ECO 4554-01

Economics of State and Local Government

Microeconomic Analysis of the Public Sector

Exercise 2 Answers

Instructions

Your answers must be clearly written and legible. What you submit must be a finished product, not a
draft or “scratch work”. Do your calculations and scratch work elsewhere and then copy it to your
final product. If your exercise is messy or hard to follow, it will not be evaluated and you will not
receive credit. Show your arithmetic.

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Your scanning software may require you to indicate that this is a single, multi-page document. From
the Exercise button on the Course Menu, click on Exercise 2. Then click Choose File, find the file on
your computer, and attach it. Finally, click Submit. Once you have submitted an exercise, Blackboard
will not allow you to change it or delete it.

Exercise 2 Quiz: When you have completed the exercise, take Exercise 2 Quiz on the course website
under Course Documents. If you do not submit a completed exercise, you may not receive credit for
the quiz.

Formatting Quiz Answers: Dollars: No decimals unless non-zero and at least one digit to the left of
the decimal even if zero. If non-zero decimals (that is, cents), you must include two digits to the right
of the decimal. Include dollar sign and commas to separate thousands. Quantities: No decimals unless
non-zero and at least one digit to the left of the decimal even if zero. Include commas to separate
thousands. If decimals, two digits to the right of the decimal. Elasticities: Do not round intermediate
calculations. No decimals unless non-zero and at least one digit to the left of the decimal even if zero.
If decimals, round to two digits to the right of the decimal. Percentages, shares, and tax rates:
Express as percentage, not as decimal. No decimals unless non-zero and at least one digit to the left of
the decimal even if zero. If decimals, two digits to the right of the decimal. Include percent sign.

Introduction

The objectives of this exercise are to

• reinforce your understanding of increasing returns to scale and its implications for economic
efficiency
• reinforce your understanding of positive and negative externalities and their implications for
economic efficiency
• demonstrate the analytical differences between private or individual consumption goods and
public or collective consumption goods.

Before beginning this exercise, read Fisher, Chapter 2 and review the lecture notes and PowerPoint
slides for Topic 1.

Increasing Returns to Scale

Waterworks, Inc., (WWI) is Hueytown’s municipal water supplier. The table displays demand and
cost data for WWI. Using this data, draw a diagram showing consumers’ marginal benefit or demand
curve (label it MB), WWI’s average total cost curve (label it ATC), and WWI’s marginal cost curve
(label it MC). Use your diagram to answer the questions below the table. Note that the price and cost
data are in dollars per thousand gallons and quantity is in thousands of gallons.
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 ECO 4554-01: Economics of State and Local Government
Microeconomic Analysis of the Public Sector
Exercise 2 Answers

Quantity (Thousands Marginal Benefit Average Marginal

of Gallons per Hour) (Demand) Total Cost Cost
0 $30 $28 $22
1 $25 $24 $19
2 $20 $20 $16
3 $15 $16 $13
4 $10 $12 $10
5 $5 $8 $7
6 $0 $4 $4

1. Complete the following statement: The supply of water to Hueytown is subject to (increasing,
constant, or decreasing) returns to scale because average total cost is (increasing, constant, or
decreasing. Therefore, marginal cost is (greater than, equal to, or less than) average total cost.

Answer: increasing; decreasing; less than

2. Efficiency

a. What is the socially efficient quantity of water?

b. What is the maximum price that consumers would be willing to pay for the socially efficient
quantity?
c. What is the average total cost for WWI to supply the socially efficient quantity?
d. How much does WWI loose if it supplies the socially efficient quantity at the price
consumers are willing to pay?

Answers:

a. 4,000 gals/hr
b. $10
c. $12
d. $8,000

3. Equilibrium

a. What is the equilibrium quantity of water in thousands of gallons per hour? (Here, the
equilibrium is the largest quantity that WWI can supply so that it does not sustain a loss given
the price consumers are willing to pay.)
b . What is the maximum price that consumers are willing to pay for this equilibrium quantity?

Answers:

a. 2,000 gals/hr
b. $20

4. Based on this analysis, you can conclude that, with increasing returns to scale, the equilibrium
quantity is (greater than, equal to, less than) the socially efficient quantity.

