Public Finance Final Exam

With respect to solving a problem of a negative externality, the assignment problem refers to difficulty in determining A. who to tax or subsidies B. who is to blame for an externality C. who bears the damage of the externality D. B and C are correct E. A, B, and C are correct

B and C are correct B. who is to blame for an externality C. who bears the damage of the externality

Suppose that a market IS IN EQUILIBRIUM and there is no government intervention in the market. If the private marginal cost of producing an item is $4 and the social marginal cost of production is $6, what is the private marginal benefit of the item IN EQUILIBRIUM? A. $2 B. $4 C. $10 D.$6 E. $0

B. $4

Suppose cutting taxes both reduces the percentage of income that is taxed and increases the size of taxable incomes. Which scoring method takes both effects into account? A. neither static nor dynamic scoring B. dynamic scoring but not static scoring C. static scoring but not dynamic scoring D. capital scoring but not cash scoring E. Cash scoring but not capital scoring

B. Dynamic Scoring but not static scoring

For a tax to lead to the optimal amount of pollution, it should be set: A. greater than social marginal damage B. equal to social marginal damage C. greater than social marginal cost D. equal to social marginal cost E. equal to private marginal cost

B. Equal to social marginal damage

Which of the following is a ballot measure allowing citizens to vote on state laws or constitutional amendments that have ALREADY BEEN PASSED by the state legislature? A. recall B. referendum C. voter initiative D. bloodless coup E. arrow vote

B. Referendum

Arrow's Impossibility Theorem concludes that: A. any social decision (voting) rule made by rational individuals converts individual preferences into a consistent aggregate decision B. There is no social decision (voting) rule that converts individual preferences into a consistent aggregate decision without restrictive assumptions C. a preference aggregation mechanism is irrelevant in a democratic society D. it is impossible to make one person better off without hurting at least one other E. Both B and C are correct

B. There is no social decision (voting) rule that converts individual preferences into a consistent aggregate decision without restrictive assumptions

If the present discounted value of $300 received 3 years from now is $213.5, what is the interest rate? A. 9.6% B. 10% C. 12% D. 14% E. None of the above

C. 12% PDV = Initial / (1+r)^n n= # years in future 213.5 = 300 / (1+r)^3 1.405 = (1+r)^3 r = .12

Which of the following is a system by which individuals report their willingness to pay for the next incremental unit of a public good and the government charges them that amount to finance this public good? A. access pricing B. voter initiative C. Lindahl Pricing D. referendum E. marginal-cost pricing

C. Lindahl Pricing

The US government issues: A. cash accounting for discretionary spending and capital accounting for defense spending B. cash accounting for discretionary spending and capital accounting for non-discretionary spending C. only cash accounting D. only capital accounting E. cash accounting for foreign assistance spending and capital accounting for domestic spending

C. ONLY CASH ACCOUNTING

Which of the following is accurate regarding the effect of amendments passed to the Clean Air Act in 1990? A. The Amendments encouraged utilities to operate older power plants longer than they would have otherwise B. The amendments had little effect on emissions overall, although they did affect local areas C. Tradable emissions permit systems work well in practice D. Tradable emissions permit systems do not work well in practices E. Both A and D are correct

C. Tradable emissions permit systems work well in practice

Which of the following was an unintended consequence of the 1970 Clean Air Act? A. Utilities relocated large numbers of power plants to Mexico B. Utilities began operating more nuclear power plants C. Utilities ran plants built prior to 1970 longer than they would have otherwise D. Both A and C are correct E. Both B and C are correct

C. Utilities ran plants built prior to 1970 longer than they would have otherwise

In a market in which there is pollution, the optimal amount of pollution reduction occurs when: A. social marginal benefits of reduction equal its total social costs B. social total benefits of reduction are maximized C. social marginal benefits of reduction equal its social marginal costs D. social marginal benefits of reduction equal zero E. Both B and D are correct

C. social marginal benefits of reduction equal its social marginal costs

The under-provision of public goods by a private market is characterized by: A. the holdout problem B. the assignment problem C. the free rider problem D. the irrationality problem E. transaction cost and negotiating problems

C. the free rider problem

An implication of Part 1 of the Coase Theorem is that in the presence of externalities , government: A. Should primarily establish property rights to prevent market failure B. Should primarily use taxes to prevent market failure C. Should primarily use subsidies to prevent market failure D. can do nothing to prevent market failure E. can prevent market failure by using quantity controls

A. Should primarily establish property rights to prevent market failure

Complete the following: ________ spending refers to funds for programs for which funding levels are automatically set by the number of eligible recipients, and Congress sets _______ spending by annual appropriations A. entitlements; discretionary B. discretionary; entitlement C. deficit; entitlement D. deficit; discretionary E. entitlement; deficit

A. entitlement; discretionary

Which of the following is necessary for the Median Voter Theorem to hold? A. single-peaked preferences B. double-peaked preferences C. Either A or B is necessary D. Both A and B are necessary E. Neither A nor B is necessary

A. single-peaked preferences

What is the intuition behind the notion of Ricardian equivalence? How might you look for evidence to test the suggestion that people account for future generations' tax burdens by saving more today?

According to the theory of Ricardian equivalence, whenever there is a deficit, the current generation realizes that it is paying less in taxes than is being spent by the government. They realize that this will result in a heavier tax burden on future generations than there would be if they were paying enough taxes to balance the current budget. To reduce this intergenera- tional inequity, the current generation saves more than they would if their taxes were higher. This will mean that children will inherit the means to pay higher taxes later. If this theory were accurate, individuals would respond to lower taxes (for the same levels of government expenditures) by raising their savings rate. To investigate whether the theory is accurate, then, one could look at how private savings rates have changed when new tax cuts (or tax in- creases) were passed.

Think about the major ways in which acid rain causes damage, such as through forest erosion, property damage, reduced visibility, and adverse health outcomes. Which of these costs are highly localized and which are borne by society more broadly? Explain.

Acid rain generates widespread damage and costs because of the way it is dispersed; however, some of the damage is locally concentrated. Direct property damage (material and paint corrosion and deterioration, for example) implies discrete, local costs, as do instances of reduced visibility. Forest erosion, on the other hand, can generate indirect costs, including increased flooding, reduced soil stability, wildlife habitat reduction, and damage to recre- ational and aesthetic assets. These costs are broadly borne.

Which statement about direct democracy in the US is NOT true? A. the important feature of a referendum is that it is designed to elicit constituents' reactions to legislation B. Voter initiative is widely used in the US, especially the West Coast states C. Referenda and initiatives are used in all kinds of issues, including but not limited to election rules, alcohol rules, animal rights, etc. D. All of the answers are true

D. All of the answers are true

Which of the following are barriers to solving the free rider problem in the provision of public goods? A. individuals may not know their valuation of a good B. individuals may not revel their valuation of a good to government C. the government may not be able to aggregate preferences of many citizens D. Answers A, B, and C are correct E. Both answers B and C are correct

D. Answers A, B, and C are correct

Which of the following must lead to less than a full crowd-out of private contributions to a public good? A. individuals deriving utility from their own individual contribution B. warm glow from individual contribution C. taxing those who do not contribute to the public good D. Answers A, B, and C are correct E. Both A and B are correct

D. Answers A, B, and C are correct

Which type of approach does the Environmental Protection Agency adopt in designing policy toward resolving externality problems? A. Public-sector solutions (price and/or quantity) B. Coasian Bargaining C. Military Action D. Both A and B are correct E. None of the answers is correct

