### The Honors Class, Part I

Each year, the economics department at Oberlin College invites an outside examiner to determine who among its top graduating seniors should receive an honors degree. Last spring, I was that outside examiner. The seven candidates had several hours to complete a written exam (which I wrote), and then a few weeks later, I interviewed each of them face to face.

I thought my readers here might be interested in seeing the written exam. It’s by no means comprehensive; entire areas of economics are omitted. Instead, it’s supposed to test core material and ways of thinking that I believe should mostly be second nature to any top economics graduate.

Where necessary, I’ve translated some of these questions from the original economese to something approximating English. Occasionally, a little has been lost in the translation, but not, I think, too much.

There were ten questions on the exam. I’ll post five today and the remaining five next week.

Here, then, is Part I:

Question 1. When the price of peanuts rises, Frieda reduces her root beer consumption. If Frieda’s income rises, will her root beer consumption go up or down?

Question 2. Bananas cost \$6 apiece, except for members of the banana club, who pay \$2 apiece.

• Given full knowledge of Thomas’s prefereces, explain how you’d compute his willingness to pay for a membership in the banana club.
• Given knowledge only of Thomas’s demand curve for bananas, explain how you’d estimate his willingness to pay for a membership in the banana club.
• Under what circumstances is your estimate an overestimate? Under what circumstances is it an underestimate?

Question 3. Snidely Whiplash owns all the grocery stores and all the houses in the Yukon Territory. He charges a competitive price for groceries, and rents the houses at the highest price residents (who are all identical) are willing to pay. (If he charged any more, they’d all leave town). True or False: If Snidely raises the price of groceries, he’ll have to lower the price of housing, so he’ll be no better off than before.

Question 4. Discuss the consequences for economic efficiency of giving your father a Barnes and Noble gift card, under various assumptions about how he uses (or doesn’t use) the card.

Question 5. Rank these taxes in order of how much you’d dislike paying them:

• A tax on consumption
• A tax on wages
• A tax on income (including wages, interest and dividends)

Assume that the tax rates are adjusted so that your total tax bill is the same in each case.

(Edited to add): At the request of a reader, I’ve also posted the questions in the orginal economese.

#### 62 Responses to “The Honors Class, Part I”

1. 1 1 someone

For non economists like me who anyhow feels competent to answer those questions, it would be very interersting to read the answers you got from seniors and/or your (correct :-) answer!

2. 2 2 Douglas Bennett

1) When Freida’s income increases, her consumption of root beer will go up, because for her it is a normal good (the reduction in root beer consumption when the price of peanuts increased implies that her root beer consumption fell due to the negative income effect of the peanut price change, making it a normal good(unless root beer and peanuts are such strong complements to Freida that the resulting substitution effect dominated the income effect on her root beer consumption, in which case root beer could be an inferior good for her)).

3) True. If he extracts more consumer surplus from the residents via groceries, he must extract less via rent or they will leave town.

4) If your father uses the card, economic efficiency has suffered due to the transaction costs involved in you obtaining the card and giving it to your father. If he does not use the card, the same transaction costs are still incurred. Beyond that, if your father uses the card to purchase something from Barnes and Noble that he would not have otherwise purchased, he has gained that amount, but Barnes and Noble has lost the amount of the gift card. If your father values his purchase at or above the amount spent on the card, economic efficiency is improved. If your father values that good at less than the amount of the card, economic efficiency is reduced, since it cost Barnes and Noble more than he gained from it. However, in this last scenario, he should just sell the card to someone who will use it to purchase something from Barnes and Noble that is worth more to them than the amount on the card, thereby increasing economic efficiency by the difference between that person’s value and the amount on the card, less the transaction costs involved in the resale of the card.

-For simplicity, this answer assumes whatever good is purchased at Barnes and Noble is priced at exactly the amount on the card, and taxes are completely ignored (taxes might not change anything, but I don’t want to think about them right now).

I need to think longer about Question 5, and I’ve answered too many questions related to Question 2 in the past few days.

My first reaction for 5 is All income, wages, consumption, (starting with most disliked) but I don’t have any reason behind it.

3. 3 3 Snorri Godhi

We are supposed to answer, aren’t we? I’ll go first, since I am in a favorable time zone.

1. Why is she consuming less root beer when the price of peanuts goes up? is it because she drinks root beer while eating peanuts, or because her demand for root beer is more elastic than that for peanuts?

In either case, one cannot extrapolate from a decrease to an increase in the amount of money available for root beer. Extrapolation would imply an increase in root beer consumption, but root beer and peanuts might be Griffin goods. Although Warren Buffett still drinks Diet Coke.

2. If I had several hours, I’d try to figure this out. The middle part should not be difficult.

3. True.

4. See my answer to [2]; except that there is no middle part here.

5. The rank is the inverse of that given in the question: I’d dislike least of all a consumption tax, most of all a tax on all income.
I cannot motivate it based on economics, at least not on the spot; but the question is about my personal taste, and I feel that the tax system should encourage bourgeois virtues such as hard work, thrift, education, and personal responsibility. WRT to this question, only thrift is relevant. To encourage hard work, I might consider adding a tax on wealth — as long as it is applied only to people who are at least 10 times as wealthy as I am. (I might want this threshold to rise if and when I become much richer). I might like even more a Georgian tax on land.

4. 4 4 Snorri Godhi

PS: actually, the main reason why I would personally be happier if I were taxed on consumption is that I would have some control on how much tax I pay: I could eat peanuts and drink root beer to pay less taxes. I would not, but it would make me happy to know that I could.

5. 5 5 Douglas

I would like, if possible, that you also posted the exam as it was given (that is, in “economese”), so we that (at least should) understand that “language” can have a look!

