ECO 4554

Economics of State and Local Government

Study/Test Questions
Topic 1: Microeconomic Analysis of the Public Sector

These questions are designed as study questions to enhance your economic knowledge and your
analytical skills. I will also use them as test questions. Because you have the questions in advance, I
expect your answers on the tests to be well-organized, clear, coherent, and concise. You might write
trial answers to each question in advance, or at the very least, outline the answers. You may not bring
any written materials to the test, but if you’ve prepared answers in advance, you can immediately
begin writing and still write competent and thorough answers.

Feel free to consult one another on the questions. In fact, I strongly encourage you to discuss the
questions with one another. No matter how confident you are of your knowledge, your command of
the material and your preparation for the test can be enhanced by sharing your knowledge. Do not,
however, simply rely on your fellow students to provide you with the answers. When the time for the
test comes, you will be on your own.

Although in most cases, the questions do not specifically request that you illustrate your answer with
an appropriate diagram, diagrams are usually quite helpful both in undertaking the analysis and in
illustrating and explaining your answer. I expect you to know the relevant diagrams, to use them, and
to interpret them. I encourage you to include them in your answers.

1-1. For each item below, define the term or state the theorem or explain the concept.

• Economic efficiency
• Externalities
• Increasing returns to scale
• Private (or individual consumption) good
• Public (or collective consumption) good
• Free rider problem
• Lindahl equilibrium

1-2. Based on the data in Fisher, Chapter 1, how does the state-local sector in your state compare to
the “national average” in terms of (1) the structure of localities, (2) the level of expenditure, (3)
the pattern of services provided, and (4) the mix of revenue sources? Can you suggest reasons
why your state might differ from the national average.

1-3. (Core Principle) Assume there are no externalities, no increasing returns to scale, and no
collective consumption goods. Prove that the competitive equilibrium quantity is also the
efficient quantity.

1-4. (Core Principle) Competitive markets may fail to supply the efficient quantity of a good or
service in each of the following settings. For each one, explain how and why competitive
markets may fail.

a. Provision of the good or service is characterized by increasing returns to scale. [Illustrate

your explanation with a diagram. Show consumers’ demand (D), supplier’s average total
cost (ATC) and marginal cost (MC), the efficient quantity (Q*), and the competitive
equilibrium quantity (Q’). Explain in your answer how the diagram illustrates increasing
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 ECO 4554: Economics of State and Local Government
Study/Test Questions: Topic 1

returns to scale and why the efficient quantity is not also the competitive equilibrium
quantity.]

b. The good or service either confers external benefits (a positive externality) or imposes
external costs (a negative externality) on third parties. [Illustrate your explanation with
two diagrams, one for external benefits and one for external costs. For the positive
externality, show marginal social benefit (MSB), marginal private benefit (MB), and
marginal cost (MC). Remember that marginal social cost and marginal private cost are
the same thing when there are no external costs. For the negative externality, show
marginal social cost (MSC), marginal private cost (MC), and marginal benefit (MB).
Remember that marginal social benefit and marginal private benefit are the same thing
when there are no external costs. On each diagram, show the efficient quantity (Q*), and
the competitive equilibrium quantity (Q’).]

c. The good or service is a public or collective consumption good. [In this case, explain why
the market equilibrium quantity is inefficient both when non-payers are excluded from
consumption of the good (the market model) and when they are not excluded (the
voluntary contributions model)].

1-5. Explain what is meant by “the government model” for supplying a public good or service. What
are three reasons that the government model does not necessarily supply the socially efficient
quantity of a public good?

1-6. Suppose the university is considering building new parking facilities on campus. The table
below shows the marginal benefit to students, to faculty and staff, and to visitors for one to five
new facilities. The table also shows the marginal cost to build the facilities.

Number of Marginal Benefits Marginal

New Facilities Costs
Students Faculty and Visitors
Staff
1 $75,000 $40,000 $20,000 $30,000
2 60,000 35,000 15,000 40,000
3 45,000 30,000 10,000 50,000
4 30,000 25,000 5,000 60,000
5 15,000 20,000 0 70,000

Note that the table shows marginal benefits and marginal costs. The marginal benefit to
students from having a third new facility instead of just two is $45,000. The total benefit from
three new facilities is $180,000 (sum of MB of first facility, marginal benefit of second facility,
and marginal benefit of third facility). The marginal cost of a third facility is $50,000, but the
total cost to build all three new facilities is $120,000.

a. Assume that the facilities will not be completely full so that students, faculty and staff,
and visitors can use them simultaneously. Therefore, the parking facilities are public
goods. Draw the marginal benefit curves for each of the three groups (MBS, MBF, MBV).
From the individual marginal benefit curves, derive the aggregate or social marginal
benefit curve (MSB). Finally, draw the marginal cost curve (MC). What is the efficient
number of new parking facilities? If the university builds this number of facilities, how

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 ECO 4554: Economics of State and Local Government
Study/Test Questions: Topic 1

should the costs be divided among the three groups; that is, what share of the costs should
each group pay?

b. Suppose the data are as follows:

Number of Marginal Benefits Marginal

New Facilities Costs
Students Faculty and Visitors
Staff
1 $75,000 $45,000 $15,000 $30,000
2 60,000 40,000 10,000 40,000
3 45,000 35,000 5,000 50,000
4 30,000 30,000 0 60,000
5 15,000 25,000 0 70,000

Does this change the efficient quantity? Does it change the appropriate distribution of the
cost shares among the three groups? Explain.