Problem Set 5 Answer Key

1. Market failure is the inability of a private unregulated market to attain efficiency, where efficiency is defined as marginal social benefits = marginal social cost. Three broad problems can lead to market failure: monopoly, public goods, and externalities.

2. Rational ignorance suggests that people will not spend a lot of time and money worrying about every piece of legislation debated by governments. Special interest groups, however, will attempt to manipulate the political process to their advantage in order to secure concentrated benefits at taxpayer expense.

3. This is straight out of your notes and the textbook.

4. We did this one in class.

5. We did this one in class also.

6. Median voter model:
a) Shawn is the median voter and the parties will propose a tax rate to appeal to him, namely, 30%.
b) The proposed tax rate will remain 30% since the median voter did not change.
c) Jamie becomes the median voter now, and a tax rate of 20% will be proposed.

7. See the answer to #2 above.

8. Mosquito abatement program.
a) Under majority rule, only Charlie would vote in favor of the abatement program (since he values the program at $100, which is more than the cost to each owner of $35). Thus, the abatement program would not be approved. From society's point-of-view this would be inefficient since the total value of the program to the three guys ($120) is greater than the total cost ($105).
b) Unanimity could be reached by having Charlie subsidize Art and Bob's "tax bill." Assuming Art and Bob are willing to pay their values, Charlie could pay $34 on behalf of Art and $16 on behalf of Bob in order to pay for the abatement program. All parties would thus benefit.

9. The class in which students earn their own grades will have the higher class average. The class in which students earn the class average as their grade will attract a lot of free riders. The free riders are likely to be (how should I say) academically-challenged, thereby ensuring an overall lower class average.

10. How would you argue?

11. Private costs = $10,000
External costs = $5000 + 4000 + 1000 = $10,000
Social costs = private + external = $20,000

12. On the one hand, a monopolist is inefficient because it tends to underproduce. On the other hand, a firm that generates a negative externality tends to overproduce its product. Combining these two yields an uncertain outcome since the two effects may tend to offset each other to some degree.

13. Does it matter whether the people living around the airport came after the airport was built? Why or why not?

14. Fishermen and sludge.
a) The fishermen will buy the nets at a cost of $2750.
b) The factory will buy the nets for the fishermen at a cost of $2750.
c) The tax is likely to be set equal to the damage done by the sludge to the fishermen, namely, $4000. Given this potential tax liability, the factory will try to minimize its costs by avoiding the tax. Since the factory is precluded from bargaining with the fishermen as in part (b), they will be unable to buy the net system. The next best option is to install the water filter system at a cost of $3500 (which is better than paying $4000 in taxes).
d) As Coase would argue, the outcomes in parts (a) and (b) are identical: as long as property rights are well-defined and transaction costs are low, private bargaining will result in the most efficient outcome. In this case, efficiency requires that the nets be used. However, in part (c), transactions costs were high enough to prevent bargaining so that only a "second best" outcome prevailed.

15. Tuna.
a) Free market price is $3.00 and output is 6,000,000 tuna where (private MB = private MC)
b) Socially optimal price is $4.50 and output is 3,000,000 tuna (where MSB = MSC)
c) Tax would be equal to the marginal external cost of tuna at the optimal output, namely, $2.25. Consumers would end up paying $1.50 of the tax (the change in market price from part (a) to part (b)).

16. This question is really good fodder for a bar debate.