6. 6 6 Steve Landsburg

Douglas: Your wish is my command.

7. 7 7 Ben

Question 5. Rank these taxes in order of how much you’d dislike paying them:

•A tax on consumption
•A tax on wages
•A tax on income (including wages, interest and dividends)
Assume that the tax rates are adjusted so that your total tax bill is the same in each case.

Does the consumption tax cover the essentials of life?
Does the income/wage tax have a deductible large enough to cover the essentials of life?

8. 8 8 Steve Landsburg

Ben: Feel free to expand the question by listing, say, an income tax with and without a deductibe.

9. 9 9 Dave

Surely question 5′s answer is that you should be indifferent if your total tax bill is unchanged? I’m hoping that the stark obviousness of this answer to me means that I’m somewhat closer (say 2% there) to thinking like an economist after all these years of reading Prof Landsburg’s work….

am I missing something?

10. 10 10 Steve Landsburg

Dave: To see that your total tax bill is not the whole story, consider this extreme example:

Tax Plan A is: No taxes.

Tax Plan B is: You pay \$100,000 every time you watch television. Of course, with this tax in place, you choose never to watch television.

In both cases, your total tax bill is zero. But if you like watching television, Plan A is preferable to Plan B.

11. 11 11 Dave

The way I understood the question was that the absolute dollar amount of tax you pay is pre-determined and completely unaffected by your actions. Isn’t that the only way to interpret “assume that the tax rates are adjusted so that your total tax bill is the same in each case”?

So IRS determines that I wil be paying \$10,000 this year no matter what.

So in your scenario, I watch TV once and get a \$100,000 bill but get a \$90,000 income tax refund.

Why should I care?

12. 12 12 Steve Landsburg

Dave: Suppose the IRS has decided that your total tax bill will be zero this year no matter what. They can accomplish that with Plan A (no taxes) or with Plan B (\$100,000 per TV viewing, knowing that you will in that case choose no TV viewings). Both plans collect the same revenue, but you do care which one they choose.

In other words: Yes, your tax bill is predetermined. No, it’s not independent of your actions. The tax rate is determined in a way that takes your actions into account.

A consumption tax, by definition, is affected by how much you consume; a wage tax is affected by how much you earn, etc.

13. 13 13 Snorri Godhi

Yes, your tax bill is predetermined. No, it’s not independent of your actions. The tax rate is determined in a way that takes your actions into account.

Is there also the implicit assumption that one will not want to leave any inheritance — or that inheritance taxes are 100%?

I still like my answer, anyway: I see that different taxation regimes might lead to different levels of my economic welfare, but I care more about having control over my life for the sake of it; and about bourgeois virtues. (If different taxation regimes lead to different rates of economic growth, that’s another matter.)

14. 14 14 Dave

I think I’m missing something.
If they pre-determined that I would pay \$0 in taxes, any tax I pay will be refunded.

In fact, in that scenario, I would choose to watch alot more TV – mainly because I LOVE collecting tax refunds…more that I hate paying consumption tax (possibly because I have now had 32 years of being accustomed to it but that’s beside the point).

Please feel free to ignore my response – I may be stuck in my “Landsburg disagreement” mode which I’ve often found I turn around on after time.

15. 15 15 Warren Wimmer

Question number three indicates that there is an inelasticity of demand for housing but the elasticity of demand for food is not determined. Consequently, it seems that raising the price of food could lead to more or less consumption or substitution. As the question does not posit that food consumption/demand is inelastic, the door is opened for total increased revenue to the monopolist.

16. 16 16 Snorri Godhi

A sketch of an answer to question 4:
If I give my father a \$20 gift card, he will, at best, use it to buy books that he would have been willing to pay \$20 for; that is, he is better off at most by \$20.
But if I had given \$20 in cash, he would have been better off by exactly \$20; so the gift card is sub-optimal.

However, a gift card is no worse, and probably better, than buying a book for \$20, because he might value this book less than another book (or non-integer amount of books) that he could have had for the same amount of money.

17. 17 17 maurile

1) Not enough information. Frieda may be long on peanut futures, making root beer an inferior good to her.

18. 18 18 maurile

Number three is a lot like movie popcorn.

19. 19 19 Louis Friedel

SL, great questions…some curious responses though.

First of all (or perhaps last of all), why the heck would people rather a wage tax than a tax on all income, assuming the same amount of taxes in each case? The wage tax is taken out day 1 and the income tax on the dividends and interest is taken out in the future! The difference is pretty clear if you just look at the existence of 401Ks…better to have your gains taxed later than your wages taxed today!!! If you prefer the wage tax I am guessing you would not contribute to a 401K assuming no employer matching and the same tax rate for wages and capital gains? That’s silly.

The only advantage to gift cards is due to the fact that this world is populated with enough people that think cash is an unthoughtful gift and gain more utility from the assumption that you spent hours upon hours pining over what store the recipient would prefer to receive a gift card from.

And finally, with regards to #1…Douglas, how do you know it will go up? What if the increase in her income now allows her to afford a more expensive drink that she prefers to root beer? If a hobo gets a job does he drink more or fewer 40′s of Colt 45? That’s a much different question than the change in the number of Patron shots 50 Cent takes after a new hit record.

20. 20 20 Jim

There are other grocery stores.
If he raises all prices to infinity, he’s not better off (unless he was running a loss. But people don’t have to leave town, they can shop elsewhere and maybe diet.

