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Various Questions on Microeconomic Theory

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1. Country A is a country that produces a variety of goods and services. Considering the policies/events listed below, how might country's A production possibilities frontier change (ie shift out or in)?

a. The government deregulates industries.
b. The government increases military spending.
c. The government increases taxes collected from business.
d. Public schools decrease college tuition.
e. OPEC oil embargo.

2. Define the term market failure. What can lead to market failure?

3. The following table shows the marginal private cost (MPC) and the marginal social cost (MSC) of a chemical factory.

Tons of Chemicals MPC MSC
1 100 120
2 110 130
3 120 140
4 130 150
5 140 160

a) What is the marginal cost of the factory's externality? Is it constant at all quantities?

b) If the factory is a perfectly competitive firm and is not required by the government to internalize its external cost, how many tons should the factory produce, given that the market price of a ton of chemicals is
$130?

c) If the factory is a perfectly competitive firm and is required by the government to internalize its external cost, how many tons should the factory produce, given that the market price of a ton of chemicals is
$130?

4. What is the difference between a negative and a positive externality? Give an example of each.

5. What is a government failure? List four reasons why it might occur.

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Solution Preview

1. The production possibilities frontier is the boundary of what can and what cannot be produced. We have something called the production function that can help us determine what will happen to the PPF depending on what you do with the factors of production. The production function is defined to be

y = f (L, K, T)

Besides this we also have an impact of natural resources. Anything that raises either L, K, T, or the available natural resources will expand the PPF, while anything that reduces them will shrink the PPF. We will consider each of the given points based on this idea.

(a) The government deregulates industry: Deregulation is expected to spur investment. This will increase available capital in the country. An increment in K will translate into higher production and hence the PPF will shift out.

(b) The government increases military spending: Government spending is generally expected to have an uncertain impact on the economy. It is expected to help the economy grow, but if it becomes too large it may hurt the growth of the economy by hurting the private sector incentive mechanism. So depending on where the earlier spending was it might be a good or bad thing for the PPF. For more see http://www.heritage.org/research/budget/bg1831.cfm.

(c) The government increases tax collection: With higher taxes people have lower incentive to work, and are more inclined to look for ways to avoid that tax. Even though government spending has the possibility of rising, but as we saw earlier this might not be such a ...

Solution Summary

The set consists of 5 questions on PPF, externality, economic growth, market failure and government failure. It shows how the PPF expands in response to a terror attack, what externalities mean, how they influence the market outcome and when should the government intervene in the market.

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