D. Both A and B are correct Public-sector solutions (price and/or quantity) Coasian Bargaining

Smoking causes externalities if: A. employers lower all wages for all workers to account for less productive workers who smoke B. smokers die too early to collect Social Security benefits C. Insurance companies adjust house insurance premiums for smoking status D. Both A and B are correct E. none of the answers is correct

D. Both A and B are correct Smoking causes externalities if employers lower all wages for all workers to account for less productive workers who smoke AND smokers die too early to collect Social Security benefits

A pure public good? A. must be nonrival in consumption B. must be rival in consumption C. must be nonexcludable D. Both A and C are correct E. Both B and C are correct

D. Both A and C are correct A public good must be BOTH nonexcludable and nonrival in consumption

Which of the following factors is likely to enable private market forces to provide more of a public good than it might otherwise provide? A. large differences among individuals in their demand for the public good B. little to no difference among individuals in their demand for the public good C. altruism D. Both A and C are correct E. Both B and C are correct

D. Both A and C are correct large differences among individuals in their demand for the public good AND altruism

The interpersonal equity condition A. states that the social marginal utilities of income must be equal for all people in society B. is the only condition that must hold for Pareto Optimality C. and the Pareto-optimal conditions must both hold to attain social welfare maximum at the bliss point D. Both A and C are true

D. Both A and C are true The interpersonal equity condition states that the social marginal utilities of income must be equal for all people in society, and the Pareto-optimal conditions must both hold to attain social welfare maximum at the bliss point SMU = changeW/changeU = changeU/changeIncome = all persons

When price levels rise: A. the real deficit increases B. the real deficit falls C. the nation forgoes less consumption to pay debt D. Both B and C are correct E. None of the answers is correct

D. Both B and C are correct When price levels rise, THE REAL DEFICIT FALLS and THE NATION FORGOES LESS CONSUMPTION TO PAY DEBT

Zorroland has a large number of people who are alike in every way. Boppoland has the same number of people as Zorroland, with the same average income as Zorroland, but the distribution of incomes is wider. Why might Boppoland have a higher level of public good provision than Zorroland?

If average incomes are the same in the two locations but the distribution is wider in Bop- poland, there are, as a matter of arithmetic, more wealthy (and more poor) people in Bop- poland. Wealthy Boppos may have a fairly high willingness to pay for or provide public goods because the cost of provision is small relative to their incomes or because of the in- come effect on their demand for public goods.

Think about the rival and excludable properties of public goods. To what degree is radio broadcasting a public good? To what degree is a highway a public good?

Radio broadcasting is nonrival: airwaves can be consumed (listened to) simultaneously by many consumers with no deterioration in sound quality. Perhaps radio signals can be made excludable by the use of scramblers, much like the ones used for pay-per-view TV. Anyone who has driven during rush hour knows that highways are subject to congestion. At these times, highways are rival: additional cars reduce the utility everyone receives from driving. Highways can also be excludable through the use of tolls. In practice, however, most highways are not excludable: any (licensed) driver is allowed to use them.

Fletcher (2003) shows that when congressional districts are redrawn to include more elderly people, members of Congress become more likely to take pro-elderly positions in congressional votes. Why does the median voter model predict that this would be so?

Redistricting can change the distribution of voters in a district. When the distribution shifts, the median of the distribution shifts with it. In this case, there are now more voters at the end of the spectrum that prefers pro-elderly policies, and thus the median shifts toward more pro-elderly policies. The median voter model predicts that representatives will seek to satisfy the median voter in an effort to obtain the most votes, so the changes in congressional votes following the redistricting are perfectly consistent with the median voter theory.

Figlio (1999) found that legislators are more likely to mirror their constituents' prefer- ences during election years than in earlier years of their terms. This is particularly true for relatively inexperienced legislators. Why might this be the case?

Reelection concerns loom largest as elections approach, so legislators may be more con- scious of their constituents' concerns at this time. In addition, the press and opposition candi- dates are more likely to report controversial votes during an election year, so legislators may feel more pressure to mirror constituent preferences during an election year. Inexperienced legislators may have come to Congress with their own ideologies and platforms, but they re- alize, as reelection time approaches, that they need to be more pragmatic about earning an- other term, and thus they give more consideration to their constituents' preferences. Experienced legislators, on the other hand, realize that they are always campaigning for the next election and thus are more attentive to their constituents' preferences throughout their terms.

Lindahl Pricing

a system by which individuals report their willingness to pay for the next incremental unit of a public good and the government charges them that amount to finance this public good

Chay and Greenstone estimated the effect of the Clean Air Act of 1970 by comparing the health outcomes of people in attainment areas with those of people in nonattainment areas both before and after the law was passed. What did they find? A. Reduced emissions led to a decrease in infant mortality B. Reduced emissions did not affect infant mortality C. The Clean Air Act of 1970 did not affect emissions in any states D. The Clean Air Act of 1970 affected health outcomes by changing attitudes regarding unhealthy practices in hospitals

A

Matsusaka (1995) showed that states that provide for voter initiatives tend to have smaller government growth than do states without such a provision. Why might this be so?

A natural conclusion might be that voter initiatives cause lower government growth. There is a natural causative channel for this conclusion, since voter initiatives have been par- ticularly successful in capping tax increases. In states that have enacted measures that restrict the government's ability to raise taxes, governments have been forced to grow more slowly. In voter initiative states that have not passed tax reform measures, governments may have restrained their own growth out of fear of a voter initiative that would severely limit their ability to raise taxes. However, as discussed in Chapter 3, it is important not to confuse correlation with cau- sation, even when there is a natural causative channel. An alternative explanation could be that citizens in some states have difference preferences than citizens in other states. If citi- zens who tend to like voter initiatives also tend to like small governments, then unobserved preferences could be the underlying cause for both smaller government growth and the presence of voter initiatives.

Why does the Congressional Budget Office (CBO) construct a cyclically adjusted budget deficit for the purposes of monitoring federal income and outlays?

A number of factors can cause short-run fluctuations in tax collections and expenditures; for example, an economic downturn can temporarily reduce tax collections while increasing expenditures on income-support programs. These fluctuations have only short-term effects on the budget, however, and given the nature of business cycles, they will be offset by eco- nomic growth cycles when tax revenues are temporarily high and social expenditures low. Removing these ups and downs from the deficit calculation provides a better long-term pic- ture of revenues and expenditures.

The Budget Enforcement Act (BEA) of 1990 created a pay-as-you-go (PAYGO) system prohibiting any policy changes which increased the estimated deficit in any year in the subsequent six-year period. Another type of possible PAYGO system would pro- hibit any policy changes which increase the present value of the deficit over the en- tire six-year period. Discuss the relative advantages and disadvantages of these "annual" and "cumulative" PAYGO systems.

Annual PAYGO systems can discourage cost-saving investments that require larger up- front payments. Under an annual PAYGO system, for example, a government cannot borrow money to pay to install an energy-saving technology in an office building, even if the technology would save more than enough in energy costs over the subsequent five years to jus- tify the expenditure. A cumulative PAYGO system would allow a government to borrow money to finance such a project, but it would give the government flexibility to use creative accounting. A government could, for example, cut this year's taxes while "planning" to raise taxes in five years so that there would be no estimated increase in the total deficit over the six-year window. In five years, the government could then use the same sort of trick to keep taxes from rising to the previously "planned" level.

Congressman Snitch argues that since obesity causes so many serious health problems, fatty foods should be regulated. Do you agree with him?