21. 21 21 Bryan

Here is the answer to 3):

Let’s first define 2 quantities. Let C be the utility a resident gets from living in the next best city. Let S be the surplus each resident gains from buying groceries at the competitive price. Since the resident’s gain no surplus from housing, we also know that S is the total utility enjoyed from living in Yukon Territory. Further, because all of these residents currently live in Yukon, we know S>C (if C<S they would live elswhere).

Given this, Snidely can raise the price of groceries to the price where consumer surplus is equal to C less epsilon (i.e the price that makes the residents just better off than they would be elsewhere). Unless, of course, this price is greater than the Monopolist's price. In that case, he will simply raise the price to the Monopolist's price.

Prof Landsburg?

22. 22 22 Bryan

Small error in my answer: I meant C PLUS epsilon in the last paragraph.

23. 23 23 Steve Landsburg

Bryan (and others): I am not ignoring your call for feedback, but I’m holding off for a few days in case others want to think about this. I promise to come back to it in a post before the end of next week.

24. 24 24 Sierra Black

Dave,

I am not an economist by any stretch of the imagination, but it seems to me that paying taxes on consumption is better than paying taxes on income because you want to keep the money you earn with you, where you can earn interest on it. If you wait to get that money back as a tax refund, the IRS gets a year’s worth of interest on it and you don’t.

Sierra

25. 25 25 Steve Landsburg

Sierra: Excellent point, but it is an artifact of my poor translation from economese to English.

In a world with a 5% interest rate, paying \$1 in tax today and paying \$1.05 in tax tomorrow counts as paying “the same total tax bill”; in other words, when I say “the same”, I mean “the same after correcting for the effect that Sierra so astutely points out”. This was clear in the exam the students took (where the key buzzwords were “hold fixed the present value of your lifetime tax payments“), but I managed to garble it in my attempt to eliminate the jargon.

So your point is excellent re the question I’ve stated here, but not re the question I intended. My apologies.

26. 26 26 kg

1. The budget set contracts when price of peanut goes up. Therefore the

revealed preference argument says that when more choice is available, Frieda

prefers more rootbeer to less. Therefore rootbear is a normal good. An

increase in income means more demand for a normal good.

2. a) If (b1, n1) and (b2, n2) are the choices of the consumer out of the

budget set at prices (for bananas) \$6 and \$2, T = 6*b1+ n1 – (2*b2+n2). The

distance between the intercepts of the budget line with the y-axis when drawn

on the same indifference curve in two prices.

b) T = Increase in the area under the compensated demand curve
It is same as the answer given in part (a). Why?
Let w = total willingness to pay for the bundle (b1, n1)
then Area under compensated Demand Curve in case 1 = w -6*b1 – n1
then Area under compensated Demand Curve in case 2 = w -2*b2 – n2

c) If we measure T by the consumer surplus, we overestimate if Banana is a

normal good and underestimate if it is an inferior good.

3. False. elasticity of the demand curve for groceries could be such that

being a monopoly in the grocery market helps you extract a greater surplus.

5. A competitive market demands least distortion. Therefore I dislike paying
(highest to lowest)
1. A tax on income
2. A tax on wage
3. A tax on consumption

27. 27 27 Ben

Question 5:

I consider it imorral to tax the essentials of life. If a person is only just keeping their body and soul together, to tax them, thereby making them dependent on the state, is just wrong.

So I prefer any form of tax which does not tax the essentials of life to any which does, a consumption tax should not tax food or food production, an income tax should have a deductible sufficient to buy food and shelter, and so forth.

Assuming all taxes on the list meet those criteria, I prefer an asset tax, which is not on the list.

Otherwise I don’t know. Assuming that for example using a plumber istead of messing the job up myself, or buying an extra-nice house and living in it counts as luxury consumption and is taxed accordingly, I can’t see the difference. I guess I fail.

28. 28 28 Snorri Godhi

Please allow me to expand and/or revise my answers.

1. Why is Frieda consuming less root beer when the price of peanuts goes up? is it because she drinks root beer while eating peanuts, or because she has less money to spend on root beer? The question in economese suggests that the latter is the case, and therefore that root beer is a normal good.

But one cannot extrapolate from a decrease to an increase in the amount of money available for root beer. If Frieda’s income rises, extrapolation would imply an increase in root beer consumption, but if the rise is substantial, root beer might become an inferior good [NB: not "Griffin good" as I originally wrote]. Although Warren Buffett still drinks Diet Coke.

2. A quick answer is that, if Thomas eats N bananas/month, then he’d be willing to pay a monthly membership price of at least \$4N, since, if he keep eating N bananas/month, he would then be no worse off; but, as a member, he could also eat more bananas at a lower unit cost. \$4N is a lower bound, but I have not opened an economics textbook for over 20 years and it would take me too long to do better than this.

3. True.
Let me expand on that: since all Yukon residents are assumed identical, one can consider the case of a single resident, call him Snorri. The question implies that Snorri cannot move to a cheaper unit within Yukon. However, he can spend more or less on groceries (thanks Warren Wimmer for pointing this out): peanuts and root beer; or salmon, venison, and Islay whisky. The better groceries Snorri consumes, the more he enjoys living in Yukon, and therefore the more *total* profit Mr. Whiplash can extract from Snorri. That means that Whiplash should make groceries as cheap as possible, perhaps even sell below cost: then, he can more than compensate by raising the rent.

I admit that I re-read “why popcorn costs more at the movies” before expanding on this answer.

Answers 4 and 5 to follow.

29. 29 29 Snorri Godhi

4. my comment @3:31 pm, with small modifications:
If I give my father a \$20 gift card, he will, at best, use it to buy books that he would have been willing to pay \$20 for (if there are books selling for \$20 that he’d be willing to pay more than \$20 for, he’d have bought them already). So my father is better off by at most by \$20.
But if I had given \$20 in cash, he would have been better off by exactly \$20; so the gift card is sub-optimal.

