PUBLIC FINANCE
Problem Set 2
3/ You have $100 to spend on food and clothing. The price of food is $5 and the price of clothing is
$10.
a. Graph your budget constraint.
b. Suppose that the government subsidizes clothing such that each unit of clothing is half-price,
up to the first 5 units of clothing. Graph your budget constraint in this circumstance.
5/ Explain why a consumer’s optimal choice is the point at which her budget constraint is tangent to
an indifference curve.
7/ Since the free market (competitive) equilibrium maximizes social efficiency, why would the
government ever intervene in an economy?
8/ Consider an income guarantee program with an income guarantee of $6,000 and a benefit reduction
rate of 50%. A person can work up to 2,000 hours per year at $8 per hour.
a. Draw the person’s budget constraint with the income guarantee.
b. Suppose that the income guarantee rises to $9,000 but with a 75% reduction rate. Draw the
new budget constraint.
c. Which of these two income guarantee programs is more likely to discourage work? Explain.
9/ A good is called normal if a person consumes more of it when her income rises (for example, she
might see movies in theaters more often as her income rises). It is called inferior if a person consumes
less of it when her income rises (for example, she might be less inclined to buy a used car as her
income rises). Sally eats out at the local burger joint quite frequently. The burger joint suddenly
lowers its prices.
a. Suppose that, in response to the lower burger prices, Sally goes to the local pizza restaurant
less often. Can you tell from this whether or not pizza is an inferior good for Sally?
b. Suppose instead that, in response to the lower burger prices, Sally goes to the burger joint less
often. Explain how this could happen in terms of the income and substitution effects by using
the concepts of normal and/or inferior goods.
11/ Consider a free market with demand equal to Q = 1,200 – 10P and supply equal to Q = 20P.
a. What is the value of consumer surplus? What is the value of producer surplus?
b. Now the government imposes a $10 per unit subsidy on the production of the good. What is
the consumer surplus now? The producer surplus? Why is there a deadweight loss associated
with the subsidy and what is the size of this loss?
14/ You have $3,000 to spend on entertainment this year (lucky you!). The price of a day trip (T) is
$40 and the price of a pizza and a movie (M) is $20. Suppose that your utility function is U(T,M) =
T1/3M2/3.
a. What combination of T and M will you choose?
