ECO 225 @ Davidson
Review II Practice
Prof. Nungsari
Instructions and Rules:
• Review II is a timed (3-hour), take-home, closed book exam with 6 short answer questions. You
may use a calculator.
• Review II will be handed in class on Tuesday, 12/1 and will be due on Thursday, 12/3 in class.
• Review II will cover the following chapters: Ch. 11 (Education), Ch. 12 (Social Insurance), Ch. 13
(Social Security), Ch. 17 (Income Distribution and Welfare Programs), and Ch. 15 (Health
Economics I).
Practice Questions
1. Suppose that a family with one child has $20, 000 per year to spend on private goods and
education, and further suppose that all education is privately provided. Draw this family’s budget
constraint. Suppose now that an option of free public education with spending of $4, 000 per pupil
is introduced to this family. Draw three different indifference curves corresponding to the following
three situations: (a) a free public education would increase the amount of money that is spent on
the child’s education; (b) a free public education would decrease the amount of money that is spent
on the child’s education; and (c) a free public education would not affect the amount of money
spent on the child’s education.
Solutions:
The family with indifference curves labeled (a) was consuming very little education prior to the
introduction of the public education program (A). When the public education program is
introduced, they move into the public education system; their consumption of education increases
to $4, 000 and their consumption of other goods goes up to $20, 000. The family with indifference
curves (b) was consuming slightly more than $4, 000 in education prior to the introduction of public
education (B). When the system is introduced, this family also moves into the public education
system. The move involves a reduction in their education spending, but the large increase in their
spending on other goods (since they no longer have to pay for the education out of pocket) more
than compensates them, and they are better off. Finally, the family with indifference curve (c) is
unaffected by the introduction of public education. They value education highly enough that the
increase in non-education spending they could achieve by switching to the new public education
system is not enough to compensate them for the reduction in spending from C to $4, 000. (Note:
Another less interesting but possible answer to (c) is a family that happened to consume exactly
$4, 000 eprior to public education.)
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ECO 225 @ Davidson
Review II Practice
Prof. Nungsari
2. Senator Deal proposes to offer a choice to future retirees: if you retire before age 70, the benefits
are calculated on the last 35 years of income; if you retire at age 73, however, you receive benefits
calculated on only the last 15 years of income. Which option are high-income workers likely to
choose? Low-income workers? Why?
Solutions: A high-income worker may not benefit by much if he delays retirement until age 73, and
he would lose three years of benefits. He is likely to choose the earlier retirement age. Assuming no
major work interruptions, which is perhaps a more reasonable assumption for a high-wage earner
than a low-wage earner, his benefits will be calculated based on his wage since he was in his
mid-thirties. These are likely to be fairly-high-earning years, as they begin a decade after a person
would have completed his education. Because of the regressive nature of benefit calculations, the
higher wages of the last 15 years would yield a low marginal benefit. High-wage earners are also
better able to save for retirement in other ways, so they may be able to afford retiring three years
earlier.
Low-wage earners will be more likely to delay retirement until age 73. They would lose three years
of benefits, but their benefits, once they do retire, will be higher if their income is higher in the last
15 years of work. This option will be particularly attractive if these workers had some low or
zero-earning years over the course of their working lives. In addition, calculated benefits are a higher
percent of average monthly wage for these workers, so they stand to lose less by working more years.
3. Redo Problem 2 on Problem Set 5 and make sure you understand the example on asymmetric
information from the textbook (pages 329-331).
4. Catastrophic injuries and illnesses account for two-thirds of total health care costs in the country of
Gnut. The Gnuti government is deciding between two different universal health insurance
programs: program X would pay for two-thirds of any health care expense that a Gnuti citizen
incurred, while program Y would pay only for catastrophic illnesses and injuries, but would cover
100% of those costs. Which program is likely to better allow Gnuti citizens to smooth
consumption? Which program is likely to cost the Gnuti government less? Explain your answers.
Solutions: Coverage of 100% of the costs of catastrophic illnesses and injuries would be more
effective at smoothing consumption, because catastrophic losses are the most difficult to save for or
to self-insure against. Routine and nonemergency medical expenses do not present a
consumption-smoothing problem; they are, by definition, expenses that tend to occur fairly
regularly. In addition, the catastrophic coverage would probably be less expensive for the Gnuti
government. If there were no behavioral response to either policy, the two policies would have equal
costs: the catastrophic plan would cover 100% of all expenditures for catastrophic illnesses and
injuries, while the other plan would cover two-thirds of all costs. However, covering routine health
care costs would tend to increase utilization by more than covering catastrophic costs since
spending for non-life-threatening events is more price-elastic.
5. Suppose that currently the government provides everyone with a guaranteed income of $12, 000 per
year, but this benefit level is reduced by $1 for each $1 of work income. The government is
considering changing this policy so that the benefit level is reduced by $1 for every $2 of work
income. What effect would this policy have on work effort? Explain your answer.
Solutions: A dollar-for-dollar reduction in benefits is essentially a 100% tax rate, surely a
substantial deterrent to working for many people. No worker who values leisure would ever take a
job earning less than $12, 000, since his effective wage is zero in that range. Similarly, it is unlikely
that a worker would ever choose to earn slightly more than $12, 000 since it would require
substantial effort but increase his take-home pay to only slightly above the government guarantee.
Hence, the government guarantee and the $1 for $1 benefit reduction system will lead to many
potential workers choosing to supply no work effort. The new system will encourage these workers
to increase their work effort by effectively reducing their tax rate by 50%.
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ECO 225 @ Davidson
Review II Practice
Prof. Nungsari
The policy change will discourage the work effort of other workers. For workers who earned
between $12, 000 and $24, 000 under the $1 for $1 reduction system, for example, the policy change
will have two effects, both of which tend to reduce their effort. First, there is an income effect:
these workers used to receive no support from the government, since the benefit reduction phased
out at $12, 000 in earned income. After the policy change, the benefit reduction doesn’t phase out
until $24, 000. Hence, these workers begin to receive some government support after the policy
change, increasing their total income. Since they value leisure, this income effect will lead them to
reduce their work effort. Furthermore, because they now find themselves in the phase-out region,
their effective tax rate increases to 50% (from 0%) under the policy change. This substitution effect
also leads them to reduce work effort.
Furthermore, workers who earned slightly more than $24, 000 before the policy change may also be
induced to reduce–but never to increase–their work effort: the slower phaseout makes earning
amounts between $12, 000 and $24, 000 more appealing. For example, a worker earning $25, 000
under the old system could reduce pretax earnings to $23, 000 and would now receive $500 in
government support, making the reduction in work effort more appealing.
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