However, a gift card is no worse, and probably better, than buying a book for \$20, because my father might value this book less than another book (or non-integer amount of books) that he could have got with the gift card.

5. I’d dislike least of all a consumption tax, most of all a tax on all income.
I originally gave 2 different motivations:

5a. I feel that the tax system should encourage bourgeois virtues such as hard work, thrift, education, and personal responsibility. WRT this question, encouraging thrift implies taxing consumption rather than interest+dividend income.

5b. However, the main reason why I would personally be happier with a tax on consumption is that I would have some control on how much tax I pay in a given year: I could eat peanuts and drink root beer to pay less taxes this year, so as to be able to afford salmon, venison, and Islay whisky next year. I would not do so, but it would make me happy to know that I could.

Extrapolating from Steve Landsburg’s replies to Dave, above, I infer another (partial) answer:

5c. In any tax regime, I would minimize my lifetime tax bill. The government will adjust taxation rates so as to pay for their spending, which we assume constant. Therefore, my lifetime tax bill will be constant (AFTER I minimize it). But there is an important difference between different tax policies: some of them leave me free to choose how and when to earn and spend my money; in other cases, to minimize my tax bill, I must follow a specific regime, e.g. earn and spend a constant amount every year; or borrow when I am young, pay off debts when I am old; or save when I am young, spend when I am old. Between tax policies, I would rationally choose the policy that gives me maximum freedom to earn and spend when I want.

I cannot prove that answer [c] leads to a consumption tax, but I note that answer [c] is the same as answer [b], at least in spirit.

30. 30 30 Ron

Here’s my take. Some of these are really easy, some aren’t.

1. A rise in salary effectively makes everything relatively
cheaper, so she will buy more root beer. She may also buy more
peanuts, or that may remain stable.

2. If membership price for the club is X, then X would be the
point where two lines cross. One line is the Thomas demand curve
for bananas. The other line is the supply curve, but it’s not
smooth. For any given interger along the Q (quantity) axis, the
Price= X + Q * 2. If the two lines do not cross, then it means
that club membership is just plain not worth it (e.g.: Thomas
only wants one banana per period, regardless of how cheap it
gets.)

The part I’m missing is that I don’t see why you’d need anything
but the demand curve for Thomas. Full knowledge of his
preferences seems like overkill.

Joining the club requires that Thomas make an estimate of how
many bananas he will eat. If he estimates too high, he may pay
too much. If he estimates too low, he may fail to join when he
should have.

3. Trick question. True and false. If Snidely raises the price
of groceries, he will need to drop rents. That doesn’t mean
he will come out even. He could end up either ahead or behind.
It all depends on the supply/demand curves for groceries, houses,
video rentals, etc. for all other purchases. For example, if the
demand curves for both groceries and houses are fairly flat, but
the curve for video rentals is steep, then Snidely could come out

4. It’s always less efficient.
a. If he’d have bought there, anyway, then the cost of creating,
selling, and processing the card is an economic loss.
b. If he’d have bought elsewhere, then he’s forced into a less
optimum choice.
c. If he really didn’t want any books, then that’s a bigger
loss.
d. If he doesn’t use the card, that’s a complete loss for him,
Note that in any cases other than choice a, it’s a win for
the book store. For the store, the gains of b, c, and d could
well offset the costs of a. However, it’s still a net loss
when both sites are accounted for.

5. If you phrased the question like that on the test, the
students could not lose. “How much you’d dislike paying them” is
purely subjective, and cannot validly be argued with. (“No, you
*should* dislike onions more!”)

If you’re looking for economic efficiency, then a tax on
consumption is easy: charge it at the point of sale. Done. A
wage tax is a little more complex, but reasonably
straightforward. An income tax turns us all into unpaid
accountants for the government, with a cadre of auditors to check
our accounting competence and honesty.

31. 31 31 Sierra Black

Steven,

In that case, I got nothin’. But I’m fascinated by the answers.

32. 32 32 Steve Harris

If Snidely owns all the grocery stores in the Yukon, what is the meaning of “a competitive price for groceries”? Who is he competing with?

I’m not being snide. I honestly have no idea what the intent of this question is (unless “competitive” is irrelevant here, and we just suppose there is some price he is charging for groceries).

33. 33 33 Snorri Godhi

Steve (Harris): I take “competitive” to mean that Snidely sells at cost, including the value of his time but without profit. That would be the price if there is perfect competition — and in this case it is also the price that Snidely should charge to Yukon residents, if my answer above is correct. (Though, on second thought, I withdraw the bit about “perhaps even sell[ing] below cost”.)

34. 34 34 Bryan

After some more thinking, one more follow up on my early post: I am taking the consumer’s willingness to pay as exogenous. If its enodogenized, then the answer to 3 is True, as Snidely will already be sweeping up all surplus via the Rental price. Further, he will be (weakly) worse off if he raises grocery prices and lowers rent.

35. 35 35 Douglas Bennett

Further thoughts/clarifications:

My economic analysis is normally based on the underlying supply and demand or utility function graphs, so explaining things without the use of such visual aids is difficult for me. I’m trying to answer these without writing anything down.

3) Think of this as a two-part tariff where groceries are the good, and housing (rent) is the membership or entry fee. In this case, it is quite clear that he would be best off charging the competetive price for groceries and then setting rent such that he extracts all of that consumer surplus. If he charges the monopoly price for groceries, he can still set rent to extract all consumer surplus, but he loses any gains on the groceries that would have been produced and sold under the competetive price. NOTE: This all assumes that his residents/customers are all identical, which was given in the problem.

