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Solutions for Public Finance problem sets

By Anita Gantner and Sofia Franco

Chapter 2: Public goods and Private goods

Exercise 2.1
(a) The equation implied by the Samuelson condition requires that:
1000

MRS
i 1

m arg inal cos t of public good

The marginal rate of substitution between skating rink and Labatts ale for a typical citizen:

U i X i , Y
100
Y
MRS i
2
U i X i , Y Y
X i
So, the Samuelson condition is

100000
10 .
Y2

(b) Since the MRSi depends only on the public good, the left side of Samuelson condition will
also depend only on the public good. So, this equation uniquely determines the efficient rink
size for Muskrat because:

U i2 X i , Y
200
(i)
3 0;
2
Y
Y

(ii) left side of Samuelson condition is a decreasing function of Y.


Given the marginal cost of the public good, there can be at most one value of y that satisfies that
equation .
The Pareto optimal amount of skating rink size is the Y=100.

Exercise 2.2
Since we have quasilinear utility functions, the sum of the MRSi will depend only on the fireworks.
So, we do not need to use the feasibility condition to determine Pareto optimal amount of fireworks
for Cowflop.

U i X i , Y
PY
Y
The Samuelson condition is: MRS i U X , Y
PX
i
i
i 1
i 1
X i
1100

MRSi =

1000

ai
2000 Y

1100

So, we have

1100

and note that

i 1

(10 2000
i 1

i 1 2 3 .... 1000

1000 *1001
.
2

) 1 and Y=626.251.

Exercise 2.3
(a) In order to find the optimal amount of public good as a function of the parameters of the
problem we have to solve the following:
L

Max
x1 Y 1
X i , X j ,Y U 1

xi Y 1 U iL

1
s.t x j Y U

500

500

x x
i 1

0
j

j 1

i 2,....,500
j 1,.....,500
500

500

i 1

j 1

Y wi w j w

From the resolution of this problem we get:

1 500 1 500
Y xi x j
i 1
j 1

500

(Samuelson Condition)

500

x x Y w
i

i 1

j 1

( feasibility condition)

500

From this system we get: Y (1 )W x j (


j 1

1 1

As we see, the optimal amount of public good depends on:


(i)
(ii)
(iii)

aggregate income of the community;


on how the private goods are divided between the Larsons and the Olsens;
on the shares and .

(b) If = , then all individuals have identical Cobb-Douglas utility functions.


The optimal amount of public good, in this case, is reduced to:
Y (1 )W

and it depends only on the aggregate income but not on how that income is distributed.
Thus, any redistribution of income that leaves the aggregate income in the community unchanged
will have no effect on the efficient allocation of Y.
An example would be:
Suppose the two following income distribution:

where,

L
1

L
O
, w2L , w3L ,......, w500
; w1O , w2O ,......., w500

L
1

L
O
, w2L , w3L ,......, w500
; w1O , w2O , w3O ,......., w500

w1L w1L

and

w3L w3L ,

w2O w2O

and

w3O w3O

It is easy to see that both will conduct to the same optimal amount of Y since the sum of all
individuals income is the same in both cases, that is, the aggregate income is unchanged.
Exercise 2.4
(a)
Max XC+ 2 Y
C ,T

s.t.

X Y U
D
D

X C X D Y W

The Samuelson condition is:


MRS XC ,Y MRS XD,Y 1 Y

1
2

1
Y 2 1
2

So, the Pareto optimal amount of Y if both persons are to have positive consumption of private
goods is:
Y=

9
4

And XC+XD= W-

9
4

any allocation (XC,XD) that divides W-

9
4

units of private goods

between person C and person D in some proportions can be achieved.

(b)
We want the set of Pareto optimal allocations in which one or the other person consumes no private
goods:
(XC, XD, Y)

At allocation (W-

9
9
, 0,
), person C gets all the private goods.
4
4

9
3
9
9
and UD =
. The allocation (W- , 0,
) is Pareto optimal and the Samuelson
4
2
4
4
9
C
D
conditions apply (since Y =
is the solution of equation MRS X ,Y MRS X ,Y 1 ).
4

UC = W +

At allocation (0,W-

UC= 3 and UD = W -

9 9
,
), person D gets all the private goods.
4 4

3
9
9
. Allocation (W- , 0,
) also is Pareto optimal and satisfies Samuelson
4
4
4

condition.