Arguments can be made both for and against regulation. Opponents might argue that this proposal is both too narrow and too broad. It is too narrow because it does not regulate all foods that lead to obesity. Sugar is fat-free, but too much of it makes people fat. It is too broad because not all fat consumption leads to obesity. New research on "good fats" suggests that some fatty foods are a necessary part of a healthy diet. Furthermore, some naturally thin people eat fatty foods without getting fat. Opponents may also raise the free-choice argu- ment: if there are no negative externalities, we should assume that the eater has weighed the costs and benefits of consuming that extra doughnut. Proponents might argue that there are indeed external costs of obesity, such as health costs, increased insurance premiums, and shrinking airplane seats. There is an additional ar- gument made in the text that "internalities" might need to be regulated because people have a difficult time making rational decisions when there are large temporal differences between realization of the benefits and the costs: gratification from doughnut consumption is immedi- ate; the cost is delayed.

In which way could smoking exert a positive externality on others?

As described in the text, the reduction in expected lifetimes can deliver a positive externality. If smokers tend to die soon after their retirement, they will collect less in Social Security payments, leaving more money for nonsmokers. In addition, if smokers pay into group retirement plans that do not differentiate smoking behavior, then their reduced time of withdrawal from the plans will subsidize the longer-lived nonsmokers.

A government is considering paving a highway with a newly developed "wear-proof" material. Paving the highway would cost $2 billion today, but it would save $300 mil- lion in maintenance costs for each of the next 10 years. Use the concept of present value to determine whether the project is worth undertaking if the government can borrow at an interest rate of 5%. Is it worth it if the interest rate is 0%? 10%? A politi- cian says to you, "I don't care what the interest rate is. The project is clearly a good investment: it more than pays for itself in only 7 years, and all the rest is money in the bank." What's wrong with this argument, and why does the interest rate matter?

As the following table shows, the project is worth undertaking at 0% and 5% interest, but it is not worth undertaking at 10%. The politician's argument is incorrect because it fails to take into account the interest the government must pay on the money borrowed to finance the project

When the state of Virginia imposed stricter regulations on air pollution in 2003, it also authorized an auction of pollution permits, allowing some plants to emit larger amounts of ozone-depleting chemicals than would otherwise be allowed, and some to emit less. Theory predicts that this auction will lead to a socially efficient allocation of pollution. Describe how this outcome would occur.

Assuming that the given level of pollution permits was set correctly, an auction would lead to a socially efficient allocation of permits across firms. Firms that would benefit the most from having the right to pollute—say, because it would be very costly for them to pro- duce without polluting—would be the most willing to pay for the right. Therefore, those firms would bid more at the auction and would receive the permits. Firms that find it easy to adopt less-polluting technologies in their production process would be less willing to pay for the right to pollute and therefore would not bid as much at the auction and would not receive as many permits. This means that the permits would be allocated to the firms that cannot easily reduce pollution, while the firms that could most easily reduce emissions would do so instead of buying permits and continuing to pollute. This is the socially efficient outcome: pollution would be reduced, and it would be reduced most by firms that could most cheaply reduce it.

Suggest one way in which generational imbalances might be understated and one way in which they might be overstated.

Calculated generational imbalances suggest that our current deficit will be balanced on the backs of future generations, to their detriment. These imbalances might be understated, in which case they will be even worse than anticipated for the next generation, if assumptions about continued growth are too optimistic; if the actual interest rate is less than the assumed rate of 3.6%; or if future policies entail higher expenditures than anticipated. The imbalances might be overstated if assumptions about continued growth are too pes- simistic; if the actual interest rate is greater than the assumed rate; if the quality of life of fu- ture generations (possibly including their economic productivity) is enhanced by expenditures made today; or if demographic shifts or policy changes result in lower expenditures than anticipated

Professor Kaz owns a dog named Melvin who has been using your lawn in an unwanted way. Prof compensates you for Melvin's use of your yard. This solution to an externality is: A. a tax B. a subsidy C. Coasian Bargaining D. Quantity Restriction E. Both A&B are correct

Coasian Bargaining

What is meant by dynamic scoring of the budget? Why does dynamic scoring poten- tially lead to more realistic estimates of the "true" effective size of a budget deficit? What are some methodological issues involved in dynamic scoring? You can read more about dynamic budget scoring in Chapter 5 of the Council of Economic Advi- sors 2004 Economic Report of the President.

Dynamic scoring allows budget predictions to incorporate changes in the economy in re- sponse to policy. Tax increases and tax cuts have direct effects on revenue collections, and they also have indirect effects on collections because they can affect economic growth. For example, some argue that a tax cut will actually increase tax revenue because workers will have an incentive to work more when they are taxed less. If done correctly, dynamic scoring can improve estimates by accounting for ripple effects of policy changes. Most people agree that policy changes do not happen in a vacuum; when one aspect of the economy changes, other variables change in response. However, the magnitude of those changes is not precisely known, so predictions can vary. This might encourage policy makers to overstate or under- state the effects of a policy.

Majority voting is: A. consistent B. inconsistent C. a preference aggregation mechanism D. Both A and C are correct E. Both B and C are correct

E. Both B and C are correct Majority voting is INCONSISTENT and A PREFERENCE AGGREGATION MECHANISM

Pam and Kunal are the only members of a community that is trying to determine how much of the public good should be produced. Suppose that Pam is willing to pay $10 for the fourth unit of the public good and that Kunal is willing to pay $6 for the fourth unity. The marginal cost of producing the public good is constant at $4. Which of the following is true? A. fewer than four units of the public good should be produced B. more than four units of the public good should be produced C. Exactly four units of the public good should be produced D. The Lindahl equilibrium is established when more than four units of the public good are produced E. Both B and D are correct

E. Both B and D are correct more than four units of the public good should be produced AND The Lindahl equilibrium is established when more than four units of the public good are produced

Which of the following is true when there is the socially optimal amount of a PRIVATE good with no externality? A. Private benefits equal private costs B. Social Marginal benefit equals private marginal cost C. Consumer surplus equals producer surplus D. Social marginal benefit equals social marginal cost E. Both B and D are correct

E. Both B and D are correct Social Marginal benefit equals private marginal cost AND Social marginal benefit equals social marginal cost

When the marginal cost of pollution reduction is certain, yet varies across many producers, which of the following generally makes sense? Assume technology exists to reduce pollution without reducing output. A. quantity regulation with equal distribution of reduction across producers B. price (tax) intervention C. direct government provision of the product in question D. quantity regulation with tradable permits E. Both B and D make equal sense; they are equivalent

E. Both B and D make equal sense; they are equivalent price (tax) intervention quantity regulation with tradable permits

Which of the following is true of median voter outcomes? A. they are always socially efficient B. they are never socially efficient C. they reflect the intensity of voters' preferences D. Both A and C are correct E. None of the answers is correct

E. None of the answers is correct

According to part 2 of the Coase Theorem, to achieve the efficient solution to an externality: A. the party imposing the externality must be assigned property rights B. the person incurring or benefiting from the externality must be assigned the property rights C. property rights must be periodically switched between the parties in answers A and B D. The government must impose taxes or subsidies E. Property rights could be assigned to either party to achieve the efficient solution to an externality

E. Property rights could be assigned to either party to achieve the efficient solution to an externality

Which of the following is true when there is optimal provision of a public good? A. marginal cost equals marginal rate of substitution for each consumer B. total costs equal total benefits for all consumers C. each consumer's surplus equals marginal cost D. total consumer surplus equals marginal cost E. the sum of all consumer's marginal rates of substitution equals marginal cost

E. the sum of all consumer's marginal rates of substitution equals marginal cost

Think back to Chapter 5. Why can the public good provision problem be thought of as an externality problem?

