Midterm 1
ECON-UA 353, Spring 2021
The rules governing this exam are in the .txt file attached to this assignment on NYU classes. You have
75 minutes to write your solutions to the exam, and then 10 minutes to scan/photograph, combine, and
upload your solution to the NYU classes site in a single file. Please remain on camera until your solutions
are uploaded.
Other than your 8.5”x11” “cheat sheet,” using any other resources or communicating with one another
(or anyone else) is strictly prohibited. Electronic devices may only be used to put yourself on camera,
display the exam, and to communicate with the proctor using the Zoom chat feature.
The exam is out of 100 points. The number of points allotted to each question is specified below. To
receive any credit, you must show your work. Showing your work will also help you receive partial credit.
1 Short Questions
(8 points each) For each question below, provide a brief answer and, where appropriate, explain your
reasoning.
1. Define Pareto efficiency and explain what it means.
2. Which assumptions of the 1st and 2nd Welfare Theorems are violated by a pure public good?
3. In the presence of an externality, will imposing an optimal Pigouvian tax necessarily generate a
Pareto improvement?
4. Give an example in which there are two allocations, A and B, where the following are all true:
• A is Pareto efficient
• B is not Pareto efficient
• B is preferred to A according to the Utilitarian welfare criterion.
2 Long Questions
1. (36 points) A factory produces cars. Its marginal cost function and demand curve are given by
M C(Q) = Q P D (Q) = 20 − Q
(a) (4 points) First, suppose the factory sells cars in a perfectly competitive market and there are
no market failures. What is the privately optimal quantity for the factory, Q∗ ? What is the
socially optimal quantity?
1
(b) (2 points) Calculate producer surplus (i.e. profits) when the factory produces Q∗ .
Now suppose that the factory’s production process causes pollution which damages the health
of nearby residents. The marginal damage function is
M D(Q) = 10
The factory does not take into account the external damage it causes.
(c) (4 points) What is the socially optimal quantity of production?
(d) (6 points) Calculate the deadweight loss that occurs due to the externality when the factory
produces the privately optimal quantity Q∗ .
(e) (6 points) What is the optimal Pigouvian Tax τ ∗ on the firm’s output? Compute producer
surplus under this tax.
Now suppose the factory can install an abatement technology that eliminates the pollution
damages caused by production. There is a one-time cost C = 40 to install the technology. If
it is installed, the government will exempt the factory from the tax τ ∗ on output.
(f) (6 points) Suppose the factory bears the cost (C = 40) of installing the technology. Will it be
privately optimal for the factory to do so?
(g) (8 points) The government could instead reimburse the factory for the cost of installing the
abatement technology. Would it be Pareto efficient to do so? Explain your reasoning.
2. (32 points) Consider the following extension of the divide-the-dollar example we discussed in
class. There is $100 to allocate, and two agents, A and B. The money can be given to A or B, or
spent on providing one unit of a pure public good G. If the public good is provided (G = 1), it
costs c = $25. If the public good is not provided (G = 0), there is no cost. So, the set of feasible
allocations is
X = {(xA , xB , G) | G ∈ {0, 1}, xA ≥ 0, xB ≥ 0, xA + xB + 25 · G ≤ 100},
where xA is the amount of money given to agent A, and xB the amount given to agent B.
Agents’ preferences are linear in money and the public good. Agent A values the public good at
$15, while agent B values it at $35. So, their utility functions can be written
uA (xA , G) = xA + 15 · G uB (xB , G) = xB + 35 · G
Note that the full amount of the public good enters each agent’s utility function.
(a) (10 points) Describe all of the Pareto efficient allocations.
(b) (8 points) Among the Pareto efficient allocations, which allocation(s) are optimal according
to the utilitarian criterion? Which are optimal according to the Rawlsian maximin criterion?
(c) (6 points) For which initial allocations (xA , xB ) (with xA + xB = 100) will the public good
be provided if agent A has to pay the cost of providing it? What if instead agent B has to pay?
(d) (8 points) Suppose the agents are able to write a contract that allows them to share the cost of
funding the public good, given the initial allocation of money (xA , xB ) (with xA + xB = 100).
For which initial allocations (xA , xB ) will the public good be funded? (You do not need to
explicitly describe the contracts, but doing so may be helpful.)
