Problem Set

Public Finance and Public Policy

Professor Damon Jones

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 give
two 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 captured
by the person who makes the investment, the market will provide the optimal level of education
and the govern- ment should not intervene.
2. Read the three readings posted in Chalk regarding the effects of climate change on the agricultural
sector. You can find the readings in the Assignments > PS 1 folder. First, read Deschenes and
Greenstone (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 read
or 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 that
there are three firms with the following costs functions for reduction of CO2 emissions, R:
cH (RH )
cM (RM )
cL (RL )

2
1.5RH

2
= .75RM

= .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 negotiation?
(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 like
in 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 generate
hot spots of pollution localized areas with very high concentration of pollutants. Why might the
ammendments lead to such hot spots? Are these hot spots necessarily a bad thing from an overall
welfare perspective? Explain.
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5. An island nation has two residents, Teddy and Frankie. Both Teddy and Frankie like to use boats so
there is demand for a coast guard. Teddy loves to take his boat far offshore so his utility over private
goods x and total coast guard services g is UT eddy = 2 log(x) + 10 log(2g). Frankie keeps his boat
close to shore so his utility is UF rankie = 4 log(x) + 5 log(g). The total amount of coast guard services
provided is g = gf + gt . That is, the total depends on the services purchased by Frankie, gf , and by
Teddy, 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 0
and 100 units of coast guard service each. [Hint: You may wish to consult the Appendix to Chapter 7
in Gruber.]
(a) How much coast guard service is hired if the government does not intervene? How much is
provided 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 10
units of coast guard service. It taxes Teddy and Frankie equally to pay for the new service. What
is the new total amount of coast guard service? How does your answer compare to (a)? Have we
achieved a more socially optimal level of coast guard service? Why or why not?