Provision of public goods generates benefits for everyone, not just for those who provide the goods, so the benefits have the same characteristics as positive externalities. Overuse of public goods, because public goods are nonexcludable, can generate negative externalities, such as congestion.

Think of an example of a free rider problem in your hometown. Can you think of a way for your local government to overcome this problem?

Examples of free rider problems could include swimming pools that are congested on hot days, litter in public parks, holiday lighting or fireworks displays, public television and radio, and parent volunteer groups in schools. Admission fees can reduce free riders at public facilities, schools could require all parents to serve on at least one school committee or provide some reward system for parents who volunteer, and taxes could be used to subsidize local public television and radio stations.

The central estimate for the _________ due to smoking (excluding secondhand smoke) are ________ the level of taxation. A. externalities; approximately equal to B. externalities; greater than C. externalities; less than D. internalities; greater than E. internalities; less than F. Both C and D are correct

F. Both C and D are correct externalities; less than internalities; greater than

Think about the concerns about the original 1970 CAA described in the text. To what degree did the 1990 amendments to the act address these concerns? Explain your answer.

First, the provisions of the act applied only to new plants, creating an incentive for plant owners to continue using old, dirty plants to avoid compliance costs. Second, the method of emissions reduction was dictated: plants had to use scrubbers rather than being allowed to use the most cost-effective technology. This removed incentives to develop new technologies or to use existing technologies that were more cost effective. Third, compliance was costly, so firms had an incentive to find loopholes. By establishing tradable allowances and removing the exemption for older plants, the 1990 amendments reduced some of these problems. The closing of the age-of-plant loophole gave firms an incentive to find the least-cost way to reduce pollution.

free rider problem

For a group, the problem of people not joining because they can benefit from the group's activities without joining.

Peterson, Hoffer, and Millner (1995) showed that air bag use has led to increases in car crashes. Despite this finding, the government mandates that new cars have airbags, rather than taxing their use. Is this policy a contradiction?

For the sake of argument, let us assume that the paper showed beyond a reasonable doubt that air bag use leads to more car crashes. Then the natural conclusion to reach, based on the analysis in this chapter, is that air bag use should be taxed: accidents impose negative externalities (on the people in the car you crash into!). This suggests that the policy of man- dating air bags is undesirable. However, there may be other effects that make this policy rea- sonable. For example, note that some people who get into accidents have no medical insurance, and these individuals impose negative externalities on hospitals, which may have to provide them with free care. These externalities may be reduced by air bags, if they miti- gate injuries caused by accidents. More plausibly: if air bags reduce the cost of injury, they may reduce insurance premiums for everybody—not just for the person with air bags. This reduction is a positive externality from air bag use that may offset the negative externality noted in the paper.

Why does Chay and Greenstone's (2003) approach to measuring the effects of acid rain reduce the identification problems associated with more "traditional" approaches?

Fortunately for the researchers, the CAA was not applied equally to all counties. That in- equality essentially created a "control" group—counties that did not have levels high enough to warrant regulation—and an "experimental" group—nonattainment counties that were forced to reduce total suspended particulates. By comparing the two groups on one measure of health outcomes, changes in infant mortality, Chay and Greenstone isolated the effects of reduction in total suspended particulates.

Why do governments sometimes impose quantity regulations that limit the level of negative-externality-inducing consumption? Why do governments sometimes impose price regulations by taxing this consumption?

If the government has perfect knowledge about the marginal benefits of consumption and the marginal damage caused by the externality, it can easily compute the socially optimal level of consumption. It can implement this level either by a tax on consumption or by regulating the total amount of consumption. When it is uncertain, for example, about the exact marginal con- sumption benefits, it will not be able to reach the socially optimal level of consumption any- more. What it needs to think about in this case is whether it is likely to cause more deadweight loss by getting the tax rate a little wrong or by getting the regulated quantity of consumption a little wrong. Suppose the government knows the entire curve of marginal damage caused by the externality at different levels of consumption. If it knows that this curve is relatively flat (i.e., doesn't depend strongly on the quantity of consumption), then using a tax to curtail consumption will tend to cause smaller deadweight losses than quantity regulations, so the government should use taxation to correct the externality. If, on the other hand, the marginal damage curve is very steep, then it will instead want to use quantity regulations. There may also be a political component to these differences. Taxing consumption of a good that generates a negative externality—gasoline, for example—implies that wealthier individuals can purchase the right to generate the externality. Quantity restrictions may seem more equitable but may also be seen as violations of our freedoms.

To determine the right amount of public good to provide, the government of West Essex decides to survey its residents about how much they value the good. It will then finance the public good provision by taxes on residents. Describe a tax system that would lead residents to underreport their valuations. Describe an alternative sys- tem that could lead residents to overreport their valuations.

If the taxes are based on reported valuations, residents have an incentive to reduce their stated valuation of the good so that they can pay lower taxes and free ride on the public good. If taxes can be levied on nonresidents—e.g., a "commuter" tax—then individuals will tend to overstate their valuations. Alternatively, a tax on only the wealthiest members of West Essex (e.g., a highly progressive income tax) might lead to overreporting, since the majority of individuals will bear very little of the cost of additional public goods provision.

How do you think population growth affects the degree of "generational balance" in government finance?

If there is population growth over time, then debts incurred by the current generation will be spread out over more people in the future. The per capita burden on future genera- tions will therefore be smaller than if there was no population growth. If this growth slows or stops, though, the per capita imbalance will worsen as there will be fewer people to pay off the debts from prior generations. On a per capita basis, then, a faster rate of population growth can be said to reduce the degree of "generational imbalance" (at least when the im- balance favors current generations at the expense of later generations).

Why is it difficult to empirically determine the degree to which government spending crowds out private provision of public goods?

In nonexperimental data it is difficult to isolate the effect of the public provision to deter- mine the extent of crowding out. Government provision of a public good reflects, on some level, a political determination that citizens have a preference for that public good. But if citi- zens like that particular public good, then they may also receive a lot of individual utility from its provision. Because these preferences are correlated, an estimate of crowding out will be low: private provision will thrive alongside public provision. Experimental investigations of crowding out can isolate the effect, but these experiments typically take place in laboratory en- vironments. They may therefore lack external validity: behavior in an artificial experiment may not mimic what people do in their day-to-day lives. Reasons for this include the use of undergraduate students as experiment participants; the relatively low dollar values for the ex- periment goods; and the lack of a realistic context in which experiment decisions are made— in most economic experiments, for example, the public good is not specifically named.

Strattmann (1994) documented a condition of "logrolling" in Congress, in which mem- bers of Congress trade votes on one bill for votes on another. Is logrolling efficient, or should it be banned? Explain.

Logrolling is one way preference intensities can be expressed in the political process. When votes are traded, as in a market, legislators have an incentive to make political ex- changes that benefit their constituents, and the greater the benefit the higher the "price," in terms of votes, the legislator may be willing to pay. Thus, it could be argued that this quasi- market increases efficiency. In practice, however, logrolling may result in more pork. Many public expenditures entail large benefits to small groups—for example, a new project may disproportionately benefit the residents of an area where the project is located—while the costs are widely dispersed. As a result, a member of Congress may be willing to vote for the pet projects of many other members in order to obtain votes for his own project, resulting in more pork.

We say that a variable is cyclical if it increases with economic booms and declines with economic recessions. We say that a variable is countercyclical if the opposite is true. Which elements of the U.S. federal budget are cyclical and which are counter- cyclical?

