Public Economics: HW2

March 10, 2021

Problem 1. On the planet Tin Can, people have identical preferences and value only
two goods – canned beef and books. People of Tin Can wants to form a library, which they
call a club of book lovers. The fixed cost of building the library is 600. The price of a book
x2 G
is 1. The price of a beef can is 2. The utility function of a person from Tin Can is Ui = i 2 ,
n
where xi is the number of beef cans, G is the number of books, and n is the number of the
library members. Income of each person is 40.
Determine the optimal number of members of the library, the optimal fee that each
member has to pay, the optimal number of books, and the optimal number of beef cans
consumed by library members.
Solution. The library’s manager maximizes utility of individuals in their library by
choosing the optimal level of members and the optimal amount of books, that is

x2 G
max
x,G,n n2

600 + G
s.t.2x + = 40.
n
x2 G 600 + G
The Lagrangian for this problem is L = 2 + λ(40 − 2x − ).
n n
The FOCs are
2xG
= 2λ
n2
x2 λ
2
=
n n
2
2x G 600 + G
3
=λ
n n2
Taking ratios of FOCs yields
x 1
=
G n

1
 600 + G
x=
2n
600 + G G
Pluging one equation into another yields = , hence G = 600. Pluging now the
2n n
600 + G
same equation into the budget constraint yields 2 = 40, hence the optimal number
n
600 + G 600 + G
of member n = = 60. The optimal membership fee is = 20, hence, taking
20 n
600 + G
into account budget constraint, each library member can consume x = = 10.
2n
Problem 2. Assume now that people of Tin Can learned that the cost of maintaining
the library has additional term equaled to 0.5V , where V = nυ is the total number of visits
to the library made by all members, υ is the number of visits to the library by a member,
and n is the number of members of the library. The utility function of a library member also
x2 Gυ 3
depends on the number of visits and is equaled to Ui = i 2 . All other assumptions are
V
the same as in Problem 1.
Calculate now the optimal number of library members, the optimal number of books and
beef cans, the optimal number of visits, and the membership fee.
Solution.
The library’s manager maximization problem is now

x2 Gυ 3
max
x,G,n,υ V2
600 + G
s.t.2x + + 0.5υ = 40.
n
x2 Gυ 600 + G
The Lagrangian for this problem is L = 2
+ λ(40 − 2x − − 0.5υ).
n n
The FOCs are
2xGυ
= 2λ
n2
x2 υ λ
2
=
n n
2
2x Gυ 600 + G
3
=λ
n n2
x2 G
= 0.5λ
n2
Taking the ratios of FOCs gives
x 1
=
G n
600 + G
x=
2n

2
 x
= 0.5
υ
600 + G G
Pluging one equation into another yields = , hence G = 600. Combining now
2n n
1 600 + G
two of three these equations and the budget constrain yields (2 + ) = 40, hence
2 n
600 + G
the optimal number of member n = = 75. Hence, x = 8 and υ = 16. The optimal
16
600 + G
membership fee is + 0.5υ = 24.
n
Problem 3. Under the settings of the previous problem, assume that the library manager
decides to introduce the two-part tariff to assure the optimal number of visit is chosen by
each member. Calculate the unit price per visit and the fixed membership fee that ensure
the optimal library use.
Solution.
Let us consider the problem of a member of club who chooses x and υ and takes n∗ , G∗
as given and believes that all other members will make υ ∗ visits

x2 G∗ υ 3
max
x,υ ((n∗ − 1)υ ∗ + υ)2

s.t.2x + F + pυ = 40.

