Study Questions 1

ECO 4554 Economics of State and Local Government Study/Test Questions Topic 1: Microeconomic Analysis of the Public Sector These questions are designed as study questions to enhance your economic knowledge and your analytical skills. I will also use them as test questions. Because you have the questions in advance, I expect your answers on the tests to be well-organized, clear, coherent, and concise. You might write trial answers to each question in advance, or at the very least, outline the answers. You may not bring any written materials to the test, but if you’ve prepared answers in advance, you can immediately begin writing and still write competent and thorough answers. Feel free to consult one another on the questions. In fact, I strongly encourage you to discuss the questions with one another. No matter how confident you are of your knowledge, your command of the material and your preparation for the test can be enhanced by sharing your knowledge. Do not, however, simply rely on your fellow students to provide you with the answers. When the time for the test comes, you will be on your own. Although in most cases, the questions do not specifically request that you illustrate your answer with an appropriate diagram, diagrams are usually quite helpful both in undertaking the analysis and in illustrating and explaining your answer. I expect you to know the relevant diagrams, to use them, and to interpret them. I encourage you to include them in your answers. 1-1. For each item below, define the term or state the theorem or explain the concept. • • • • • • •

Economic efficiency Externalities Increasing returns to scale Private (or individual consumption) good Public (or collective consumption) good Free rider problem Lindahl equilibrium

1-2. Based on the data in Fisher, Chapter 1, how does the state-local sector in your state compare to the “national average” in terms of (1) the structure of localities, (2) the level of expenditure, (3) the pattern of services provided, and (4) the mix of revenue sources? Can you suggest reasons why your state might differ from the national average. 1-3. (Core Principle) Assume there are no externalities, no increasing returns to scale, and no collective consumption goods. Prove that the competitive equilibrium quantity is also the efficient quantity. 1-4. (Core Principle) Competitive markets may fail to supply the efficient quantity of a good or service in each of the following settings. For each one, explain how and why competitive markets may fail. a.

Provision of the good or service is characterized by increasing returns to scale. [Illustrate your explanation with a diagram. Show consumers’ demand (D), supplier’s average total cost (ATC) and marginal cost (MC), the efficient quantity (Q*), and the competitive equilibrium quantity (Q’). Explain in your answer how the diagram illustrates increasing 1

ECO 4554: Economics of State and Local Government Study/Test Questions: Topic 1 returns to scale and why the efficient quantity is not also the competitive equilibrium quantity.] b.

The good or service either confers external benefits (a positive externality) or imposes external costs (a negative externality) on third parties. [Illustrate your explanation with two diagrams, one for external benefits and one for external costs. For the positive externality, show marginal social benefit (MSB), marginal private benefit (MB), and marginal cost (MC). Remember that marginal social cost and marginal private cost are the same thing when there are no external costs. For the negative externality, show marginal social cost (MSC), marginal private cost (MC), and marginal benefit (MB). Remember that marginal social benefit and marginal private benefit are the same thing when there are no external costs. On each diagram, show the efficient quantity (Q*), and the competitive equilibrium quantity (Q’).]

c.

The good or service is a public or collective consumption good. [In this case, explain why the market equilibrium quantity is inefficient both when non-payers are excluded from consumption of the good (the market model) and when they are not excluded (the voluntary contributions model)].

1-5. Explain what is meant by “the government model” for supplying a public good or service. What are three reasons that the government model does not necessarily supply the socially efficient quantity of a public good? 1-6. Suppose the university is considering building new parking facilities on campus. The table below shows the marginal benefit to students, to faculty and staff, and to visitors for one to five new facilities. The table also shows the marginal cost to build the facilities. Number of New Facilities

Marginal Benefits Students

1 2 3 4 5

$75,000 60,000 45,000 30,000 15,000

Faculty and Staff $40,000 35,000 30,000 25,000 20,000

Marginal Costs Visitors $20,000 15,000 10,000 5,000 0

$30,000 40,000 50,000 60,000 70,000

Note that the table shows marginal benefits and marginal costs. The marginal benefit to students from having a third new facility instead of just two is $45,000. The total benefit from three new facilities is $180,000 (sum of MB of first facility, marginal benefit of second facility, and marginal benefit of third facility). The marginal cost of a third facility is $50,000, but the total cost to build all three new facilities is $120,000. a.

Assume that the facilities will not be completely full so that students, faculty and staff, and visitors can use them simultaneously. Therefore, the parking facilities are public goods. Draw the marginal benefit curves for each of the three groups (MBS, MBF, MBV). From the individual marginal benefit curves, derive the aggregate or social marginal benefit curve (MSB). Finally, draw the marginal cost curve (MC). What is the efficient number of new parking facilities? If the university builds this number of facilities, how 2

ECO 4554: Economics of State and Local Government Study/Test Questions: Topic 1 should the costs be divided among the three groups; that is, what share of the costs should each group pay? b.

Suppose the data are as follows:

Number of New Facilities

Marginal Benefits Students

1 2 3 4 5

$75,000 60,000 45,000 30,000 15,000

Faculty and Staff $45,000 40,000 35,000 30,000 25,000

Marginal Costs Visitors $15,000 10,000 5,000 0 0

$30,000 40,000 50,000 60,000 70,000

Does this change the efficient quantity? Does it change the appropriate distribution of the cost shares among the three groups? Explain.

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