Many categories of federal revenue are cyclical. For example, both the personal income tax and the corporate income tax tend to move with the economy: during a downturn, indi- viduals and corporations have lower tax burdens, and during boom times their tax burdens increase. Revenue from excise and other taxes on consumption (such as import taxes and gift taxes) also increase during particularly prosperous (high consumption) times and decrease during downturns in the economy. In contrast, there are a number of expenditure categories that tend to be countercyclical. Examples include human services, which includes some income-support payments. These payments tend to rise during a recession, as more people become unemployed. Payments to bail out struggling companies or to honor insurance commitments (Federal Depository Insur- ance for banks, for example) also tend to increase during bad economic times.

In close congressional votes, many members of Congress choose to remain "unde- cided" until the last moment. Why might they do this? What lesson does this example teach about a potential shortcoming of the Coasian solution to the externality problem?

Members of Congress who remain undecided until the last moment may be engaging in a form of the holdout strategy. Suppose vote trading, or logrolling, is occurring with respect to a piece of legislation. The sponsor of the bill might offer his or her support for other bills in exchange for votes on this bill. As the call for the vote approaches, the sponsor may be willing to offer more to obtain the support needed to pass the bill, so remaining undecided increases a Congress member's negotiating strength. The situation in which legislators fail to commit their votes until the final hour is analogous to the holdout problem that exists with Coasian solutions that involve several parties. If the purchaser of the right to impose an ex- ternality needs to strike a deal with many sellers, each individual seller can delay settling to pressure the purchaser to increase the price.

Coasian Bargaining

Negotiation between parties internal to and external to a transaction, which influence whether a transaction takes place; a bargaining process that internalizes an externality.

In Becker and Murphy's "rational addicts" model, smokers are perfectly aware of the potential for smoking to cause addiction, and they take this into account when decid- ing whether or not to smoke. Suppose a new technology—such as a nicotine patch— has just been invented which makes quitting smoking much easier (less costly) for an addict. If Becker and Murphy's model is correct, what effects would you expect this invention to have on people's smoking behavior? Would your answer be differ- ent for young people and older people?

Older people who are already addicted to smoking might suddenly find it worthwhile to quit, now that it is less costly to do so. This would lead to lower smoking rates. At the same time, people considering starting to smoke—particularly young people—would now find it less costly to become addicted to smoking because it would be easier to quit later. Since they take this cost into account when making their decisions, their smoking rates are likely to in- crease.

Evans, Farrelly, and Montgomery (1999) found evidence that workplace smoking bans substantially reduce overall rates of smoking, particularly for people with longer work- weeks. Why should workplace smoking bans be particularly influential in affecting the behavior of people who work long hours?

People who cannot smoke at work have an externally imposed control on their behavior. Longer hours means this "commitment device" has more bite: people have to wait even longer for their smokes. Making it through a nine-hour day without a smoke might be just the impetus needed to get people to quit; six hours without a cigarette might not be long enough to have an impact.

Several public interest watchdog groups point out "pork" in the federal budget— spending that they claim would have little or no national benefit but would benefit a small number of people in a geographically concentrated area. Why are these types of spending more likely to occur in the federal budgeting process than they would if they were each voted on individually?

Possible explanations include the following: It is easier to "hide" pork in large, multi- issue bills, where relatively small items may escape scrutiny. These bills might contain a bit of pork for everyone, encouraging "logrolling" among representatives who have a very strong interest in benefiting their local constituents and see expenditures in other districts as having a minimal negative impact on the budget as a whole. Special interest groups and lobbyists may push hard for their own pieces of the pork, while there is often little organized opposition to these items.

The citizens of Balaland used to pave 120 miles of roadways per year. After the gov- ernment of Balaland began paving 100 miles of roadways per year itself, the citizens cut back their paving to 30 miles per year, for a total number of roadway miles paved per year of only 130 miles. What might be happening here?

Private paving in Balaland is partially crowded out by the public paving. On their own, Balalanders chose to pave 120 miles of road, presumably their optimal number of miles when they were bearing the cost themselves. When the government began providing 100 miles of paved roadway, Balalanders chose a new optimal quantity. That new quantity is more than the original 120 because the cost borne by them is less, but the quantity is less than the original 120 plus the government's 100 because the marginal benefit of additional paved miles declines with each additional mile that is paved. If Balalanders strongly desire the first 120 miles of paving but get no additional utility from additional miles of paving, they would have paved only an additional 20 miles after the government paved 100. This would have been complete crowding out. However, by paving 100 miles for the citizens, the Balaland government made them richer. This income effect may have increased their de- mand for paved road miles to 130.

Can an activity generate both positive and negative externalities at the same time? Explain your answer.

Sometimes externalities are in the eye (or nose or ear) of the beholder. If you like the music your roommate plays, you can free ride when he or she is playing music, enjoying a positive externality. Your other roommate, though, who hates that kind of music, would ex- perience a negative externality. Sometimes a positive externality becomes too much of a good thing. During the holiday season, some people construct elaborate displays that every- one can enjoy just by driving by them. But if too many people drive by every night, traffic congestion becomes a problem for those living in the neighborhood: for them, the holiday display creates a negative externality.

Can government assignment and enforcement of property rights internalize an exter- nality? Will this approach work as well as, better than, or worse than direct govern- ment intervention? Explain your answers and describe one of the difficulties associated with this solution.

The Coasian approach of assigning property rights and then allowing the affected parties to negotiate a solution can internalize an externality. If one party has a clear, enforceable right to engage in an activity that generates an externality, then the injured party or parties have an incentive to pay the externality generator to stop or curtail the activity. Similarly, if the injured parties have a right to be free of an externality but also have an enforceable right to sell the freedom, a person or firm that profits from generating the externality might be able to negotiate for the purchase of the right to operate. This might be better than govern- ment intervention when the number of affected people is small and there are no barriers to negotiation. Social norms or large power or wealth differentials, however, could deter negoti- ation. For example, a manufacturing firm might easily pay off residents of a poor neighbor- hood to acquire the right to dispose of toxic materials, which some people might regard as inequitable. Some other difficulties with this solution arise when there are too many affected parties to be able to negotiate a transaction, when one of the affected parties engages in the "holdout" strategy, and when it is difficult to identify the source of the externality.

How have the major federal laws to promote balanced budgets lost their effectiveness over time?

The Gramm-Rudman-Hollings act was a major federal law designed to promote bal- anced budgets. It set annual targets for federal deficit spending and included a provision for automatic spending cuts if the targets were not met. In practice, the law was rendered inef- fective because, for example, deficit targets were simply reset when it became clear that the targets were not going to be met. The Budget Enforcement Act tried to promote balanced budgets by setting caps on the amount of discretionary spending that could take place in future years. Recently, the caps have been avoided by making use of the provision in the law that allows for unlimited "emergency" spending beyond the cap. Such "emergency" spending has been used for fi- nancing spending for nonemergency purposes.

Nordhaus and Boyer (2000) estimated that the United States would bear over 90% of the total world cost of achieving the Kyoto targets for greenhouse gas emission re- ductions. Explain how this can be, when the United States produces only about a quarter of the world's greenhouse gasses.

The United States relies on many coal-fired power plants, in part because it has large coal deposits (and relatively little oil and natural gas). There is no easy way to reduce emis- sions from these plants. Furthermore, the emissions targets were set to be 5% below 1990 emission levels. The United States experienced rapid growth through the 1990s, and it is pre- dicted to have continued growth through 2010. This means that, in order to achieve emis- sions targets, the United States will have to reduce emissions by 30% relative to projected 2010 emissions. In countries that have experienced slower growth, the relative amount by which they must reduce emissions is much lower.

