Midterm Exam 1 Dr. Goodman

ECO 5520/6520 Page 1 of 4

Name______ID ______

Midterm Exam 1 – Dr. Goodman ECO 5520/6520 - Winter 2008

Instructions

This examination has five questions and you are to do all five in a bluebook that you provide. Please number your answers clearly. Each question will be worth 20 points, and each part of each question will be weighted equally, so allocate your time accordingly. The exam is “closed book – closed notes.” You may use a calculator, although you shouldn’t need one.

You will have until from 3:00 until 4:50 to complete the exam. Latecomers will not be given extra time to finish the exam. If you are unsure of a question, indicate what assumptions you are making and go forward.

Undergrad question – ECO 5520

Total Total CS PS Quantity Benefits Costs MB MC 0 0.0 0.0 1 19.5 5.0 6.5 8.0 19.5 5.0 2 38.0 12.0 5.5 6.0 18.5 7.0 3 55.5 21.0 4.5 4.0 17.5 9.0 4 72.0 32.0 3.5 2.0 16.5 11.0 5 87.5 45.0 2.5 0.0 15.5 13.0 6 102.0 60.0 14.5 15.0 7 115.5 77.0 13.5 17.0 8 128.0 96.0 12.5 19.0 9 139.5 117.0 11.5 21.0 10 150.0 140.0 10.5 23.0 11 159.5 165.0 9.5 25.0 12 168.0 192.0 22.5 20.0 8.5 27.0

1. Economic efficiency is a key concept in all microeconomic analysis.

a. State in one sentence the rule for economic efficiency in terms of benefits and costs. Why does this rule lead to economic efficiency? b. In the table above, fill in the empty boxes for marginal benefits and marginal costs and determine the efficient quantity produced. c. Assuming that at the efficient quantity, the price is 13.0, calculate and show the consumer surplus. CS = 22.5 d. Assuming that at the efficient quantity, the price is 13.0, calculate and show the producer ECO 5520/6520 Page 2 of 4

surplus. PS = 20.0. ECO 5520/6520 Page 3 of 4

Graduate question – ECO 6520

1. Suppose total benefits and total costs are summarized by the two following equations.

Total Benefits: TB = 20Q – ½ Q2 Total Costs: TC = 4Q + 1 x Q2.

a. State in one sentence the rule for economic efficiency in terms of benefits and costs. Why does this rule lead to economic efficiency? b. Calculate the efficient quantity produced. 5.33 c. Calculate and show the consumer surplus on a graph. 14.22 d. Calculate and show the producer surplus on a graph. 28.44

These curves are drawn to scale so you can use 30 them to answer Question 2. $

Quantity 10 20

a. Suppose that Ed and Phil both want tennis courts in their suburb. Ed’s demand curve is DE, and Phil’s demand curve is DP. Draw the appropriate marginal benefit curve for the two of them on the graph above. Discuss briefly how you did it. (Add vertically) b. Suppose that the marginal cost per tennis court is 15 at all quantity levels. How would you use this in your analysis? (Horizontal line at 15) c. What principal would you use to estimate the optimum amount of this local public good? Is it the same or different from that used for private goods? Sum of MB = MC. d. Show the optimal number of tennis courts, based on your answers to parts (a) and (b). Give your best estimate, either geometrically or algebraically. Algebraically, Q* = 6. ECO 5520/6520 Page 4 of 4

3. Consider a metropolitan suburb (call it Grosse Bloomwoods), with 7 residents. Each is a corporate vice president with a major bank, and each earns 200 thousand dollars a year. Here are their preferences for school spending:

Alice – $5,000 Bob – $6,000 Carol – $7,000 D’Angelo– $15,000 Edna – $20,000 Fergie - $60,000 Godzilla - $90,000

a. Sketch out a diagram using indifference curves to indicate their preferences between school spending and restaurant spending, where each is measured in dollars. Standard IC. b. Grosse Bloomwoods is looking to elect a school administrator. If one is to be elected, how much school spending would she have to promise in order to win the election? Why? Would promise 15,000. c. What are the criteria for the “efficient” amount of school spending in this example? Sum of MB = MC. d. Is it likely that your answer in part b would exactly satisfy your criteria from part c? Why or why not? No. Median voter does not guarantee exact efficient solution.

Extra Credit (5 points)

e. If the price of schools doubled relative to restaurant food, would your answer to part (b) change? Why or why not? I don’t need a specific answer, but I want you to provide a general approach.

1. Less real income 2. Relative prices change Restaurant 3. May not have the same median voter.

15 School ECO 5520/6520 Page 5 of 4

4. Charles Tiebout wrote a very influential article regarding local public goods.

a. Briefly discuss the underlying assumptions of Tiebout’s model. Jurisdictional Choice -- Households shop for what local governments provide. Information and Mobility -- Households have perfect information, and are perfectly mobile. No Jurisdictional Spillovers -- What is produced in Southfield doesn’t affect people in Oak Park. No Scale Economies -- Average cost of production does not depend on community size. Head Taxes -- Pay for things with a tax per person. b. How is a local public good equilibrium determined in Tiebout’s model? When do we know that it has occurred? We have a set of communities that provide sets of public goods. People stop moving, i.e. voting with their feet.

c. How did Dr. Goodman test Tiebout’s model? 1,835 houses in New Haven. Looked to see tax capitalization within and among municipalities. Found results similar to Oates. d. If you were to test Tiebout’s model for houses in communities on the north edge of 8 Mile Road how would you do it?

Give some communities. Collect data. What kind of test? ECO 5520/6520 Page 6 of 4

5. This question will look taxes and asset values. Consider a house that could be rented for $1,000 per month. We will assume that the house will last forever and that rents are capitalized with an interest rate of 5% per year. In the state of Michigan, the house is subject to a tax of 1.5% of its value.

a. Assuming that there are no public goods included in the value of the house, but that the owner pays the 1.5% tax, calculate the equilibrium value of the house. D = 20. Value = (20 x 12)/(1 + (20*0.015)) = 240/1.3 = 184.6 b. Suppose that the community is homogeneous (remember what that means) in terms of houses (renting for $1,000 per month) and house values. If, instead of the 1.5% tax (with no public goods), if each house is taxed $6,000 to pay for $6,000 worth of public services, what will happen to the house values? Why? House values will stay at $240,000, because people are paying $6,000 for what they value at $6,000. c. Suppose that a developer announces plans to build condominiums that would rent for $1,250 per month, pay taxes, and share in the public services. Would the current residents be happy or unhappy about this? Why? They would be happy, because the new units would subsidize the existing units! They are paying more taxes and getting same amount of services. d. How might people in neighboring communities react with respect to moving in or moving out if the proposed condos were built? Why? People in neighboring communities would want to move in. This would bid up the values of the $1,000 per month houses.