EC3200

UNIVERSITY OF WARWICK

Summer Examinations 2019/20

Economics of Public Policy

Time Allowed: 2 Hours

Answer TWO questions ONLY. All questions carry equal marks (50 marks each). Answer each
question in a separate answer booklet.

Approved pocket calculators are allowed.

Read carefully the instructions on the answer book provided and make sure that the particulars
required are entered on each answer book. If you answer more questions than are required and do
not indicate which answers should be ignored, we will mark the requisite number of answers in the
order in which they appear in the answer book(s): answers beyond that number will not be
considered.

1. (a) The local authority of Islington has £2 million to spend either on park maintenance or
private goods. Each unit of park maintenance costs £10,000. [diagrams not necessary]
(i) What is the maximum units of private goods that Islington can afford? What is the
maximum units of the public good Islington can afford? At what units of public and
private goods does Islington’s indifference curve over these two goods become
tangent to its budget constraint? (5 marks)
(ii) Now suppose that the central government decides to subsidize Islington’s purchase
of park maintenance by providing the local authority with 1 unit of maintenance for
every 2 units it purchases on its own. Will Islington purchase more or fewer units of
park maintenance? Will Islington purchase more or fewer units of the private good?
Explain. (Assume both private good and park maintenance to be normal goods.)
(10 marks)
(iii) What is the outcome if the central government instead provides a block grant such
that the cost to the government is the same? (5 marks)
(b) Two consumers - A and B - each have the utility function U = 3x + 5y. Good x is a
public good and good y is a private good. The price of good x equals the price of good
y and each consumer is endowed with 100 units of the private good.

(Question 1 continued overleaf)

(i) How much of the public good will each consumer provide in the Nash equilibrium?
Is the equilibrium level of provision efficient? If not, what is the efficient level of
public good provision? (10 marks)
(ii) Now suppose that instead consumer B’s utility function is U = x + 5y, but
everything else in the problem remains unchanged. How much of the public good
will each consumer provide in the new Nash equilibrium? Is the equilibrium level of
provision efficient? If not, what is the efficient level of public good provision?
Explain why it is that your answer here is different from that in [(b)i]. (10 marks)
(c) According to Hoxby (2001), after the introduction of the school finance equalisation
laws in the US, California experienced a decline in the quality of their public schools.
Explain this finding. (10 marks)

2. Consider an economy with two consumers of skill levels s1 and s2 , s2 > s1 . Denote the
allocation to the low skill consumer by (x1 , z1 ) and that to the high skill consumer by (x2 , z2 ).
√
(a) For the utility function U = x − zs , write down and explain the incentive compatibility
constraints for the consumers. Which constraint binds at the optimum? (5 marks)
(b) For the utilitarian social welfare function:
√ z1 √ z2
W = x1 − + x2 −
s1 s2
set up the optimisation problem of the government and express W as a function of x1
and x2 only. For s1 = 15 and s2 = 20, derive the optimal values of x1 and x2 and
hence, z1 and z2 . (10 marks)
(c) Contrast the above outcome to the case when skills are publicly observable.
(10 marks)
(d) Describe the method by which Saez (2001) derives the optimal top income tax rate.
Explain the properties of such a tax rate. Under what conditions is the optimal top
income tax rate equal to the revenue maximising tax rate. (15 marks)
(e) What were the effects of the 1986 EITC expansion on labour force participation and
hours of work? Explain. (10 marks)

3. (a) A village has 6 people. Each can either fish in a nearby lagoon or work in a factory.
Wages in the factory are £4 per day. Fish sell in competitive markets for £1 per piece.
If L persons fish the lagoon, the total number of fish caught is given by F = 8L − 2L2 .
People prefer to fish unless they expect to make more money working in the factory.

(Question 3 continued overleaf)

(i) If people decide individually whether to fish or work in the factory, how many will
fish? What will be the total earnings for the village? (10 marks)
(ii) What is the socially optimal number of fishermen? With that number, what will be
the total earnings of the village? Is there a difference between the equilibrium and
socially optimum numbers of fishermen? Why? (10 marks)
(b) Two firms X and Y have access to five different production processes, each one of
which gives off a different amount of pollution. The daily costs of the processes and the
corresponding number of tonnes of smoke are listed in the table below:

Process (smoke) Cost to Firm X Cost to Firm Y

(i) If pollution is unregulated, which process will each firm use, and what will be the
total daily smoke emissions? (5 marks)
(ii) The city council wants to cut smoke emissions by half. To accomplish this, it
requires a municipal permit for each tonne of smoke emitted and limits the number
of permits to the desired level of emissions. The permits are then auctioned off to
the highest bidders. If X and Y are the only polluters, how much will each permit
cost? How many permits will X buy? How many permits will Y buy? (10 marks)
(iii) Which system is socially more efficient - the permit auction procedure or having
each firm reduce emissions by half? (5 marks)
(c) According to Chay and Greenstone (2003), did the Clean Air Act of 1970 in the USA
have an effect on pollution reduction? What effect did it have on infant mortality?
(10 marks)

4. (a) A health study in England surveyed people from 1972 to 1974 and then followed up on
them 20 years later. In the original sample, 44% of women were smokers, but only 19%
of women over the age of 65 were smokers. At the end of the study, it was found that
24% of the smokers had died while 31% of the nonsmokers had died. Does this mean
that smoking is good for you? What would be a better way to look at the effect of
smoking on mortality? (20 marks)
(b) Rhode and Strumpf (2003) evaluated historical evidence to investigate the impact of
changes in moving costs within the Tiebout model. What does the Tiebout model

(Question 4 continued overleaf)

predict should happen to the similarity of residents within a community as the costs of
moving fall? What were the findings of Rhode and Strumpf? (15 marks)
(c) Should higher levels of government mandate redistribution across lower levels of
government? In this context, when does a conditional block grant lead to a different
outcome from an unconditional block grant? (15 marks)

(End)
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