Problem Set 1

Due Sunday, February 11th, 11:59pm

Q1 (25 pts, 5 pts each)

The Leon?ef preference illustrates the case where commodi?es are perfect complements.
The u?lity func?on is:
U(x, y) = min(x, y)
In this equa?on:

• U represents the total u?lity derived from consuming a combina?on of goods.

• x and y represent the quan??es of different goods consumed.
Consider a scenario where a pa?ent with a specific medical condi?on requires two types of
medica?ons. For example, a pa?ent might need one unit of Medica?on A and one unit of
Medica?on B for each treatment to be effec?ve. In this case, if the pa?ent doesn't have the
required 1:1 propor?on of both medica?ons, they won't experience any therapeu?c benefit.
In this example, the actual u?lity the pa?ent can obtain is determined by whichever is
smaller: the quan?ty of Medica?on A or Medica?on B, irrespec?ve of the quan?ty of the
other medica?on.
Addi?onal examples of perfect complementary goods include hot dogs and hot dog buns,
leS-foot shoes and right-foot shoes, as well as leS-hand gloves and right-hand gloves, among
others.
Suppose that goods X and Y form a set of perfect complements. The indifference curves can
be depicted as:
Good Y

U2

U1

U0

Good X
 a) Assume Income = $12, the price of good X is $2, and the price of good Y is $1. Write
the equa?on for the budget constraint. Create a graph to illustrate the op?mal
consump?on bundle. How many units of X does the consumer plan to purchase?
b) The government has implemented a subsidy for the consump?on of good X,
providing a $1 subsidy for each unit of X consumed, resul?ng in a new price of px =
$1. Write the equa?on for the updated budget constraint. Display the new op?mal
consump?on bundle on your graph. How many units of X does the consumer intend
to purchase with the subsidy?
c) Present the Hicksian decomposi?on on your graph. Annotate and calculate the
subs?tu?on effect and income effect.
d) On the graph, indicate the compensa?ng varia?on (CV) and equivalent varia?on (EV),
and compute the numerical values for both.
e) If the government opts not to subsidize the consump?on of X but instead provides
consumers with an equivalent amount of money equal to its expenditure on the
subsidy, will there be a difference in the outcome? Why?

Q2 (25 pts, 5 pts each)

The Singaporean government announced last year that it would provide public
transporta?on subsidy vouchers to households with a monthly per capita income not
exceeding 1,600 Singapore dollars. Each voucher is worth a certain amount and can be used
to purchase monthly passes or top up transporta?on cards.
Public transporta?on is considered an inferior good for high-income households but a
normal good for low-income households.
a) Illustrate the impact of the public transporta?on subsidy on low-income households.
The graph represen?ng the "indifference curve-budget constraint" should include the
following elements: the op?mal consump?on bundles for low-income households
before and aSer the subsidy, compensa?ng varia?on (CV), and equivalent varia?on
(EV). You do not have to include any specific number.
b) On the "price-quan?ty" graph, draw the Marshallian demand curve and two Hicksian
demand curves for low-income households. Discuss the rela?ve magnitudes of CV,
EV, and ∆CS.
c) If you were to jus?fy the necessity of this subsidy policy, which measurement of the
change in consumers’ benefits would you choose: CV, EV, or ∆CS? Why?
d) Even though this is not a non-market environment, use the language of WTP/WTA to
interpret the measurement you chose.
e) Consider the poorest within low-income households, can the measurement you
selected beher jus?fy the necessity of the policy? Why?
Q3 (15 pts)
In Taiwan, whether or not to use nuclear power has sparked long-standing debates. People
are not only concerned about the environmental pollu?on caused by nuclear power
genera?on in daily life but also worried about the poten?al catastrophic disasters that could
result from extreme events affec?ng nuclear power plants, as seen in the Fukushima
incident in Japan.
a) (5 pts) Considering the nega?ve externali?es associated with nuclear power
produc?on, use supply, demand, and SMC (Social Marginal Cost) to create a graph
illustra?ng the market failure resul?ng from the use of nuclear power. On your graph,
indicate the deadweight loss. (Please bear in mind that having more nuclear power
plants implies a higher likelihood of exposure to risks from extreme events, so the
SMC curve should not be parallel to the supply curve.)
b) (10 pts) Given the uncertainty associated with evalua?ng the MCA of nuclear power
producers, would the government be more inclined to use the price instrument
(Pigouvian taxes) or the quan?ty instrument (regula?on) to address the nega?ve
externali?es of nuclear power? Explain your answer with a graph and point out the
key factor influencing your answer.

Q4 (35 pts, 5 pts each)

Consider two plants, M and N, both of which emit carbon. The two plants have the following
marginal benefit of pollu?on (MBP) schedules.
𝑀𝐵𝑃! = 10 − 0.25 ⋅ 𝑒!
𝑀𝐵𝑃" = 8 − 0.2 ⋅ 𝑒"
Where 𝑒 represents the quan?ty of emissions.
a) What are the quan??es of emissions for each plant without any government
interven?on?
b) The marginal damage of emissions is MD=4. What are the socially op?mal emission
levels for each plant?
c) To correct the nega?ve externali?es with a Pigouvian tax, how much should the tax
be per unit of emissions to incen?vize both plants to produce at the socially op?mal
level? What would be the total emission level under this tax?
d) Alterna?vely, if the government aims to achieve the same goal as in (c) using a cap-
and-trade system instead of a tax. Each plant would be given the same number of
permits, and each permit would allow a plant to emit one unit of carbon. How many
permits should each plant ini?ally receive?
e) What would be the equilibrium price of a permit? Which plant would be the buyer,
and which one would be the seller? How many permits would the buyer purchase
from the seller?
f) Create a cap-and-trade graph to illustrate your answers for (d) and (e).
g) *Suppose there are transac?on costs associated with permit trading, with each
transac?on incurring an addi?onal cost of $2, borne only by plant M. On the graph
from part (f), depict how these transac?on costs impact the outcome of the cap-and-
trade system.