PUBLIC ECONOMICS – Sample Fall Term Test Questions

November 2011

Please fill in your full name and student number in the spaces below.

NAME:_____________________________________

STUDENT NUMBER:__________________________

You have 1 hour and 40 minutes to complete this closed-book test. When the invigilator asks everyone to stop, you must stop writing. This should be entirely your own work – no conferring please.

Non-programmable calculators are allowed, but not needed.

The test is worth X points. Please attempt all the questions, and be sure to read each question carefully. The number of points each question is worth is indicated in brackets.

You should answer the test directly on this booklet, in the spaces provided. Please write legibly, and answer in proper sentences. If you need additional space, indicate clearly which question you are answering, and write on the reverse side of the page. [Approximate guidelines as to the length of the perfect answer are given in square brackets, where necessary.]

Question 1 (worth 5 points)

1a) Economists have drawn attention to some potentially perverse effects that may arise from smoking bans. How might a government policy to ban smoking in public places (including parks) actually increase the exposure of some groups of people to the adverse health effects associated with secondary smoking? Please explain clearly, giving an appropriate example. [Two sentences.] (2 points)

1b) Would you expect the consequences of such a ban for government tax revenues to be significant? What would the effect size depend on? Please explain your answer clearly. [Two sentences.] (3 points)

Question 2 (worth 9 points)

2a) What is a direct tax, in general? After stating that, please then give an example of such a tax. [Two sentences.] (3 points)

2b) In 2006, which form of taxation provided the Canadian government with its second largest revenue source? (2 points)

2c) How might the existence of tax competition among local governments affect their ability to raise revenue through local taxes? Please explain clearly. [Three sentences.] (4 points)

Question 3 (worth 11 points)

3a) Please circle the appropriate letter (A – D).

Government spending in Canada (in 2006) accounts for what percentage of GDP, to the nearest two percent? (1 point)

A 38 percent

B 41 percent

C 44 percent

D 49 percent

3b) In 2007, was government spending as a percentage of GDP the highest in Canada or France or the United States? [2 points]

3c) How is GDP defined? [Hint: the relevant answer in this instance is not “gross domestic product.”] [One sentence.] (2 points)

3d) GDP per head is often used as a welfare measure, yet its use as a welfare measure has been criticized by a number of economists. Please give one weakness of GDP as used to construct the GDP-per-head welfare measure. [One sentence.] (2 points)

3e) Related to your answer to 3d), please list two additional components you think are likely to be important when devising an improved welfare measure that are not directly included in GDP (and therefore are also not in GDP per head). [One sentence.] (4 points)

Question 4: Climate Change (worth 7 points)

4a) Agreements on climate change – specifically, reducing the amounts of carbon emitted by all nations – are inherently difficult to achieve. Why is this? [Hint: game theory.] [Four sentences.] (5 points)

4b) So-called ‘clean coal’ as a means of generating power involves an expensive and not-entirely proven technology called ‘carbon capture and storage’ (often abbreviated as ‘CCS’). Planet earth has a pre-existing technology that stores carbon very well. What is it? [One word.] (Two points.)

Question 5: Government Debt (worth 17 points)

5a) Suppose you are offered a choice of cash – specifically, $105 today – versus a nominal bond that pays a 10 percent rate of interest, to be redeemed in one year (the principal for $100 cash). Matters are complicated by the fact that the rate of inflation is going to be five percent over the course of that year. Which option should you choose if you are certain about the rate of inflation? Please set out your reasoning clearly. [Hint: you do not need a calculator for this problem. To obtain full marks, you need to show your logic.] [Hint 2: 0.05 = 1/20.] (5 points)

5b) Consider a nominal and an indexed bond, which both have one year to mature, and which are both traded on the bond markets. At today’s prices, the break-even inflation rate (or BEIR) is 5 percent. (Recall: the BEIR is that rate of inflation that would equate the yields on the two types of bond, and so make investors indifferent between them.) If you expect inflation to be 10 percent over the course of the next year, which bond should you invest in and why? (4 points)

5c) Suppose that the government objective can be represented by the following payoff function:

R = G + a S,

where R measures overall government utility, G is the private payoff to the government, S represents the welfare of the general public, and a is a parameter measuring how much weight the government attaches to the general public’s interests.

Consider two alternative options:

i. Option 1 involves the government issuing nominal debt, then subsequently inflating the economy a lot. This yields a private payoff to the government of G₁ = 4 and a payoff to society, S₁ = -10;

ii. Option 2 involves the government issuing indexed debt, then subsequently keeping inflation low. This yields a private payoff to the government of G₂ = 1 and a payoff to society of

S₂ = 20.

If the parameter a were equal to 1/15, would the government to choose the best course of action for society? Please explain, showing any relevant calculations. (5 points)

5d) Continuing on from your answer to 5c), an election is approaching, and this leads the government to increase the weight it attaches to the welfare of society. Would this lead to a change in the government’s optimal choice, given its objective? Please explain clearly, and show any relevant calculations. (3 points)

Question 6 (worth 2 points)

6a) State the First Welfare Theorem in the context of the pure exchange economy. (2 points)