Answer: less than

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 ECO 4554-01: Economics of State and Local Government
Microeconomic Analysis of the Public Sector
Exercise 2 Answers

Externalities

Education provided to students in Hueytown not only benefits Hueytown’s residents but also confers
external benefits on residents of Deweyburg because, for example, some students educated in
Hueytown may eventually relocate to Deweyburg. The table shows the marginal private benefit of
high school graduates to Hueytown’s residents, the marginal external benefit to Deweyburg’s
residents, and the marginal cost (all expressed as thousands of dollars of expenditure per student).
Using this data, draw a diagram showing the marginal private benefit to Hueytown’s residents (label
it MB), the marginal social benefit to both Hueytown’s residents and Deweyburg’s residents (label it
MSB), and the marginal cost (label it MC). Use your diagram to answer the questions below.

Quantity (Number Marginal Private Marginal Marginal

of High School Benefit (MB) External Cost (MC)
Graduates (Thousands of Benefit (Thousands
Annually in Dollars per (Thousands of Dollars per
Hundreds) Graduate) of Dollars per Graduate)
Graduate)
0 $7 $4 $5
1 $6 $3.5 $5
2 $5 $3 $5
3 $4 $2.5 $5
4 $3 $2 $5
5 $2 $1.5 $5
6 $1 $1 $5

5. What is the private equilibrium number of high school graduates (in hundreds of graduates per
year)?

Answer: 200

6. What is the socially (economically) efficient number of high school graduates (in hundreds of
graduates per year)?

Answer: 400

7. How large a subsidy (in thousands of dollars per graduate) would Hueytown have to receive
from the state in order to persuade its voters to vote for the socially efficient number of high
school graduates?

Answer: $2,000

8. Complete the following statement: With a positive externality or external benefit, marginal social
benefit at each quantity is (greater than, equal to, less than) marginal private benefit, and the
private equilibrium quantity is (greater than, equal to, less than) the socially efficient quantity.

Answer: greater than; less than

Louieville’s municipal waterworks company provides drinking water to residents of both Louieville
and Deweyburg. Louieville’s government imposes a tax on each gallon of water supplied and uses the

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 ECO 4554-01: Economics of State and Local Government
Microeconomic Analysis of the Public Sector
Exercise 2 Answers

revenues to pay for recreational activities. The recreational activities are available only to residents of
Louieville, not to residents of Deweyburg. The table shows the marginal benefit and the marginal
private cost of recreational activities to Louieville’s residents. It also shows the marginal external cost
imposed on Deweyburg’s residents by the water tax. Using this data, draw a diagram showing the
marginal benefit to Louieville’s residents (label it MB), the marginal private cost to Louieville’s
residents (label it MC), and the marginal social cost to both Louieville’s residents and Deweyburg’s
residents (label it MSC). Use your diagram to answer the questions below.

Quantity (Hours of Marginal (MB) Marginal Marginal

Recreational (Dollars per Hour) Private Cost External
Activities per Day) (MC) Cost (MEC)
(Dollars per (Dollars per
Hour) Hour)
0 $7 $3 $2
1 $6 $3 $2
2 $5 $3 $2
3 $4 $3 $2
4 $3 $3 $2
5 $2 $3 $2
6 $1 $3 $2

9. What is the private equilibrium number of hours per day of recreational activities?

Answer: 4

10. What is the socially (economically) efficient number of hours per day of recreational activities?

Answer: 2

11. How many hours per day would Louieville’s voters choose if they had to pay the full $5 per hour
cost themselves—that is, if they were unable to externalize part of the cost to Deweyburg’s
residents through the water tax?

Answer: 2

12. Complete the following statement: With a negative externality or external cost, marginal social
cost at each quantity is (greater than, equal to, less than) marginal private cost, and the private
equilibrium quantity is (greater than, equal to, less than) the socially efficient quantity.

Answer: greater than; greater than

13. Compare your answers in 8 and 12. How are they alike? How are they different?

Answer: With both positive and negative externalities, marginal social benefit or cost is greater
than marginal private benefit or cost. But with positive externalities, the private
equilibrium quantity is less than the socially efficient quantity (underproduction), while
with negative externalities, the private equilibrium quantity is greater than the socially
efficient quantity (overproduction).