4) First assume no transaction costs:

Buying the card form B&N simply transfers \$20 cash to them and has no impact on economic efficiency. If you then give him the card and he does not use it, it is like you gave him nothing, and there is again no impact on economic efficiency. However, if he uses the card to buy something from B&N anyway, then it is exactly like you gave him \$20 cash, which is a simple transfer and has no impact on economic efficiency. Lastly, if he uses the card to buy something worth less than \$20 to him, then you are down \$20, B&N is up \$20 then down \$20 (what they could have gotten for that book they just gave your father), making them no better or worse off, and your father is up by however much he valued that book, which in this case was less than \$20. In this last scenario, economic efficiency deteriorates by the difference between \$20 and the value he places on the book he got.
Add in transaction costs and the cost of producing the card, and economic efficiency is worse in every scenario than if you had just given him cash. Giving him a book makes it much more likely that we end up in the last scenario (unless you somehow know he values it at more than \$20), which reduces efficiency by the greatest amount. Thus, for economic efficiency, it is best to give him cash, next best to give him a gift card, and worst to give him a book.

5) I can’t do this one without writing some things out first. However, I can give an answer assuming a very specific scenario.
Suppose at the beginning of the period, I am a major stakeholder in Company X. All of my income comes from Dividends and capital gains on Company X stock. Company X is one of several companies that produces widgets, but Company X is the only comapny that produces red widgets (by law, no other company can), and Company X only produces red widgets (the color makes absolutely no difference, and all customers are indifferent between red widgets and widgets of other colors). Neither I nor Company X demand any widgets for ourselves. Widgets sell for about \$1. Industry demand is downward sloping and firm demand is perfectly elastic.
My most disliked tax would be a \$1,000 consumption tax on all non-red widgets. Company X would enjoy monopoly power in the widget market and reap positive economic profits. As a result, my holdings in Company X would appreciate in value. I would pay no taxes.
I would dislike somewhat less a tax on all wage income that is earned at firms which do not produce red widgets. Company X would have lower costs compared to all other companies, again allowing positive economic profits. I would pay no taxes.
I would least dislike a tax on all income earned from firms that do not produce red widgets. I would benefit from the wage tax as before, but also Company X stock and bonds would become much more attractive relative to other companies, allowing Company X to borrow at lower rates while also boosting capital gains on the stock. I would still pay no taxes.

Now that I think about it, I haven’t taken into account the fact that I would need to pay higher prices for other good that I purchase in some of these examples. I give up on this question until I write things out in economese and then translate back to English.

36. 36 36 JLA

I don’t think that 5 can be answered without making assumptions about my utility function (do I want to eat everything at the end of 2 years or do I care about leaving a bequest?) and about my elasticity of labor.

37. 37 37 Mark Liu

I will do this just for fun (and probably for old time sake of the in class exams!=D ).

1.) Up. Income Effect in the first case shows that Root Beer is a normal good for her. So Income Rise –> Consume More.

2.)
a.) Let x = number of bananas he consumes initially. His willingness to pay = (6-2)*x.
b.) Let x = number of bananas he will consume at the price of \$6. Let y = number of bananas he will consume at the price of \$2. His willingness to pay = 4(x+y)/2.
c.) Answering in the case of (b): Overestimate if his demand curse is convex (bows inward). Underestimate if his demand curve is concave (bows outward).

3.) True. If we assume that he, as the owner of the town, is already maximizing revenue. This is the same way as saying that the movie theater raises price on their tickets.

4.) Assume that he can’t get a cash refund on it. It is efficient is he is willing to spend an amount greater than that of the gift card before receiving it (his optimal consumption of B&N books, coffee, or whatnot). It is inefficient if that gift card amount exceeds his optimal consumption without it.

5.) This question really is hard. I can only regard it as a ranking based on the amount of distortions.
Most Evil:) Tax on Income – Distorts your labor supply, your savings
Second Most Evil:) Tax on Wage – Distorts your labor supply.
Least Evil:) Tax on Consumption – assume it’s the same tax rate for all consumptions.

38. 38 38 Jay Fraz

These are senior level questions?

No wonder economics is not considered a real science.

39. 39 39 squidflakes

Hey why not!

1.) Her root beer consumption patterns will not change. Unless the increase in pay is substantial the psychological effect of a rise or fall in peanut prices remains, causing the same or similar behaviors solely based on a Pavlovian self-conditioning when it comes to peanut prices.

2.) Thomas will only join the banana club if the initial entry price is within an acceptable multiple of banana prices. While joining the Banana Club would surely be beneficial at nearly every point along the demand curve, the self-imposed mental barrier to entry will only be overcome if it is easy to estimate the savings.
Overestimation will occur if Thomas has a high income and is not adversely effected by a \$6 banana.
Underestimation will occur if Thomas has a low income or is an economist.

3.) False. The average identical consumer will not simply leave town because grocery prices rise, especially if their job, family, and house are already in the Yukon. Rise in grocery prices is often viewed as an inevitably rather than a mustache stroking grab for additional profit.

