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MPS 541 ECONOMIC FOUNDATIONS TO PUBLIC SERVICE
HOMEWORK 2
Please answer all questions. To get partial credit for incorrect answers, please show your work. To get
full credit, properly label all graphs where appropriate.
The assignment has 6 points.
1. Consider and income guarantee program with an income guarantee of $4,000 and a benefit reduction
rate of 50%. A person can work up to 2,000 hours per year at $9 per hour. (3 points)
a. Draw the person’s budget constraint with the income guarantee
b. Suppose that the income guarantee rises to $6,000 but with a 75% reduction rate. Draw the
new budget constraint.
c. Which of the two income programs is more likely to discourage work? Explain in terms of
substitution and income effects.
2. The private marginal benefit for commodity X is given by 10-X, where X is the number of units
consumed. The private marginal cost of producing X is constant at $2. For each unit of X produced,
an external damage of $3 is imposed on members of society.
What type of externality is this? In the absence of any government intervention, how much X is
produced? What is the efficient level of production of X? What is the gain to society involved in
moving from the inefficient to the efficient level of production? Suggest an approach that the
government could take that could lead to the efficient level. How much would such an approach cost
or benefit government in the form of increased government tax revenues or increased government
costs? Please draw the graph that visually shows this externality situation as well as the movement
of the supply and/or demand curves. (2 points)
Gruber problem (note – these are problems from the Third Edition of the text)
3. Chapter 5, Problem 2 (1 point)
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 led to a socially efficient allocation of pollution. Describe how this outcome would occur.
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