11. Table 6.1 from the 2009 federal budget's historical tables shows how the main categories of federal outlays have changed from 1940 to 2013 (projected). Where have the biggest changes over time occurred? Where are the biggest changes from 2009 to 2013 projected to occur?

The budget totals have increased enormously; outlays as a percent of GDP have in- creased by less (from approximately 10% immediately preceding World War II and a high of 43.7% five years later in 1944 to approximately 20% in recent decades). Defense spending was very high during and immediately following World War II: in 1945 almost 90% of fed- eral outlays were for defense. Briefly during the mid-1950s defense spending accounted for more than 50% of all federal outlays. By the mid-1990s the percentage had fallen to less than 20% of total outlays, and it has increased to slightly over 20% since. Interest payments increased until 2000, then fell briefly. They are now back on the rise and are expected to in- crease through 2013. Grants to state and local governments have also increased and are also predicted to increase further. Payments to individuals, both indirect in the form of grants to state and local governments and direct, have accounted for an increasing share of the federal budget: in 1940 only 17.5% of the budget went to these items; that share fell to as low as 2% during World War II, then increased and remained in the 20-30% range from the late 1940s until the early 1970s (with a brief dip during the Korean War). In the 1970s payments to in- dividuals surpassed defense expenditures and, as a share of the budget, have increased to more than 60% of outlays. By 2013, this category is predicted to represent 67.9% of the budget. It is difficult to compare numbers that vary so much in magnitude over such a long pe- riod of time. Comparing the distribution of outlays can make it somewhat easier to see how some categories fare relative to others.

The National Institute on Drug Abuse describes four-year trends in teenage smoking, drinking, and other drug use on the Web at http://www.nida.nih.gov/infofax/ hsyouthtrends.html. According to this site, for which age groups have the changes in the rates of teenage smoking and drinking been most pronounced?

The data indicate that the lifetime cigarette use rate among twelfth graders has fallen from 50% in 2004 to 44.7% in 2008. Among tenth and eighth graders, lifetime cigarette use has fallen from 38.9% and 25.9%, respectively, to 31.7% and 20.5%, respectively, over the same time period. In absolute, percentage point terms, the fall in smoking rates over these periods was largest for tenth graders. In relative terms, however, the largest drop was among eighth graders, among whom the data indicate a 20.8% drop in lifetime use—100% ×(20.5 - 25.9)/25.9 = -20.8% Similar trends hold for the other frequency-of-use categories. The data also indicate that lifetime alcohol use fell uniformly but modestly across ages between 2004 and 2008.

Many towns and cities on the northeast and west coasts have passed bans on smok- ing in restaurants and bars in the past decade. What is the economic rationale behind these bans? Would there be similar rationales for banning smoking in automobiles? Apartment buildings? Houses?

The economic rationale for these bans is that smoking causes externalities, in particular through the health effects of secondhand smoke. The secondhand smoke externality does not apply in private automobiles, homes, or apartments. But there may be other externalities as- sociated with smoking in these settings. Smoking while driving may increase the risk of an accident, which would potentially injure other drivers, passengers or pedestrians. Smoking in an apartment building may increase the risk of a fire, which would injure other residents in the building. Smoking in a private house also poses the risk of a fire, but if houses are suffi- ciently far apart, this may not impose significant externalities. It is important to note that, even when there is an externality providing an economic ra- tionale for banning smoking, the ban should not necessarily be imposed. Bans restrict free- dom of choice, which is valuable to individuals, and therefore impose real costs as well as the benefits they may produce in terms of reducing externalities.

When energy companies wish to raise the rates they charge to their customers, they must first argue their case at a public hearing before a regulatory body. How does the free rider problem explain why energy companies are usually successful in getting permission to raise their rates?

The energy companies have a strong incentive to expend resources lobbying for higher rates. Because a rate increase is valuable to each of those companies, no individual company will risk trying to free ride on another energy company's efforts. Individual consumers, how- ever, do not stand to lose a substantial amount of money from a rate increase, so each indi- vidual has less of an incentive to be involved in the issue. The large number of consumers, together with the small potential individual gain from lobbying against rate hikes, increases the likelihood that nobody will oppose the rate increases.

When Wisconsin had lower drinking ages than its neighboring states, it experienced higher levels of alcohol-related crashes in its border counties than in other counties in its interior. What does this finding imply for the spillover effects of the policies of one state (or country) on other jurisdictions?

The evidence from Wisconsin suggests that people from nearby states who were old enough to drink in Wisconsin but not in their own state were driving to Wisconsin to drink. In this particular case, the older drinking ages in nearby states was imposing a negative ex- ternality on Wisconsin. (Of course, Wisconsin's lower drinking age may have been imposing a negative externality on nearby states as well.)

In two-car automobile accidents, passengers in the larger vehicle are significantly more likely to survive than are passengers in the smaller vehicle. In fact, death probabilities are decreasing in the size of the vehicle you are driving, and death probabilities are increasing in the size of the vehicle you collide with. Some politicians and lobbyists have argued that this provides a rationale for encouraging the sale of larger vehicles and discouraging legislation that would induce automobile manufacturers to make smaller cars. Critically examine this argument using the concept of externalities.

The evidence suggests that driving a larger vehicle imposes negative externalities on other drivers. (Or, viewed from the other direction, driving a smaller vehicle imposes positive externalities on other drivers.) Individuals probably take their own safety into account when selecting an automobile but probably do not fully take into account these externalities, which suggests that people choose vehicles that are larger than is socially optimal. The cor- rect conclusion is that intervening to encourage the sale of smaller vehicles (or to discourage the sale of larger vehicles) can improve welfare—just the opposite of the proposed argument.

Table 4-1 in the textbook shows the remarkable difference across generations in their likely net tax payments to the federal government. What is responsible for these large intergenerational differences?

The generational accounting used to generate Table 4-1 assumes that our current deficit will be paid for by future generations. Specifically, this accounting sets current plus future tax payments equal to the current debt plus future government consumption. Future tax pay- ments will need to be sufficient to pay off the current deficit as well as to pay for the com- mitments the government has made to the current generation, including the commitment to make Social Security and Medicare payments when that generation retires. The baby boom generation will require high government expenditures when they retire. Those commitments plus current deficit spending (which benefits the current generation) mean that future tax payments will have to be high to keep this account in balance. Thus the tax burden of future generations will be greater than the benefits they are predicted to receive.

We add the demands of private goods horizontally but add the demands of public goods vertically when determining the associated marginal benefit to society. Why do we do this and why are the procedures different for public and private goods?

The horizontal summation of private goods adds up the individual quantities demanded by each consumer, which we do because each consumer uses up the quantity he or she pur- chases. The vertical summation for public goods adds up each consumer's willingness to pay for each additional unit. Because the good is public, each consumer gets to consume each unit. This sum therefore gives the total social valuation of each additional unit—society's demand curve.

Suppose that a firm's marginal production costs are given by MC = 10 + 3Q. The firm's production process generates a toxic waste, which imposes an increasingly large cost on the residents of the town where it operates: the marginal external cost associ- ated with the Qth unit of production is given by 6Q. What is the marginal private cost associated with the 10th unit produced? What is the total marginal cost to society as- sociated with producing the 10th unit (the marginal social cost of the 10th unit)?

The marginal private cost is 10 + 3(10) = 40. The external cost associated with the 10th unit is 6(10) = 60. So the marginal social cost of producing the 10th unit is 100.

The preference revelation problem associated with Lindahl pricing becomes more se- vere as the number of people in society increases. Why do you think this is true?

