UNIVERSITY OF TORONTO AT MISSISSAUGA
DEPARTMENT
OF ECONOMICS
ECONOMICS
336Y5Y – FALL/WINTER 2011
Please fill in your full name and student number in the spaces below.
NAME:_Robert McMillan
_____________________________________
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)
Second-hand smoke is
harmful. One unintended adverse effect
might arise if smokers increased the amount of smoking they did in the home,
increasing the exposure of others (children, for example) to the smoke.
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)
It is unlikely that a
smoking ban would have significant consequences for government revenue. Unlikely that such a ban would have a major
effect on smoking rates in the short term, and so unlikely that tax revenues
would be affected in a major way.
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)
A
direct tax is one that is borne by the agent on whom the tax is levied. A prime example would be the personal income
tax.
2b) In 2006, which form of taxation provided the
Canadian government with its second largest
revenue source? (2 points)
Customs,
excises, and sales taxes provided the second largest revenue source, at 19.2
percent.
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)
If there were intense
competition among governments to attract mobile businesses, this could lead to
a situation where each local government tried to undercut its rivals by
offering lower taxes. This is known as
a ‘race to the bottom,’ in which local taxes are all very low. The net outcome would be that local
governments were unable to raise much money locally.
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
[What
do you think?]
3b) In 2007, was government spending as a
percentage of GDP the highest in Canada or France or the United States? [2 points]
It was
highest in France.
3c) How is GDP defined? [Hint: the relevant answer in this instance is
not “gross domestic product.”] [One
sentence.] (2 points)
GDP
measures the total value of goods and services produced in a country in one
year.
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)
GDP does
not include externalities.
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)
There
are a variety of answers. One could
include the amount of time commuting, and the amount of air and water pollution.
We noted in class
that the climate change problem has been described as the largest collective
action problem in human history.
Cutting back on carbon emissions, given current
technology, is very costly. Each nation
would like other nations to cut back
on their emissions while continuing to emit themselves. This allows them to enjoy their existing
carbon-based lifestyle, while also enjoying the spillover benefits of emissions
reductions by others. Thus there is a
clear free-rider problem: each nation has an incentive to defect from any
co-operative reduction, as in a standard prisoner’s dilemma.
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.)
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)
It
would be better to choose $105 dollar option.
Other
would yield 100 * (1.1/1.05) = 100 * (22/21).
But 22/21 < 21/20. Therefore
the 105 option is better.
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)
.
You
should invest in indexed debt, as the payout would be adjusted at higher
inflation rate, at 10 percent, not the 5 percent required for
indifference. Therefore indexed debt
would yield higher nominal return.
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)
No. The cutoff is 1/10. (Please note the correction from earlier.) We get 1/10 by solving for 'a' in 4 - 10a = 1 + 20 a. So for a = 1/15, the government would choose
to inflate.
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)
It
depends whether a rises above the
indifferent point (a = 1/10). If so, then it would switch to taking the
socially optimal course of action, issuing indexed debt.
Question
6 (worth 2 points)
6a) State the First Welfare Theorem in the
context of the pure exchange economy. (2 points)
The
First Welfare Theorem states that in the absence of externalities, every competitive
equilibrium must be Pareto-efficient.