4.) The economic efficiency of giving my father a Barnes and Noble gift card is 0. After receiving the gift, my father will place the card in his wallet and forget it exists. Months later, he will be locked out of a room and attempt to use the card to jimmy it open in the manner of a suave Hollywood super spy. This will remind him that he really should use the card, but also deform the card in to roughly a Z shape as the plastic used lacks the structural integrity to stand up to the unstoppable force of my father and the immobile object that is the locked door. Additional months will pass wherein the card is flattened again due to the applied forces of assal horizontology within my father’s wallet. Nearing the 12 month mark, my father will begin to shop for a Christmas gift for me that is both easy to buy and inexpensive. He will remember that he has a Barnes and Noble gift card in his wallet but will not remember why it is there. He will remember that I enjoy reading but not remember that I consider Barnes and Noble to be El Diablo. He will cunningly place the gift card inside a large box and surround it with paper trash in an attempt to fool me in to thinking he’s purchased a large gift. I will experience the requisite amount of filial love and disappointment as a \$20 expired Barnes and Noble gift card marked “Merry Christmas 2007!” flutters from the cavernous confines of the 16X19X20 box.

5.) I would dislike the taxes in the following order.

I. Consumption. I consume all the time. “Twelve point two five percent! What the fuck!” I would yell, every time I made a purchase and noticed the tax. After being taxed for a number of purchases, I would be furious with my government and start searching the web for others who shared the same feelings. Finding these websites to be common, I would spend several hours on the one with the most clever name reading about how it is completely unfair that poor people get all the breaks like a free pair of socks on Christmas and a free meal on Thanksgiving while I have to spend and extra twelve point two-five god damn percent every time I buy a new Snuggli or jet ski. Filled with self-loathing at my one time desire to associate with the people who would actually post such crap on the web, I will binge drink vodka (Monopolowa, \$12.14 for 750ml, plus 12.25%) until I pass out and hit my head on the coffee table. I will wake up in a pool of various body fluids and blame my headache on the consumption tax.

II. Wages – Every two weeks I would look at my paystub and be furious “Thirty-five fucking percent!” I would scream. “That’s robbery!” Full of anger and visions of all of the fine products I could have bought with that extra money I would get in my car, drive on public roads to a public government building, and very publicly take a dump on the top step near the door. This would, of course, lead to my arrest by public safety officers who would place me in a publicly funded incarceration facility where I would be hit on by no more than six but no fewer than three men. Two of these men will have committed violent crimes in the past 6 hours. A few hours later, after my father has posted bail but held up the process attempting to show the bail clerk this tick he knows how to do with a Barnes and Noble gift card, I will return home and shower with water provided by my public water utility in the vein hope of scrubbing the shame from my skin. I will, of course, blame all of this on the government.

III. Income – I don’t invest, so fuck ‘em.

40. 40 40 Nick

No 1

It will depend if Frieda makes her money by selling peanuts. If so, then it will go down.

41. 41 41 nick

\$6 x banana demand = \$2 x banana demand + subscription – %30ish because you just can’t get out of that gym/banana membership

demand curve for bananas? meh! there is no curve.

It is an underestimate if he is literally addicted to bananas, it is an overestimate if he lives in California with an option ARM about to reset and there are people he cares about more than bananas

42. 42 42 nick

True – if he really owns all the grocery stores that are arbitrarily competitive. If there is competition, then False

43. 43 43 nick

Barnes & Noble

He will really hate it and not use it.

Therefore it will be extremely efficient economically for B&N and extremely inefficient for both me and my father

44. 44 44 nick

5

Favorite = consumption

I can at least choose my taxes. Wages bad, wages + dividends etc worse unless you believe in Keynes, in which case we’re all doomed

45. 45 45 Tom (NOT an economist)

4. Gift cards almost always represent increased profit for a retailer. They represent guaranteed profit for the store; since the money was paid up-front, they win no matter what.

The best possible case is the unused cards. Since most retailers can expire cards (except in some states), unused cards represent pure profit (minus the administrative cost.)

In every other scenario except one, the card still represents profit above what they would have made without the gift card:

If I get my dad a card and buys \$48 worth of books, then tosses the card because he can’t use the last \$2 or get a refund on it, the store will eventually consume that \$2 through administrative fees and count it as profit.

If he spends the entire balance of the card, he’ll probably also end up spending additional cash, which is still additional profit for the store, although at a smaller rate than the first two scenarios.

The least valuable option is if my father is a regular customer and a cheapskate. In that case, they’ve basically only made money he would have spent anyway, and he’ll either use the saved \$50 on other consumable items or just stick it in the bank.

This benefits membership stores, like Costco, even more. Since the cards let non-members shop there, there’s a stronger chance that people who don’t normally shop there will use the cards. Positioning the cards as “let your friends and family see what we’re all about” opens up a new avenue for members to advertise to people who normally wouldn’t shop there. If some of those people are converted to members, then the store not only gains the immediate profit of the sale, but it gains the long-term benefit of having the extra customer.

5. Taxes: assuming there’s no financial benefit to any specific tax scheme, the most important factor to me is predictability, followed by controllability.

I should be able to predict the tax consequences of any action I take. For example, what’s the exact amount I’ll pay to taxes if I sell my house for double what I paid for it? How much will I lose to taxes if I put in 20 hours of overtime this week? It’s possible that on a good year, I may choose NOT to sell property or stocks simply because it would raise my tax bracket and my overall tax burden. Charging punitive rates for high-income individuals or transactions simply makes people avoid these transactions or find ways to avoid reporting their income. In my opinion, the secondary market created by our tax system in this country is a leech on our labor and should not exist in a rational world.

Because of this, a sliding-scale income tax is the the most unfair system of taxation, even if it’s the easiest to collect. This penalizes labor, since the tax rises out of proportion with the work done. It’s also very demoralizing to see my tax burden increase dramatically as my income goes up.

However, even a flat-rate tax is still somewhat out of my control, since I really can’t control the availability of overtime hours or the specific amount I earn.

This leaves a consumption tax as the least offensive alternative. A consumption tax is predictable and somewhat controllable, since all it takes is basic math to know what your sales tax will add up to.

