Intermediate Microeconomics Main Coursework

Targeted Subsidies vs. Monetary Payments

The answers do not need an introduction or conclusion. Simply state each question followed by an answer.

The answers should contain three ingredients: relevant diagrams; explanation in your own words; relevant mathematical expressions.

A key ingredient of a successful answer is that it has explained accurately the economic logic involved. Refer to the diagram(s) and say what they show.

You do not need to read more widely than the core textbook (Varian Intermediate Economics). The point of the exercise is to show you understand the analysis. It helps, however, to use real world illustrations to show personal understanding.

Again, if you have any questions please contact me. If I cannot answer your question by email then we can arrange to meet. Alternatively, you can make an appointment – see the appointment process on the Moodle site for the module.

All page numbers below refer to the Varian text (ninth edition – earlier editions contain same info but different pagination. Ask me if you need help finding the material in an earlier edition). 

1. Are targeted subsidies (such as food stamps) better for individuals than monetary payments? (20)

Guidance

See pp. 26-31. This gives the relevant kind of budget constraint. You should introduce indifference curves to show and compare optimal bundles under the different scenarios.

A monetary payment scheme is not shown in the Varian text but impacts the budget constraint in the same way as an increase in income. Compare the budget sets under the two policies.

Consider alternative types of preference and how this might change your view of which is best. Consider Cobb-Douglas, perfect substitute, perfect complement and quasi-linear preferences.

For Cobb Douglas preferences change the parameters. For perfect substitutes change the coefficients – how does these changes affect your answer as to which is the best policy? For perfect substitutes see, for example, pp. 79-80 (and fig. 5.5).

2. Is a quantity tax better than an income tax? Explain your answer. (20)

Guidance

Varian pp. 88-90. In your own words reconstruct the analysis in detail to show that you understand it. There is no need here to experiment with different types of preferences – you can use ‘well-behaved’ preferences. But do say why we are assuming strict convexity (as a technical assumption in the analysis).

3. Distinguish carefully, using appropriate diagrams, between the income effect and the substitution effect following a change in the price of a good. (20)

Guidance

Varian pp. 137-149. Again, the point is to demonstrate understanding through detailed explanation in your own words. Take the reader through the inferior and Giffen cases. Use the mathematical expression and say what each term in the expression means. The derivation of the Slutsky equation using calculus (in the appendix to Ch8) should be included if possible – pp. 158-159

4. A way to reduce carbon emissions is to put a carbon tax on petrol and compensate people fully by increasing income through a tax rebate. Using the logic of the Slutsky identity discuss the likely effects of this policy. (40)

Guidance

Varian pp. 149-152. Reconstruct the analysis in the Varian text. Also show the case in which all of the income effect is compensated for (Varian only compensates for the value of the tax). Apply the reasoning to the case of a carbon tax on petrol. Some background on why such a tax is important would be helpful here.