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Problem Set Professor Damon Jones

Public Finance and Public Policy Winter Quarter

Problem Set 1

Due Date:

Wednesday, January 20th, 12:00 pm

1. Short Answers:

(a) Discuss two reasons that government should intervene in the operation of free markets and givetwo examples of real-world government policies or programs motivated by these reasons.

(b) True, False, Uncertain: Since education yields private market returns, which are fully capturedby the person who makes the investment, the market will provide the optimal level of educationand the govern- ment should not intervene.

2. Read the three readings posted in Chalk regarding the effects of climate change on the agriculturalsector. You can find the readings in the Assignments > PS 1 folder. First, read Deschenes andGreenstone (2007). Next, read the comment by Fisher, Hanemann, Roberts and Schlenker (2012).

Finally, read the rebuttal by Deschenes and Greestone (2012). In each case, you do not have to reador understand the entire paper. In most cases, the abstract and introductory section will be sufficient.Answer the following questions. Your total answer should not be more than one typed page:

(a) What is the original research question in DG (2007)?

(b) What are the main results of the original paper by DG (2007)?

(c) What were at least two of the critiques brought up by FHRS (2012)?

(d) Relate this debate to our discussion of the Coase Theorem and externalities in class.

3. Consider the example of firms with heterogenous costs of pollution reduction from class. Assume thatthere are three firms with the following costs functions for reduction ofCO2 emissions, R:

cH(RH) = 1.5R2

H

cM(RM) = .75R2

M

cL(RL) = .75RL

Suppose the total benefit of reduction of carbon emissions of amount R is B (R) = R .125R2.

(a) What is the private market equilibrium of pollution reduction, in the absence of Coasian negoti-ation?

(b) What is the socially optimal level of pollution reduction for each firm?

(c) Would you suggest a carbon tax as a policy solution? What would a carbon tax policy look likein this case?

(d) If you were only allowed to use a uniform pollution reduction regulation across the three firms,what level of reduction would you impose on each firm?

(e) How would a cap-and-trade policy work in this setting?

(f) Discuss a real world policy example that makes use of a cap-and-trade policy.

4. Some people were concerned that the 1990 amendents to the CAA [Clean Air Act] would generatehot spots of pollution localized areas with very high concentration of pollutants. Why might theammendments lead to such hot spots? Are these hot spots necessarily a bad thing from an overallwelfare perspective? Explain.

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5. An island nation has two residents, Teddy and Frankie. Both Teddy and Frankie like to use boats sothere is demand for a coast guard. Teddy loves to take his boat far offshore so his utility over privategoods x and total coast guard services g is UTeddy = 2log(x) + 10 log(2g). Frankie keeps his boatclose to shore so his utility is UFrankie= 4log(x) + 5log(g). The total amount of coast guard servicesprovided is g = gf+ gt. That is, the total depends on the services purchased by Frankie,gf, and byTeddy, gt. Teddy and Frankie both have an income of 100, and the price of both the private good and

coast guard service is 1. They are limited, for the purposes of this problem, to providing between 0and 100 units of coast guard service each. [Hint: You may wish to consult the Appendix to Chapter 7in Gruber.]

(a) How much coast guard service is hired if the government does not intervene? How much isprovided by Teddy? By Frankie?

(b) What is the socially optimal amount of coast guard service? If your answer differs from (a), why?

(c) Suppose the government is not happy with the private equilibrium, and it decides to provide 10units of coast guard service. It taxes Teddy and Frankie equally to pay for the new service. Whatis the new total amount of coast guard service? How does your answer compare to (a)? Have weachieved a more socially optimal level of coast guard service? Why or why not?

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