To alleviate the burden on families, the tax agency could issue “tax cards”: special debit cards issued by the tax agency. The card would be filled up each month, based on the consumer’s deductions: one unit per dependent. There would be no benefits for a married couple with no children and no penalties for a married couple when both work. If the mother stops working to raise a child, they would both count as dependents. Adult students should also get a tax credit, as should disabled persons when the disability affects the ability to work.

This card could then be used to purchase necessary goods: food, food preparation equipment, basic clothing, transportation, utilities, and rent. The card would not be able to pay for toys, consumer electronics, entertainment, or designer clothing.

Basic clothing should be available at a budget price, but it will not have designer labels or logos. Alternatively, the card could just pay a base rate for clothing items, and the consumer could choose what to get.

Since our nature is generally to earn money for the purpose of spending it, this system seems most fair. It taxes at the point of use: where we SPEND our money, and it does not tax savings or interest. In fact, it encourages saving and investing, since that is essentially free money. It also simplifies the whole tax system, reducing the parasitic burden that the tax-preparation industry places on our economy.

Incidentally, this system would also work best if implemented in a cashless economy: if everyone paid for items electronically, then payments would be easy to track, and even personal transactions could be taxed. This system also reduces the potential for larceny, since all transactions would be traceable.

46. 46 46 Brian Boyko

I solemnly swear I did not look at any other postings before making this one.

Question 1)

Rootbeer consumption is likely to increase or stay level, it is not likely to decrease.

Frieda prefers to spend money on peanuts than rootbeer. Reasoning: If Frieda preferred to spend money on rootbeer than on peanuts, the consumption of peanuts would go down with the price. Instead, a tradeoff is made.

If Frieda’s income rises, her rootbeer consumption will go up if she is sated with her peanut purchases and chooses to spend it on her second-favorite item, rootbeer.

Her rootbeer consumption will remain the same if she chooses to spend it on peanuts, as her rootbeer consumption would be sated at the level prior to the raise.

It is unlikely that her rootbeer consumption will go down.

The optimal solution to this problem involves finding Frieda and asking her the question directly.

Question 2)

The number of bananas that Thomas prefers to purchase = B
Membership Fee = F

If B*6 < F+(B*2), Thomas will not join the club.

Knowing only Thomas’s demand curve for bananas, I would calculate the price of total bananas for each banana under both membership and non-membership, and find which curve matches his point of diminishing returns most accurately. If Thomas eats more than the point at which bananas start losing marginal utility for Thomas, I have
underestimated Thomas’s banana demand, if less, I have overestimated the demand.

Question 3)

False. The value of groceries is independent of the value of housing, and consumers assign value separately. While we know that people are unwilling to pay more in rent, and are unwilling to cut elsewhere to afford more rent costs, we do not know that people are unwilling to pay more in groceries.

Question 4)

Dad uses card to full value: Economic Efficency negative but nominal, as it requires an extra trip to Barnes and Noble.

Dad uses card to partial value: Economic efficiency = Goods Received/Price Paid.

Dad does not use card: Economic efficiency = 0%, using the same formula.

Question 5:

Consumption, Wages, Income, as Income is most progressive, consumption is least progressive.

Question 6)

0%. Philosophical concerns aside, Eve is unwilling to work for less than 1 hour for 1 apple, and that is the maximum she can produce. With the goal of increasing production, any tax rate higher than 0% results in a decrease in production. With the goal of increasing utility, any tax rate higher than 0% results in a decrease in utility.

Question 7)

No matter What Jill has or says, Saying “Black” always results in a gain for Jack when he has heads. The only situation saying “Red” would result in a gain for Jack when he has heads is if Jill also says Red and has Tails.

When Jill DOES have Tails, saying “Black” always results in a gain for Jill no matter what Jack does, and a 50% chance of a gain with “Red.” She knows, therefore, that it is better to say “Black.” We can assume Jack knows this and therefore will also say Black if she has tails.

Playing optimally, no player will ever choose “Red.” Ever. It is a sad and dreary game.

Question 8:

Work backwards. Duke #5 will kill Duke #4 unless Duke #4 supports the king. Therefore Duke #4 will support the king, cancelling Duke #5’s visit. Duke #3 knows this and will want to be the king, so he will kill Duke #2 unless Duke #2 supports the king. Duke #2 knows this and supports the king. Duke #1 knows that Duke #2 will support the king, so he will kill the king. Duke #1 is King on May 6th.

Question 9:

Wouldn’t it be easier simply to look up how it actually worked when it was tried in real life?

Question 10:

This increases confidence in results because with twins, variables based on genetics and age are eliminated. It decreases confidence in results because you’ve now gone from studying “the effect of education on wages” to “the effect of education on wages of twins.”

47. 47 47 Bubbly Bob

Mr. Landsburg:

I’ve read Dave’s (and Ben’s) answers to your tax question and your clarifications for them and at first I thought they were being facetious. But the more I think about it the more I realize there’s a fundamental flaw in your assertions.

At first I thought I would prefer a consumption tax, for a two-fold reason: a) Off the bat I’d pay less tax then my peers – I’m not much into shopping. b) This tax would make me buy even LESS things and save more.

However, you said that somehow the state would be able to recoup the same amount from me no matter which tax is place.

Seeing as how I spend less than those who make the same as me – I’d be moving down a tax bracket automatically.
There’s two ways to read this:
1) Everyone’s tax burden above me gets steeper just so the state can recoup the same tax from me (and a LOT more from those above me) – which would mean the state gets A LOT more money overall, which stifles the economy, which leads to no one consuming anything etc. etc.