But we can find other Pareto optimal points in which one or the other person consumes no private
goods by making people act in a purely selfish way. These points, by contrast with (Wand (W

9
9
, 0,
)
4
4

9
9
, 0,
), do not maximize the sum of utilities.
4
4

Person C has no interest in persons D consumption,

Max XC+ 2
X C ,Y

s.t. X C Y W

The solution of this problem is Y=1. So, the allocation that we have is (w-1, 0,1) and the utilities
associated to it are:
U C w 1 w

3
3
D
and U 1 .
4
2

We have a set of Pareto optimal allocations where the utility distributions result from allocations (W

Y, 0, Y) with Y 1, . But for Y 1, 4 , the allocations do not satisfy the Samuelson conditions.
4

We know that MRSC =

1
2

and MRSD =

Y = 1 MRSD + MRSC =

Y=

1
1
. So, take for example:
2 Y 2

P
1
3
1 1 Y .
2
2
PX

3
MRSD + MRSC = 0.41 + 0.82 =1.23 > 1
2

Person D has no interest in persons C consumption and acts in a selfish way.


Max XD+
X D ,Y

s.t. X D Y W
1
1 1
. The allocation we have now is ( 0, W, ) and the
4
4 4
1
3
w w .
4
4

The solution of this problem is Y=


utilities are U C 1 3 and U D

By the same reason used in the case before, we have a set of Pareto optimal allocations in which
Person C gets no private goods and where the utility distribution result from allocations of the type
1 9
1 9
, . As before, the allocations (0, W-Y, Y) with Y , do not meet
4 4
4 4

(0, W-Y, Y), with Y

Samuelson condition.
But for all these points be pareto optimal points is necessary to impose a restriction to W.
W has to be superior to 2.25, as we will see in the next question.
In summary,
The set of Pareto optimal allocations in which one or the other person consumes no private goods is:

9 9 9
9

9
S X C , X D , Y : w ,0, ; 0, , w ; w Y ,0, Y Y 1, W 2.25;
4 4 4
4

0, w Y , Y

9
Y 1, W 2.25
4

All these points are Pareto optimal since we cannot improve one persons utility without making the
other person worse off. On the other hand as it was shown, at these Pareto optimal points the
Samuelson condition does not necessarily apply.

( c ) Before look at the graph take a look in the following two tables:

Consider the case where (W-Y, 0, Y) with Y 1, 4 .

(i)

Y
1
1.5
2
2.25

UC
W+1
W+0.95
W+0.83
W+0.75

UD
1
1.2
1.4
1.5

Consider the case where (0, W-Y, Y) with Y

1 9
,
4 4

(ii)
Y

UC

UD

0.25
0.5
0.75
1
1.5
2
2.25

1
1.41
1.73
2
2.45
2.83
3

W+0.25
W+0.21
W+0.12
W
W-0.28
W-0.59
W-0.75

In order for all these points (W-Y, 0, Y) be better than points (0, W-Y, Y) for person C we need to
assure that w + 0.75 > 3 w >2.25.
By the same logic, for the points (0, W-Y, Y) be better than points (W-Y, 0, Y) for person D we need
to assure that w > 1.25.
If we consider both restrictions then we need to assure that the aggregate income is bigger than 2.25
in order for those allocations be Pareto Optimal.
The graph for an aggregate income W=3 is then:
7

The utility possibility frontier (UPF) is the set CBAD . Any point between the straight line AB
can be achieved by supplying

9
9
units of public good and dividing (w- ) units of private goods
4
4

between C and D in some proportions. The curved line CB corresponds to the utility distributions

1 9
,
and w =3. The curved line AD
4 4
9
corresponds to the utility distributions that result from allocations (W-Y, 0, Y) with Y 1, and w
4

that result from allocations (0, W-Y, Y) with Y

=3.
The curved segment DE does not belong to the UPF since it consists of the utility distributions for
the allocations where person C has all the private goods but the amount of public good is less than
the amount person C would prefer to supply for himself. Symmetrically, the curved segment CF
also does not belong to the UPF since it consists of the utility distributions corresponding to

allocations where person D gets all the private goods and the amount of public good is inferior to the
amount person d would like to supply for himself.
(d) The straight-line portion of the UPF is the zone achievable with positive private consumption
for both people.
9
9
. So we have that U C U D X C X D .
4
2
9
Since the amount of income left for C and D after the public good has been paid is w then we
4
9
have U D w U C .
4

At the UPF:

UC UD XC 2 Y * X D Y *

with Y*=

So, the straight-line portion of UPF is: U D ,U C ;U C 3;3.75 : U D w

9
UC
4

(e)
For the curved portion (CB) we have that X C = 0 and XD =W-Y. So UC =2 Y and UD=W-Y + +
U C2
and plugging this expression into
Y . From person C utility function we have that Y
4
U2 U
person D utility function we describe the top curved part of UPF as being U D W C C .
4
2
For the bottom curved part we set X C = W-Y and XD = 0 and we get U C = W-Y + 2 Y and UD=
2
Y . So, the bottom part is described as U C W U D 2U D .