recipients entitling them to a government subsidy of $200 a month toward the premium of
an insurance plan for buying prescription drugs. Discuss whether a plan of this kind would
solve the problems of those seniors who already have typical drug bills far in excess of $200
a month.
Answer:
In a plan of this kind, the problem of adverse selection is extreme. Think of
what would happen to an insurer (company A) who oered a plan that was targeted
toward the average consumer: In exchange for the Medicare recipients voucher, it
would pay for all drug bills. If all Medicare recipients joined this insurer, then its
costs would match its expenses. But suppose another insurer, B, enters the market
promising to pay only half of expenses over $200, but to pay for a membership in
a health club for its clients. Then the healthy people would buy coverage from B,
because they also get the health club memberhship. The sick people would buy
coverage from A. Thus the people buying from A would have monthly medical bills
much greater than $200 per month. Since A is only collecting $200 per month, it
will go bankrupt.
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