2) The state finds a system to recoup the same money from the entire population, in which case my personal tax burden is significantly sliced. (Though I assume in this case too, people start saving more – not just me. The state switches to working with a smaller budget or else raises taxes to keep the coffers at the same level – which would actually lead to yet more savings and less taxes again and a smaller economy)

Either way, the assumption that the tax burden stays the same in each case seems false.

On an individual level I still intuitively prefer a consumption tax.
On a state or social level I don’t see how it could be workable. The way I see it wages would go up so people would start spending more. And money would devalue so it can be more easily spent.

48. 48 48 Steve Landsburg

Bubbly Bob: Neither of your two readings matches the intent of the problem. The tax rates are adjusted so that your personal tax burden is the same in each case. No assumption is made about anyone else’s tax burden.

49. 49 49 flubber

kg is right, #5 is apparently about trying to minimize dead weight losses (distortions of behavior).

Therefore:
Least despised to most:
(1) Income – behavior (investing, labor supply, consumption) all affected equally, least distortion.
(2) Wages – you would tend to over-invest (under-consume) and under supply your labor, in relation to your preferences.
(3) Consumption – you would under-consume (over-invest) and over supply your labor.

50. 50 50 ken M

You spelled “preferences” wrong. This invalidates the whole test :)
oh wait, that would be a law exam.

51. 51 51 Tank

1. She prefers peanuts to root beer. As the price of peanuts goes up, she allocates some of her root beer money to satisfy her peanut addiction. Therefore, more money means she can get her peanut fix and still drink more root beer, which she would drink if peanuts cost less.

2. Membership entails fee that needs to be advantageous to Thomas for him to sign up. In other words, the fee needs to be less than the savings he realizes by consuming the amount of bananas that he would typically consume… This would be based on his demand for bananas versus their cost. Where the two curves meet is usually the bullseye. I’m not sure about the over and under estimates, but I would guess (in my random interweb walk) that it would depend on the market for banana resale.

3. False. Housing is an investment. If the price is too high, then it’s an impossible investment. Yay, recession! Groceries are a necessity. You can charge more for necessities, especially in a monopoly.

4. Gift cards are a sham, but they show that you “care” enough to get something from a store that they like. The store receives your money faster than if you gave cash, and this could allow them to stock more books that you want… but cash would allow you to purchase those books on the internet without wasting your money on fuel to get to the store… although, you pay for that in shipping costs… so as I’m hacking through these questions… Barnes & Noble makes out, but may provide you with added benefit… however, when they go bankrupt… you lose your money. So, essentially, you’re making a bet that the store will exist long enough for your family to use their gift cards, which has some expected value depending on the reclusiveness of your family. In this economy, just give cash.

5. I don’t have the expertise to delve into, but I would rank them as follows according to preference:
all income
consumption
wages
according to who should shoulder most of the tax burden… those which are benefiting the most off of the economy. I could be convinced to put consumption above all income, but I don’t think that consumption alone would provide the necessary infrastructure and support that a sustainable system needs.

I’ve never taken an econ class outside of high school… a decade ago. I’m sure it shows, but I felt like throwing in.

52. 52 52 outsidethehollowcube

1
Frieda is paid peanuts. When the price of peanut rises her relative purchasing power increases and she presumably switches to a better beverage like ginger ale. Thus if her income (in peanuts) rises, her root beer consumption declines.

2
Nothing is mentioned regarding a membership fee, therefore Thomas will join providing he is ever likely to buy a banana. It would be bananas not to.

3
If Snidely raises the prices of groceries his residents will shop elsewhere as they are competitively priced, but if he raises his housing rent his residents will leave. Either way he’s worse off and presumably wouldn’t do either as he’s smart enough to have acquired all the houses in the territory.

4
Assuming he can read and chooses to employ this skill, it is efficient for you to buy the gift card as you don’t have to spend time choosing a book. If you do buy a book instead and he doesn’t like it (and lets face it, your taste in books sucks) he will swap it for one he does want and have to spend more time choosing a new one anyway. Having said that, if you do spend the time choosing a book and he does like it the kudos gained will probably outweigh the time costs as you have finally proved that your taste in books no longer sucks.

5
Only two things are inevitable; death and taxes. So you can either kill yourself, pay the taxes, or fake your own death and avoid succumbing to either.

53. 53 53 Richthespoof

Question 3. How can his grocery store prices be competitive if there is no competition.

54. 54 54 Ross Parker

Question 6:

If Snidey owns all the grocery stores in the Yukon, what on earth *is* a ‘competitive price’? Competitive with what, or whom?

55. 55 55 Steve Landsburg

Ross Parker: The competitive price is the price that would prevail if the grocery stores were competitive.

56. 56 56 Dave

I’ve only got time to look at a couple of these, so here are my thoughts on questions one and three.

Question 1 – We can’t say.
There could be a variety of reasons for Frida’s root beer consumption to fall in the first case. She may really enjoy eating peanuts while drinking root beer, but not particularly enjoy doing them separately. Or, when the price of peanuts rises, she may think they’re better quality and buy more of them (making them a giffin good in her market), leaving her with less money for root beer. Or, she may want to buy a fixed amount of peanuts, regardless of cost, and thus have less money left over for root beer.

Question 3 – False

Sydney will be able to sell both housing and grocery at monopoly prices without people leaving. Saying that they’ll leave if housing prices increase is not the same as saying that they’ll leave if their expenses in general increase. Residents may not have a great deal of money to spend on groceries which will somewhat constrain their demand curve, but Sidney can still monopoly price the groceries based on this constrained demand curve without them leaving.

Thanks for sharing, Steven.

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