The more people there are in a community, the easier it is to free ride. One reason is that it is less likely that anyone would detect a single free rider in a large community. Another reason is that by free riding, a person reduces the aggregate contribution to the public good, thus reducing the level of public good provision; in a large community, though, each indi- vidual's share is so small relative to the whole that free riding by a single individual does not significantly change the level of public good provision.

Consider the same highway paving project from question 8. A second politician says to you, "At an interest rate of 6%, the project is a bad idea. Over 10 years, the project reduces maintenance costs by a total of $3 billion. But borrowing $2 billion for 10 years at a 6% interest rate means paying $1.58 billion in interest. The total cost of the project over 10 years is therefore $3.58 billion!" Use present value calculations to show that the project is, in fact, worth undertaking at 6% interest rate. What's wrong with the second politician's argument?

The net benefit of the project, in present value terms, is $208.0 million. (This can be computed using a table like the solution to question 8.) The politician's mistake is to count the interest on the initial expenditure ((1.06)10 × $2b = $3.58) but not the interest on the $300m saved by the project in years 1-9.

From 1962 to 1965, federal spending for the conduct of education and training rose from $1.30 billion to $1.96 billion, while from 2004 to 2008, it rose from $85.80 billion to $90.96 billion. Given that the Consumer Price Index (CPI) (in January) was 30.0 in 1962, 31.2 in 1965, 185.2 in 2004, and 211.1 in 2008, which period saw the larger in- crease in education and training spending?

The nominal increase in education spending was larger between 2004 and 2008 than be- tween 1962 and 1965 ($5.16 billion versus $0.66 billion), but in real terms, the increase be- tween 1962 and 1965 was actually bigger. In fact, real spending actually declined between 2004 and 2009.

median voter theorem

The theory that parties in a two-party system can maximize their vote by locating themselves at the position of the median voter—the voter whose preferences are exactly in the middle.

Is it necessarily inequitable for future generations to face higher taxes as a result of benefits that accrue to those living today? Explain.

There are some reasons why the apparent intergenerational inequity might not be as bad as it seems. First, many of the expenditures made today will yield benefits far into the future. Be- cause future generations will benefit from these current expenditures, it is not unreasonable to ask them to shoulder some of the costs. Second, the historical trend is for future generations to live better lives (measured on some dimensions) than their parents' generation. Technological advances constantly improve productivity and increase real incomes. Therefore, future genera- tions may be better able than the current generation to shoulder this debt.

Some observers argue that since carbon dioxide (CO2) and temperature levels have been much higher in Earth's history than they are today, the current concerns about the human contribution to global warming are overblown. How would you empirically test this argument?

There are two interpretations of this argument. First, it suggests an alternative explana- tion to human-caused global warming: since carbon dioxide levels and temperatures have been much higher in Earth's prehuman history than they are today, causes other than human action may be responsible. Second, it suggests that even if the current warming is human- caused, it is well within the bounds of historical norms and may therefore not be problem- atic. To test the first interpretation, researchers should ask: What was also true at other times when CO2 levels and temperatures were high? Perhaps data on other atmospheric activity (sunspots?) would suggest nonhuman causes for the rising levels. Do the same causes exist today? Another thing to consider is whether the rates of increase of CO2 and temperature lev- els today seem similar to the rates of increase in the past. Did CO2 and temperature levels previously increase at the same rate at which they are currently increasing? It will be difficult to answer these questions and thus to eliminate competing explana- tions for observed temperature and CO2 levels. Data from early historic periods would have to be inferred from currently available sources, since recorded climate and atmospheric data for those periods are not available. This may therefore be an empirically challenging ap- proach. Testing the second interpretation is more difficult, but one could try to look at how pre- vious periods of high temperatures differed from previous period of comparable tempera- tures. This would help in understanding the potential impacts on humans of rising temperatures and whether the impacts would be harmful.

Arrow's Impossibility Theorem

There is no social decision (voting) rule that converts individual preferences into a consistent aggregate decision without restrictive assumptions

A problem with the median voter outcome is that it does not take into account inten- sity of preferences. Suppose that the government decided to give multiple votes to people with strong preferences, pro or con. Does this solve the problem? Why or why not?

This does not necessarily solve the problem of preference intensities. For example, con- sider a vote involving a simple "yes" or "no" decision (as opposed to one with multiple op- tions). If individuals are multiple votes on this issue, they will not divide the votes between "yes" and "no" in proportion to their preferences. Instead, they will simply cast all of their votes in favor the position they prefer, regardless of their preference intensity. There will be no change in the outcome of the vote. Giving individuals multiple votes may help to solve the problem of preference intensities when individuals can decide to split those votes across various different initiatives. A person with strong opinions about education but only mild preferences about building bike paths could cast all of her votes for her favorite school councilor, for example, and none of her votes for whether to build a bike path. This sort of mechanism has its own problems, how- ever: it provides strong incentives for strategic voting, for example.

In a recent study, Americans stated that they were willing to pay $70 billion to protect all endangered species and also stated that they were willing to pay $15 billion to pro- tect a single species. Which problem with Lindahl pricing does this demonstrate? Explain.

This illustrates the preference knowledge problem. Lindahl pricing requires an accurate measure of each individual's marginal willingness to pay, but people often do not have a good idea of their own marginal willingness to pay for things that are not ordinarily bought or sold in the market. Endangered species protection is an abstract concept, so it is unlikely that people had thought about their willingness to pay for it before being surveyed. At $15 billion per species, all endangered species could not be protected for $70 billion. It appears that the respondents either overstated their willingness to pay to preserve one species or un- derstated their willingness to pay to preserve all endangered species.

Some people were concerned that the 1990 amendments to the Clean Air Act (CAA) would generate "hot spots" of pollution—localized areas with very high concentrations of pollutants. Why might the amendments lead to such "hot spots"? Are these "hot spots" necessarily a bad thing from an overall social welfare perspective? Explain.

Trading of emissions permits generally does not address the spatial distribution of pollution sources. It is conceivable that the ages of factories tend to be about the same in similar areas: newer plants are found in recently settled areas; older plants are found in older cities. If the age of a plant correlates with its emissions reduction costs, which is also conceivable, demand for emissions permits might be high in some parts of the country, and these areas could become "hot spots." Whether this is a bad thing depends on the nature of the pollutants. If the effects of emissions are very local and the damage from exposure rises at an in- creasing rate (if twice the emissions cause more than double the damage), then concentration of the pollution would be bad. But if the damage from concentration does not follow this pattern, isolated hot spots might be a good thing—these small, concentrated areas could be quarantined, leaving the rest of the country fairly clean. In addition, the effects of some pollutants are readily dispersed. For these pollutants it would not matter that the sources are geographically concentrated.

The federal government is considering selling tracts of federally owned land to private developers and using the revenues to provide aid to victims of an earthquake in a foreign country. How would this policy affect the levels of federal revenues, expenditures, and deficits under a cash accounting system? What would be different under a capital accounting system?

Under a cash accounting system, there would be no effect on the current level of the deficit. Revenue would increase by the amount of the sale, but the revenue increase would be exactly offset by the increased expenditures on foreign aid. A capital accounting system would recognize that the government has sold off a valuable asset. It would therefore regard the policy as increasing the overall deficit. The capital account deficit would be unchanged: the additional revenue from the sale would be offset by the decrease in the value of assets held by the government. The cash account would move towards deficit as a result of the in- creased consumption expenditures.

Caffeine is a highly addictive drug found in coffee, tea, and some sodas. Unlike ciga- rettes, however, there have been very few calls to tax it, to regulate its consumption, or limit its use in public places. Why the difference? Can you think of any economic arguments for regulating (or taxing) it's use?