The FOCs for this problem is

2xG∗ υ 3
= 2λ
((n∗ − 1)υ ∗ + υ)2

3x2 G∗ υ 2 2x2 G∗ υ 3
− = λp
((n∗ − 1)υ ∗ + υ)2 ((n∗ − 1)υ ∗ + υ)3
Taking the ratio of the FOCs gives
3x 2x
p= − ∗ ,
υ (n − 1)υ ∗ + υ

To find the price per visit that ensure the optimal club use, we should evaluated the above
equation at x = x∗ and υ = υ ∗ . Hence,
3 2 3 2 223
p = x∗ ( ∗
− ∗ ∗ ) = 8( − )= .
υ nυ 16 75 · 16 150
The fixed component of fee should guarantee the sufficient resources for public good:
223
C(G∗ , n∗ υ ∗ ) − n∗ υ ∗ p 600 + 600 + 0.5 · 75 · 16 − 75 · 16 ·
F = = 150 = 16 .
n ∗ 75 75

3
 We can also derive p and F in terms x. For this, same as last time, we should consider
the problem of a member of club who chooses x and υ and takes n∗ , G∗ as given and believes
that all other members will make υ ∗ visits
x2 G∗ υ 3
max
x,υ ((n∗ − 1)υ ∗ + υ)2

s.t.x + F x + px υ = 20.

The FOCs for this problem is

2xG∗ υ 3
=λ
((n∗ − 1)υ ∗ + υ)2

3x2 G∗ υ 2 2x2 G∗ υ 3
− = λpx
((n∗ − 1)υ ∗ + υ)2 ((n∗ − 1)υ ∗ + υ)3
Taking the ratio of the FOCs gives
3x x
px = − ∗ ,
2υ (n − 1)υ ∗ + υ

To find the price per visit that ensure the optimal club use, we should evaluated the above
equation at x = x∗ and υ = υ ∗ . Hence,
3 1 3 1 223
px = x ∗ ( ∗
− ∗ ∗ ) = 8( − )= .
2υ nυ 32 75 · 16 300
The fixed component of fee should guarantee the sufficient resources for public good,
but, since we should translate fixed cost of building the library, the price of a book and the
coefficient of additional term into x terms too, we have

C(G∗ , n∗ υ ∗ ) 600 + 600 + 0.5 · 75 · 16 223

− n∗ υ ∗ px − 75 · 16 ·
Fx = 2 = 2 300 = 8 .
n ∗ 75 75
F p
As we can see, F x = and px =
2 2
Problem 4. a. List all the assumptions underlying the Tiebout model of local public
good provision. State the Tiebout hypothesis.
b. Why does the Tiebout model solve the problems with preference revelation?
Solution.
a. The Tiebout model relies on a set of basic assumptions. The primary assumptions are
that consumers, who maximize their utility, have perfect information about fiscal packages
in a large number of local governments, that provides them with a great opportunity to be
free to choose community and sort themselves into groups with similar preferences for public

4
goods by moving there, because there is no any restrictions due to employment opportunities
and lack of moving costs. This essentially means that they can move from community to
community at no cost, and that they know everything they need to know about services pro-
vided by local governments and the tax rates of all local governments. For these reasons, the
Tiebout model has been shown to be most accurate in suburban areas with many different
independent communities. Moving between communities in these areas tends to have the
lowest costs, and the set of possible choices is very diverse. Further, the model requires that
community managers have instruments to adjust population size so that average cost per
person of public good is minimized. Lastly, the model also assumes that there are not exter-
nalities or spillover of public goods across jurisdictions that means that fiscal decisions taken
by one local government do not produce welfare variations on residents in other jurisdictions.
Taking into account all these assumptions, the hypothesis asserts that competition across
local jurisdictions consumer migration place competitive pressures on the provision of local
public goods such that these local governments are able to provide the optimal level of public
goods. In other words, economic efficiency will be attained in an economy with local public
goods.
b. If there are a number of alternative communities in which a consumer can choose to
live and these differ in their provision of local public goods, then the consumer’s choice of
location provides a very clear signal of preferences. The chosen location is the one offering
the provision of local public goods closest to the consumer’s ideal, because it is irrational to
be dishonest, and, therefore, through community choice preference revelation takes place. It
follows that if there are enough different types of community and enough consumers with
each kind of preference, then all consumers will allocate themselves to a community that is
optimal for them and each community will be optimally sized. This ensures that the market
outcome is efficient. It can be said that consumers reveal their preferences by ”voting with
their feet” and this ensures the construction of efficient communities.