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Economics of the Public Sector

EC 371



Midterm Examination 2


April 10, 2000


Instructions:  Please answer all the questions on the paper provided, then staple your work together in proper order with this as the cover sheet.  If appropriate, sign the pledge below.


Show all work.  I will not be able to award credit (even partial) unless I can determine how you arrived at your answer.  For the analysis question in particular, NEATNESS COUNTS.  Your graphs should provide a clear illustration of your answer.  Label them appropriately, and make sure that they are understandable.







I pledge my honor that on this examination I neither gave nor received assistance

and that I saw no dishonest work.




¥Check to indicate if you have left the pledge blank intentionally.


Short Answer:


Answer 2 questions from part A, and one question each from parts B and C.   No extra credit will be awarded for additional answers.   (10 points each)


Part A:  Income Redistribution  (answer 2)

1)      Compare the method for calculating the poverty rate in the United States with the method employed by most European countries.  What are the advantages and disadvantages of the U.S. method?


2)      Significant government assistance to the poor comes in the form of cash aid, education, food benefits, housing benefits and medical care.  Which of these programs is the largest?  Can you offer any reasons, discussed in your text, for this relative ranking?


3)      The Gini coefficient for Rice County, MN for 1990       is 0.397051, while the Gini for Dakota County for the same period is 0.352624.  Which county has greater income inequality?  Illustrate and explain your answer with reference to a Lorenz curve.


4)      Describe the four basic changes that were introduced to the U.S. welfare system in 1996 with the passage of the Personal Responsibility and Work Opportunity Reconciliation Act.


Part B:  Social Security (answer 1)

1)      The Social Security Trust Fund was established in 1983 with the stated purpose of providing for the baby boom generation in its retirement.  In 1983, the  gross federal government debt (revenues – expenditures) increased by 20.61%, the greatest single-period increase in the 50-year time period between 1950 and 2000.  Suggest how these two facts might be related.


2)      Economists have tried to discern the overall effect of Social Security on individual savings behavior, and have argued that the net effect is a combination of three independent effects:  the wealth substitution effect, the retirement effect, and the bequest effect.  Define and describe each of these, and indicate whether it is predicted to increase or decrease individual savings.


Part C: Health Care (answer 1)

1)      Explain how adverse selection and moral hazards might affect the provision of health care insurance in the United States.


2)      Compare Medicare and Social Security with respect to (a) sources of funding (b) return on individual contribution (c) financial solvency.


This is hot off the press.  It appeared this Saturday in the Minneapolis Star Tribune.


Published Saturday, April 8, 2000

Social Security Earnings Test Ended

By TERENCE HUNT / AP White House Correspondent

WASHINGTON (AP) -- Hundreds of thousands of Americans age 65 through 69 will be able to earn as much money as they want without losing SocialSecurity benefits under a bill signed Friday by President Clinton repealing a Depression-era penalty.

The elimination of the so-called earnings test will mean a bonanza averaging an additional $6,700 in payments this year for some 800, 000 recipients who are working and another 100, 000 who haven' t sought benefits because they have jobs, the SocialSecurity Administration says.

The measure repealed a law in which people age 65 to 69 lost $1 in SocialSecurity benefits for every $3 in wages above an annual limit of $17, 000. The cost of the repeal was estimated at $22 billion over 10 years.

The earnings penalty was a remnant from an era of high unemployment when policy-makers wanted to encourage older Americans to retire and make room for younger workers.

But today' s booming economy and tight labor market have changed the picture. Clinton said the repeal would benefit workers and companies alike.

" It means companies with labor shortages will have a fresh supply of experienced workers, increasing our ability to grow without inflation, " Clinton said. " In the future, it will mean more baby boomers working longer, contributing more to the tax base and to the SocialSecurity trust fund."

With Democrats and Republicans both eagerly courting the senior vote, the repeal sailed through Congress without dissent, approved by a 100-0 vote in the Senate and by 422-0 in the House.

"Common sense has finally prevailed, " said House Speaker Dennis Hastert, R-Ill. " For too many years, America' s working seniors have been getting penalized. Starting today they will get the paycheck they deserve."


1)      Use indifference curve analysis to evaluate how this new law will change the behavior of 65-69 year olds. (30 points)

2)       What impact, if any, will the new law have on the Social Security Trust Fund?  Explain your answer, being as specific as possible. (10 points)

3)      While Hastert is certainly on firm ideological grounds in claiming that workers “deserve” a paycheck for work that they perform in the marketplace, is it equally obvious that people who choose to support themselves through participation in the labor force “deserve” to receive Social Security?  Base your answer on considerations of the purpose of the Old Age, Survivors and Disability Insurance Program.  How might the passage of this law affect the ability of a future generation of senior citizens to claim that they have a “right” to retire with benefits? (20 points)