Economic questions

This assignment is worth a total award of 30 points by completing all 5 questions. This is an individual assignment. Always explain your answer. If you only give an answer without explanation, no points are awarded! Question 1 (6 points) In a utopian country people only require one type of hospital treatment. The yearly supply and demand in a free market is as follows: Price (GBP) 100 150 200 250 300 350 400 450 Quantity demanded 70 60 50 40 30 20 10 0 Quantity supplied 10 15 20 25 30 35 40 45 a) Calculate the current equilibrium price. (1 points) Since there are 40 people that require treatment, the government decides to give the hospital a subsidy per treatment. b) Calculate the subsidy per treatment such that, in equilibrium, all patients receive treatment. (3 points) Instead of a subsidy the government could also decide to introduce a mandatory health insurance. Then all costs will be reimbursed in case someone requires treatment. c) Explain how the demand and supply curves change. (2 points) Question 2 (8 points) Two firms (firm I and firm II) are considering entering a market. If only firm I enters, this firm obtains a value of 3 units. If only firm II enters, firm II obtains a value of 4. No entry means a value of 0. However, if both firms enter the common value will be 9. To see what each firm receives when they both enter the market, the firms agree to characterise the entry game as a cooperative game with two players where N={I,II}. v(I) is then the profit generated when only firm I enters and v(II) is the profit generated when only firm II is in the market. Suppose the firms agree that the profit of v(N)=9 will be divided according to the Shapley rule. a) Calculate the Shapley value. (3 points) Now the game can be seen as a Nash game where each firm has two strategies: entry and no entry. b) Generate the pay-off matrix associated with this game. (1 point) c) Calculate all equilibria. Specify for each equilibrium whether it is pure or mixed. (2 points) d) What happens to the equilibria when the common value is 5 instead of 9? (2 points) Question 3 (7 points) Read the attached article ‘Negative Income Tax and Redistribution’. a) Draw up a similar table to the one in the article, only this time assume that the basic benefit is £6000. Assume that the marginal tax rate is 20 per cent up to £10 000 and 40 per cent from £10 000 to £20 000. (4 points) b) To what extent would this particular system help to tackle the problems of (i) equity; (ii) cost of provision; (iii) incentives? (3 points) Question 4 (4 points) Read the attached article ‘Can the Market Provide Adequate Protection for the Environment?’. The following table gives the costs and benefits of a firm operating under perfect competition: Output (units) Price per unit (MSB) (£) Marginal (private) costs to the firm (MC) (£) Marginal external (pollution) costs (MEC) (£) Marginal social costs (MSC = MC + MEC) (£) 1 100 30 20 50 2 100 30 22 52 3 100 35 25 60 4 100 45 30 75 5 100 60 40 100 6 100 78 55 133 7 100 100 77 177 8 100 130 110 240 Its activities create a certain amount of pollution. Assume that the costs of this pollution to society can be accurately measured. a) What is the profit-maximising level of output for this firm? (1 point) b) What is the socially efficient level of output? (1 point) c) Why might the marginal pollution costs increase in the way this example illustrates? (2 points) Question 5 (5 points) Consider the situation of a market where only one firm is active. We then have the standard set-up for a monopoly as we have seen in Chapter 5 and Chapter 6 (see, e.g., Figure 5.21 and Figure 6.8). Now suppose that a second firm enters this market. Assume that both firms have the same total revenue function. Describe what will happen to the equilibrium price and quantity in the cases where a) both firms have the same cost functions. (2 points) b) different cost functions. (3 points) Also describe what will happen to the amount the first firm (the incumbent) produces after entry by the second firm (the entrant). Illustrate all your answers by means of figures with the demand and supply curves. If you have to make any assumptions, state all of them. What is a good answer? As an example, for question 1a, one could phrase the answer as follows: ‘Equilibrium prices are found by looking at … (and … ). We then find the price by … (doing) ... In the case of this exercise we see that … (and … ). Therefore, the equilibrium price can be calculated/found by … . Hence, the current equilibrium price is equal to …. .’ In this way you not only show how you have obtained your answer but also that you understand how to do it. Another advantage is that, in the case that you have accidentally made a calculation error and have not obtained the correct answer, we can still award you points for the correct method and reasoning. This would generally mean that you are able to receive most of the points. Negative Income Tax and Redistribution A unified system of tax and social security The complexities of welfare provision have led many economists to look for a more simplified and effective means to cure poverty and redistribute income, while avoiding the poverty trap. One such solution is the negative income tax system, which works as follows. First, a minimum entitlement must be set, on or about the poverty line. Assume for the sake of argument that this level is £2000. Under the system, everyone is entitled to this level of benefit. If you earn nothing, then you just get the £2000. Second, income tax is paid right from the first pound a person earns. Assume that the tax rate is 25 per cent. These taxes are then offset against the fixed benefit. If taxes exceed the benefit, a person pays the difference to the tax authorities. If taxes are less than the benefit, the person receives the difference from the tax authorities – a negative tax. The table shows how it works. With earnings up to £8000, people receive a net benefit (a negative income tax). Over £8000, people pay a positive net tax. A negative income tax system (1) Earnings (£) (2) Tax on earnings at 25% (£) (3) Benefit (£) (4) Tax minus benefit (£) (2)–(3) (5) Net income (£) (1)–(4) 0 0 2000 –2000a 2000 4000 1000 2000 –1000a 5000 8000 2000 2000 0 8000 12 000 3000 2000 1000 11 000 16 000 4000 2000 2000 14 000 a Negative income tax. The level of fixed benefit can be made to vary with people’s circumstances. Thus if a single person’s benefit were £2000, a married couple’s with four children could be, say, £5000. The advantages claimed for the system are as follows:  It eliminates the poverty trap. There are no levels of earnings where benefits suddenly disappear.  It is simple to administer. A single agency – such as the Inland Revenue – is involved.  It would have a high take-up rate. The system, however, does have serious drawbacks. If the marginal tax rate is to be kept low (say, at a standard rate of 25 per cent), and if the basic benefit for the poor is to be sufficiently high (say, £5000), anyone earning less than £20 000 will receive a negative income tax payment. This would put a tremendous cost burden on indirect taxes: a burden paid disproportionately by the poor! Alternatively, the marginal tax rate could be increased, but then the problem of disincentives is likely to arise. Thus the conflict between equity and efficiency is not resolved. Can the Market Provide Adequate Protection for the Environment? The problem of externalities In recent years people have become acutely aware of the damage that pollution has wreaked on the environment. But if tipping chemicals and sewage into the rivers and seas and releasing toxic gases into the atmosphere cause so much damage, why does it continue? If we all suffer from these activities, both consumers and producers alike, then why doesn’t a pure market system deal with the problem? After all, a market should respond to people’s interests. The reason is that the costs of pollution are largely external costs. They are borne by society at large and only very slightly (if at all) by the polluter. If, for example, 10 000 people suffer from the smoke from a factory (including the factory owner) that owner bears only about 1/10 000 of the suffering. That personal cost may be quite insignificant when the owner decides whether the factory is profitable. And if the owner lives far away, the personal cost of the pollution will be zero. Thus the social costs of polluting activities exceed the private costs. If people behave selfishly and take into account only the effect their actions have on themselves, there will be an overproduction of polluting activities. Thus it is argued that governments must intervene to prevent or regulate pollution, or alternatively to tax the polluting activities, or subsidise measures to reduce the pollution. But if people are purely selfish, why do they buy ‘green’ products? Why do they buy, for example, ‘ozone-friendly’ aerosols? After all, the amount of damage done to the ozone layer from their own personal use of ‘non-friendly’ aerosols would be absolutely minute. The answer is that many people have a social conscience. They do sometimes take into account how their actions affect other people. They are not totally selfish. They like to do their own little bit, however small, towards protecting the environment. Nevertheless to rely on people’s consciences may be a very unsatisfactory method of controlling pollution. In a market environment where people are constantly encouraged to consume more and more goods and where materialism is the religion of the age, there would have to be a massive shift towards ‘green thinking’ before the market could truly solve the problem of pollution. Certain types of environmental problem may get high priority in the media, like acid rain, the greenhouse effect, damage to the ozone layer and brain damage to children from leaded petrol. However, the sheer range of polluting activities makes reliance on people’s awareness of the problems and their social consciences far too arbitrary.