Unlike cigarettes, caffeine does not cause any obvious externalities (e.g., secondhand smoke). If we believe Becker and Murphy's rational addiction model, then addictiveness does not provide a motivation for regulating a good—only externalities do. On the other hand, if people have self-control problems, then "internalities" could potentially provide a motivation for taxing or otherwise regulating caffeine. This is particularly true for children, who tend to be short-sighted and may not fully appreciate the long-term consequences of caffeine addiction. This might be a reason to regulate sales of sodas containing caffeine in schools, for example.

In the midwestern United States, where winds tend to blow from west to east, states- tend to more easily approve new polluting industries near their eastern borders than in other parts of the state. Why do you think this is true?

When a state approves new polluting industries, it imposes an externality on neighboring "downwind" states. It is unlikely that downwind states have figured out a way to make up- wind states fully internalize their externalities. States are therefore unlikely to fully take into account the costs they impose on other states by locating their polluting plants near their eastern borders. On the other hand, they will tend to take into account the pollution costs they would impose on themselves by locating their plants farther west. Hence, the private cost of installing plants in the eastern part of the states will tend to be smaller than the pri- vate cost of installing plants in the western part, and they are therefore more likely to ap- prove new polluting industries near their eastern borders. Of course, there may be other, more important reasons for them to locate their polluting industries on the eastern border of their state. Possibly because of patterns of settlement (east to west), large cities in midwest- ern states tend to be located on the eastern borders of their states; examples include Detroit, Chicago, Milwaukee, and the Twin Cities. It may be that industrial plants tend to be located near such population (employment) centers.

How might large federal deficits affect future economic growth? How would your an- swer change if foreign confidence in the ability of the United States to repay its debts erodes?

When governments run deficits, they compete with private individuals to borrow loan- able funds. With increased deficits, the total demand for loanable funds increases, driving up the rate of interest. The quantity of private investment in assets that improve economic pro- ductivity therefore falls. This is the basic theory of crowding out. If international in- vestors/savers lose faith in the ability of the United States to repay its debt, the supply curve of loanable funds will become steeper: foreigners will supply additional loanable funds only if they receive higher interest rates to compensate them for what they perceive to be a riskier investment. This means that deficit spending will have larger effects on interest rates, and it will crowd out private investment to an even greater extent.

Answer the following two questions for each of the following examples: (i) smoking by individuals; (ii) toxic waste production by firms; (iii) research and development by a high-tech firm; and (iv) individual vaccination against communicable illness. a. Is there an externality? If so, describe it, including references to whether it is posi- tive or negative, and whether it is a consumption or production externality. b. If there is an externality, does it seem likely that private markets will arise that allow this externality to be internalized? Why or why not?

a) i. Smoking by individuals generates negative consumption externalities by generating secondhand smoke. ii. Toxic waste production by firms generates negative production externalities be- cause the harm (or toxicity) is a by-product of the firm's production. iii. Research and development by a high-tech firm generates positive production ex- ternalities when the results of that research expand the knowledge and productivity of all firms. iv. Individual vaccinations generate positive consumption externalities by reducing the number of people in the population who have a communicable illness. When the number of infected people is reduced, the probability of catching the illness is reduced for everyone. b) i. The problem of secondhand smoke is unlikely to be solved by private markets. Smoke is widely dispersed, making it difficult to account for and negotiate with every affected person. In addition, the value of smoking a single cigarette is likely to be small relative to the transaction costs of negotiating the solution. ii. The problem of toxic waste might be amenable to a private market solution. The generator can be easily identified, and a finite number of people in a localized town or community are likely to be affected. If local residents have property rights to restrict toxic waste production, it should be relatively easy for a firm which places a high value on the ability to produce toxic waste to compensate them in exchange for the right to pollute. iii. A firm that purchases a patent or license is in some sense using a market mechanism to partially compensate the researching firm for its contribution to the knowledge base. However, it is hard to completely restrict or contain the flow of information. It is unlikely that a private market for intellectual property could completely internalize this externality. iv. Private compensation for the reduced risk of exposure associated with vaccinations seems unlikely. It would be virtually impossible to identify the beneficiaries of increased vaccination rates.

People in your neighborhood pay annual dues to a neighborhood association. This association refunds neighborhood dues to selected home owners who do a particu- larly nice job in beautifying their yards. a. Why might the neighborhood association provide this refund? b. At the most recent home owners' association meeting, home owners voted to end this practice because they felt that it was unfair that some people would not have to pay their share of the costs of maintaining the neighborhood. What is likely to happen to the overall level of neighborhood beautification? Explain.

a) Neighbors who are good gardeners provide an external benefit to the entire neighbor- hood. Everyone's property values are a little higher when the neighborhood looks nice. The refund helps to compensate the gardeners for providing this public good and might induce other neighbors to beautify their lawns in hopes of receiving the refund. b) Ending the refund program removes the private incentive to provide the positive ex- ternality. The benefits to gardening have declined but the costs have remained the same. Because maintaining a lawn is costly in terms of time and money, those who once re- ceived the refund but no longer do will cut back on their gardening efforts. When there is no compensation for providing the positive externality, people are likely to free ride on those who do provide it. However, it is unlikely that canceling the refund program would completely eliminate private provision of nice lawns and gardens. People who like to gar- den and receive private utility from doing so will continue to maintain their yards but at a level at which marginal private benefit just equals marginal private cost. This level will be less than the level at which marginal private benefit plus the refund equaled marginal private cost.

Bill's demand for hamburgers (a private good) is Q = 20 - 2P and Ted's demand is Q = 10 - P. a. Write down an equation for the social marginal benefit of the consumption of ham- burgers. b. Now suppose that hamburgers are a public good. Write down an equation for the social marginal benefit of hamburger consumption.

a) The social marginal benefit from the Qth hamburger is the willingness of society to pay for the hamburger. To compute it, we first find the social demand curve for hamburg- ers by summing individual demands horizontally: Q = (20 - 2P) + (10 - 3P) = 30 - 3P. Inverting this gives P = 10 - Q/3. The willingness of society to pay for the Qth ham- burger is thus 10 - Q/3. b) For public goods, we don't add quantities horizontally; we add prices vertically. For Bill, Q = 20 - 2P; solving for P yields P = 10 - 0.5Q. For Ted, Q = 10 - P, so P = 10 - Q. Summing vertically, total P = (10 - 0.5Q) + (10 - Q) = 20 - 1.5Q.

Imagine that it is 1970, and your parents are in college, debating the merits of the CAA of 1970. Your father supports the act, but your mother says that since it only covers new plants, it might actually make the air dirtier. a. What does your mother mean by her argument? b. How would you construct an empirical test to distinguish between your parents' hypotheses?

a) Your mother anticipated the incentive for owners to keep old plants in operation to take advantage of their exemption from the rules. If the old plants are dirtier than new ones would be, this loophole could lead to dirtier air. b) Chay and Greenstone compared improvements in particulate levels in counties that were regulated by the 1970 rules (the nonattainment counties) with improvements in ex- empted counties. A similar approach could be taken with plant closures. You could compare data on new plant construction and old plant closures in nonat- tainment counties with data on plant construction and closures in exempted counties. If other potential explanations are controlled for, this comparison would help identify the extent to which the 1970 rules encouraged firms to keep old plants on line. Your mother's argument would be supported by a finding that old plants were closed more frequently in the nonattainment counties than in the exempt counties. Confounding effects would have to be considered. For example, demographic shifts could account for plant openings and closings, regardless of the application of the CAA. The empirical test would have to con- trol for these effects. It would be difficult to know whether the demographic shift was in response to patterns of factory closing and construction brought on by the CAA.