Ramjas College

Delhi University

Name of Course: B.A. (Hons.) Economics 2017

Name of Paper: Public Economics

Solution Set: 1
1. Suppose it takes four days of labour to produce a week’s food and one day of labour to steal a week’s
food. In case of theft, the producer is compensated for his labour. Given that there is a cost c to provide
one day’s labour, what will be the equilibrium outcome if there may or may not be any punishment?
(Assume for simplicity that if there is a theft then the entire week’s food will be stolen.)

Solution:
Let p denote the expected value of being caught stealing and subsequently being punished.
Let x be the value of the produce.
The payoffs can be described by the following matrix:

Y
P roduce Steal
P roduce x − 4c, x − 4c 0, x − c − p
X
Steal x − c − p, 0 −c, −c

The equilibrium of the game depends on the value of p. If p is low such that p < 3c, then the equil-
brium will be {Steal, Steal}. If p is high such that p > 3c, then the equilbrium will be {Produce, Produce}.

In the state of anarchy, p = 0, then no production will occur because the equilibrium will be {Steal, Steal}
and any produce will be stolen.
2. Would a minimal state:
(a) Finance a fire service?
(b) Ensure that wage agreements were enforced?
(c) Limit maximum working hours?
(d) Prevent involuntary overtime?

Solution:
3. Consider two identical consumers who each have a total of T hours to allocate between production and
theft. Asume that production produces output ypi = log(tip ) for tip units of time devoted in production by
consumer i. If time tif is devoted to theft, then a proportion αtif /T of the other consumer’s output can
be stolen. Assume that each unit of output has price p and both consumers attempt to maximise their
wealth.
(a) What is the equilibrium?
(b) How does the equilibrium depend on the value of α?
(c) What is the equilibrium if there is no theft?
(d) What is the maximum that would be paid to prevent theft?

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Solution:
(a) The value of consumer i’s output is
pypi = plog(tip ).
After the act of theft by consumer j, i’s output is reduced to
αtjf
 
1− plog(tip ).
T
If consumer i steals from j, then the value of the stolen output is
αtif
plog(tjp ).
T
Adding them up, the total wealth of consumer i is W i given by

αtjf αtif
 
Wi = 1− plog(tip )+ plog(tjp ). (1)
T T
The total stock of time available is T . Therefore, thp + thf = T , h = 1, 2. Substituting for thf in (1),
the decision problem of the two consumers can be defined by
α(T − t2p ) α(T − t1p )
 
1 1
max W = 1 − plog(tp ) + plog(t2p ) and
{t1p } T T
α(T − t1p ) α(T − t2p )
 
2 2
max W = 1 − plog(tp ) + plog(t1p ).
{t2p } T T
Each consumer will take the other’s choice as given while maximising and thus, we’ll find the Nash
equilibrium. The necessary conditions are
α(T − t2p ) p
 
α
1− − plog(t2p ) = 0 and
T t1p T
α(T − t1p ) p
 
α
1− − plog(t1p ) = 0.
T t2p T

Since the consumers are identical, we’ll have a symmetric equilibrium with t1p = t2p = tp characterised
by

(1 − α)T + αtp (1−log(tp )) = 0 or (2)

(α − 1)T
tp (1−log(tp )) =
α
(b) From (2), differentiating tp with respect to α we get
dtp
−T + tp (1−log(tp )) − αlog(tp ) =0
dα
dtp T − tp (1 − log(tp ))
=− .
dα αlog(tp )
Substituting for (1−log(tp )) we get
(α − 1)T
dtp T−
=− α or
dα αlog(tp )
dtp T
=− 2 .
dα α log(tp )
Provided that the initial solution has tp > 1 so that log(tp ) > 0, this implies dtp /dα < 0. Therefore,
the time devoted to production is reduced as α increases. α can be interpreted to measure how

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 successful the theft was, the higher the value of α the more you are able to steal.

(c) If there is no theft tp = T .

(d) The maximum amount V that one would be willing to pay to avoid theft is the difference in payoffs
with and without theft, that is
 
α(T − tp ) α(T − tp )
V = plog(T ) − 1 − plog(tp ) − plog(tp )
T T

 )−
= plog(T  plog(tp )
T
= plog .
tp

4. (a) Provide a graphical two-commodity (one private good and one public good) example of a preference
relation generating an income elasticity of the demand for public good greater than one.
(b) Show that in this case the fraction of the budget spent on the public good increases as income in-
creases. (Assume that the price of the public good is 1.)

Solution:
5. (a) Assuming a constant price of the private good, give a graphical illustration of a preference relation
generating a price elasticity of demand for a public good that is less than one in absolute value.
(b) Show that in this case the fraction of the budget spent on the public good increases as the (relative)
price of public good increases
Solution:
6. Assume the rental rate for capital is fixed at r. The private sector is competitive and has a production
1 1
function y = K 2 {tL} 2 and sells the output at a price p at zero profits. What happens to the wage rate as
technical progress increases t? What would happen if r were not fixed? Relate your answer to Baumol’s
law.

Solution:
7. Consider a simplified setting for Baumol’s law where there is no capital. Let the private sector have the
production technology y p = tL where L is the labour input and t denotes exogenous technical progress
that occurs as time passes.
(a) With output price p, use the condition of zero profit at the competitive equilibrium to determine the
wage rate.
(b) Calculate the cost function for the firm.
(c) Let the public sector have production function y g = L. Show that the ratio of marginal costs in the
two sectors grows at the rate t.
(d) Find the equilibrium path for the economy if it has a single consumer with preferences given bt
U =log(y p )+log(y g ) who can supply one unit of labour in each time period. Comment on the rela-
tive size of the public sector. (Assume marginal cost pricing.)

Solution:
8. (a) For the inverse demand function p = a − by and cost function C(y) = cy, contrast the output choices
of a profit- maximising monopolist, an output maximising monopolist, and a revenue-maximising
monopolist. Can you use this exercise to decide which is the best description of the public sector?

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(b) Now let the number of members in a profession be n. Given a fixed price p for output, and a cost
function C(y)
n , can you determine the values of y and n that maximise per capita profit? What are
the efficient values of y and n?

Solution:

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