2.7 Exercises

  1. Real vs. Nominal Income (*): Assume that your income in year 1 is $200 and that the prices of raspberries and orange juice are $20 and $10, respectively. In year 2, the prices of raspberries and orange juice are $22 and $11, respectively. Assume that you fully exhausted your income in both years to purchase raspberries and orange juice and that you purchase the same quantities of those items in both years. Did your income increase if you earned $210 in year 2? Distinguish between real and nominal income. How much money do you need to earn in year 2 to have the same real income in both years?

  2. Inflation and Price Indices (***): The Bureau of Labor Statistics (BLS) publishes several price indices, including the traditional Consumer Price Index for All Urban Consumers and the Chained CPI. These indices are frequently used in public finance to adjust tax brackets, Social Security benefits, and other government programs for inflation.

    1. What is the difference between the traditional and chained CPI?
    2. Download the two indices from the FRED website (links included above) from January 2005 to the most recent month available as an Excel file. Since both indices have different base years and thus, differ in level, set both of them equal to 100 for January 2005.
    3. Plot the evolution of both indices from January 2005 until the most recent month. What do you observe? If Social Security benefits had been adjusted using the Chained CPI instead of the traditional CPI, how much different would benefits be today, expressed as a percentage?
    4. Compute and plot the annual inflation rates implied by each index. How much is it different over the years?

  3. Core Inflation, Headline Inflation, and Public Perception (***): Policymakers often focus on core inflation, which excludes food and energy prices, arguing that it better reflects the underlying trend in inflation. Citizens, however, experience headline inflation, which includes food and energy, more directly in their daily lives. This difference can create tension between technical policy analysis and public perception of fairness.

    1. Download monthly data that forms the basis to calculate headline and core inflation, i.e., CPI for All Urban Consumers and CPI for All Urban Consumers: All Items Less Food and Energy in U.S. City Average from FRED for the period 2010–present.
    2. Compute and plot annual inflation rates for both indices. Highlight periods where headline inflation diverges sharply from core inflation (e.g., during energy price spikes).
    3. Discuss the moral and policy dilemmas. That is, from the perspective of citizens, is it fair to exclude food and energy—essential goods—when adjusting social benefits and/or minimum wage? From the perspective of policymakers, is it reasonable to focus on a more stable measure to ensure long-run fiscal planning? How might this gap between “lived experience” and “technical measurement” influence public trust in government finance? How can this gap be overcome?

  4. Government Intervention (*): There are various reasons why governments intervene in the economy. Describe three reasons that justify government’s role in the economy. Each reason must include a definition of the concept and a discussion of why the government is required to address the identified problem.

  5. Businesses and Education (**): Private businesses have a great interest in quality primary and secondary education because today’s students are tomorrow’s employees. However, private businesses make limited financial contributions to this sector of education (excluding the taxes they pay to public school systems) even to market-oriented programs like vouchers and charter schools.

    1. What kind of good is primary and secondary education?
    2. Identify the characteristics of the good you identified in part (a) and explain how primary and secondary education satisfies these characteristics.
    3. Given your response to parts (a) and (b) above, does it surprise you that private firms contribute so little to primary and secondary education? Explain?

  6. Smoking (*): One rationale for imposing taxes on cigarette consumption is that smokers impose negative externalities on the rest of society for example through secondhand smoking. In the absence of taxation, will people tend to consume too much, too little, or the right amount of cigarettes?

  7. Public Good (*): A community project (a public good) will cost $2,500 and will benefit the five residents of the community as indicated in the table below. Answer the following question:

    1. Are the benefits of this project bigger than the costs?
    2. Would the project be approved by a majority at a referendum?
    3. Does the project meet the Pareto Criterion?
    4. Does the project meet the Kaldor-Hicks Criterion?
    Resident Individual Benefit Cost Share
    A 800 500
    B 800 500
    C 300 500
    D 350 500
    E 450 500
    Total 2700 2500

  8. Fishing (**): There are various indications that the fish population in some fisheries is declining (see for example Are cod ‘severely depleted’ in the Gulf of Maine? Why fishermen, scientists view ocean depths differently. To stop the depletion, fishing bans have been imposed in various regions globally (Frank et al., 2005). Explain the problem associated with fishing in the context of excludability and rivalry in consumption.

  9. Agency Budget I (***): This exercise involves learning to read and use information in public budgets. As part of this assignment you will be looking at a budget of an U.S. federal agency. First, pick an agency (do not pick a state) from A-Z index of U.S. government departments and agencies and make sure that the agency publishes a budget online. Download the budgeting information of the agency. Review the agency’s budget and answer the questions below. Note that every budget will not provide sufficient information to answer all of these questions. If the information is not available, you should note this in your answers.

    1. What is the mission of this agency?
    2. What are the major programs carried out by this agency?
    3. What is the percent increase in total requested expenditures for the next year over the last year’s budget?
    4. What object of expenditure category is the largest? Which is growing the fastest?
    5. Is the number of personnel (full-time equivalent also known as FTE) in the agency growing, and is the growth rate faster or slower than the personnel budget (in dollars)? What does this tell you about changes in average salaries?
    6. What information does this budget give you on the productivity and performance of this agency?
    7. What information would you like to have to be able to assess the ‘efficiency’ and ‘effectiveness’ of this agency?

  10. Rodent Control (**): The marginal private benefit of rodent control is \(MB=60-Q\), the marginal social benefit is \(MSB=80-Q\), and the marginal cost is constant at \(MC=20\), where \(Q\) is the number of rodents controlled. What is the market equilibrium \(Q_m\) and the social optimum \(Q^\star\)? What is the per-unit subsidy to implement \(Q^\star\). Why would the government prioritize rodent control even when individuals do not invest sufficiently?

  11. Public Goods and Congestion (***): Note that for this question, an template spreadsheet is available. A city of 100,000 residents considers building a public park. Each resident’s utility from the park is \[U_i = v \cdot \ln(G) - \phi \cdot \frac{N}{G}-T\]

where \(T\) is the tax per person, \(G\) is the park size, \(N\) is the number of users, \(v=80\), and \(\phi=30\). The cost is \(C(G)=200G+0.05G^2\).

  1. Calculate the socially optimal \(G^\star\)** by maximizing total surplus.
  2. If financed with a head tax, how much would each resident pay, and what would their net utility be?
  3. Suppose the city instead leaves funding to voluntary contributions. Explain (and calculate if possible) why the outcome differs.