Microeconomics (Requires Graphing Expertise and M.S. in Economics)

1. Assume a government is planning to finance a large expansion of a national defense program. However, the government is loathe to raise taxes due to election consequences. It needs to decide now on whether or not to go through with the plan. It needs to raise taxes 1 year from now in order to finance this expansion which will yield benefits 2 years from now. Using behavioral economics, briefly describe the factors that the government considers in making its decision, and if it will credibly follow through with its plans a year from now.

2. An individual has $25000 a year that they can spend on liters of soda and all other goods. The price of liter of soda is $2. The individual optimizes at 500 liters of soda. Assume regular convex preferences throughout the question, and that both liters of soda and dollars spent on all other goods are normal.

(a) Draw the initial conditions, including the intercepts, slope, and indifference curve through the optimal point that you label.

(b) The government comes up with an interesting policy. It taxes soda at 10 cents per liter. However, it also rebates the individual $50 cash. Illustrate this situation on a diagram with part (a) included. Include the intercepts, slope, and indifference curve through the optimal point in part (a).

(c) What happens to soda consumption with this plan and why?

3. An individual has $100000 in income now, but no income in the future. The current interest rate is 5%. We observe that the individual consumes $50000 now and will consume $52500 in the future. Assume preferences satisfy our usual assumptions (convex, continuous, etc) and that consumption now and in the future are normal goods.
4. Illustrate the situation above, making sure that you label the intercepts, slope, and point of consumption (with an indifference curve through it).
5. Briefly evaluate and explain the following statement: “A fall in interest rates will decrease savings.” Please use a graph as part of the explanation.
6. Now assume that the individual has $50000 in income now and $52500 in income in the future. You see that the individual does not lend or borrow at the current 5% interest rate. Briefly evaluate and explain the following statement: “A fall in interest rates will induce borrowing.” Please use a graph as part of the explanation.

4. There are 3 firms that pollute in a certain town. Firm A emits 70 units of pollution, and its cost of reducing pollution by 1 unit is $20. Firm B emits 80 units of pollution, and its cost of reducing pollution by 1 unit is $25. Firm C emits 50 units of pollution, and its cost of reducing pollution by 1 unit is $10. The government wants to reduce pollution to 120 units total. It gives each firm 40 pollution permits, and each permit allows 1 for unit of pollution to be produced.
5. If the permits are not allowed to be traded, what will be total cost of pollution reduction.
6. If the permits are allowed to be traded, what firm(s) will sell and what firm(s) will buy permits. What possible prices would the permits be sold/bought for? What will be the total cost of pollution reduction (noting that any transaction between firms will be net gain/loss of 0 for all firms).