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EC202: Intermediate Microeconomics

Semester 2, 2022
Tutorial 12 Solution (Week 13)
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Question 1

a) Why does an otherwise competitive market with a negative (positive) externality produce more
(less) output than would be economically efficient?

A competitive market with a negative externality produces more output than is socially
optimal. This occurs because the firms in the industry do not consider the external costs
associated with production; they only consider their private costs. Because they view the
cost as lower than it actually is, they produce more than would be produced if they were
forced to take into account the external costs.

A competitive market with a positive externality produces less output than is socially
optimal. This occurs because consumers do not consider the external benefits associated
with consumption; they only take into account their private benefits. Because they view
the benefit as lower than it actually is, they consume less than they would if they were
forced to take into account the external benefits.

b) When do externalities require government intervention, and when is such intervention unlikely
to be necessary?

Negative externalities may require government intervention when there is significant

disparity between the socially optimal production level of a good and the unregulated
equilibrium production level. To limit production, the government might impose taxes
on production or a production quota limiting production. If property rights are clearly
defined and bargaining is costless, the market may reach the socially efficient level of
production without government intervention.

Positive externalities may also require government intervention when there is significant
disparity between the socially optimal production level of a good and the unregulated
equilibrium production level. To encourage production, the government might provide
production subsidies. If property rights are clearly defined and bargaining is costless, the
market may reach the socially optimal level of production without government
intervention.

c) Compare and contrast the following three mechanisms for treating pollution externalities when
the costs and benefits of abatement are uncertain: (a) an emissions fee, (b) an emissions
standard, and (c) a system of transferable emissions permits.
 The choice between an emissions fee and an emissions standard depends on the marginal
cost and marginal benefit of reducing pollution. First, suppose small changes in
abatement yield large benefits while adding little to cost. In this case, if an emissions fee
is set too low because of uncertainty, the firm will produce far too many emissions, so a
standard is better. However, if small changes in abatement yield little benefit while
adding greatly to cost, the cost of reducing emissions is high. In this case, fees should be
used because setting a standard too high (due to uncertainty) yields little benefit but
increases costs way beyond the efficient level.

A system of transferable emissions permits combines the features of fees and standards
to reduce pollution. Under this system, a standard is set and fees are used to transfer
permits to firms that value them the most (i.e., firms with high abatement costs).
However, because of uncertainty, the total number of permits can be incorrectly chosen.
Too few permits will reduce emissions to inefficiently low levels and create excess demand
for the permits, increasing their price and inefficiently diverting resources to owners of
the permits.

Typically, pollution control agencies implement one of the three mechanisms, measure
the results, reassess the success of their choice, then reset new levels of fees or standards
or select a new policy tool.

d) How might an emissions fee /emissions standard lead to an efficient level of output in a market
with a negative externality?

With a negative externality, an emissions fee might lead to an efficient level of output. By
imposing a fee on production, producers are forced to take into account not only their
private costs but also the external costs (as measured by the emissions fee) of production.
This has the effect of raising the firm’s costs and reducing the firm’s production. If the
level of the emissions fee is set so that, for the last unit produced, the fee equals the
external cost, this fee could lead to an efficient level of output.

An emissions standard could lead to an efficient level of output. By setting a standard

and only selling the rights to a limited amount of emissions, the government can reduce
the level of emissions. In addition, by implementing a system whereby the rights can be
traded, the government could reduce emissions and distribute the rights so that
abatement costs are as low as possible.

e) What is the Coase Theorem, and when is it likely to be helpful in leading a market with
externalities to provide the socially efficient level of output?

The Coase Theorem states that, regardless of how property rights are assigned with an
externality, the allocation of resources will be efficient when the parties can costlessly
bargain with each other. This Theorem will be helpful in leading a market with
externalities to the socially efficient level when the cost of bargaining is low and when all
parties involved can agree on the costs and benefits associated with the externality.
Question 2

Assume that the market for rental cars for business purposes is perfectly competitive, with the
demand for this capital input given by
K = 1500 - 25v
and the supply given by
K = 75v - 500
where K represents the number of cars rented by firms and v is the rental rate per day.

a) What will be the equilibrium levels for v and K in this market?

Demand: K  1500  25v

Supply: K  75v  500
Equilibrium is found by setting quantity supplied equal to quantity
demanded. 1500  25v  75v  500; 2000  100v; v  20, K  1,000 .

b) Suppose that following an oil embargo gas prices rise so dramatically that now business firms
must take account of gas prices in their car rental decisions. Their demand for rental cars is
now given by
K = 1,700 - 25v - 300g
where g is the per-gallon price of gasoline. What will be the equilibrium levels for v and K if
g = $2? If g = $3?
With g = 2, demand is K  1100  25v . Equilibrium is v  16, K  700 .
With g = 3, demand is K  800  25v . Equilibrium is v  13, K  475 .

Question 3

A firm in a perfectly competitive industry has patented a new process for making widgets. The
new process lowers the firm’s average costs, meaning this firm alone (although still a price taker)
can earn real economic profits in the long run.

a) If the market price is $20 per widget and the firm’s marginal cost curve is given by MC = 0.4q,
where q is the daily widget production for the firm, how many widgets will the firm produce?

MC = 0.4q ; P = $20.
Set P = MC
20 = 0.4q
q = 50.

b) Suppose a government study has found that the firm’s new process is polluting the air and the
study estimates the social marginal cost of widget production by this firm to be MCS = 0.5q.
If the market price is still $20, what is the socially optimal level of production for the firm?
What should the amount of a government-imposed excise tax be to bring about this optimal
level of production?
 MCS = 0.4q + 0.1q = 0.5q.
Set P = MCS
20 = 0.5q
q = 40
At optimal production level of q = 40, the marginal cost of production is
MC = 0.4q
= 0.4(40)
= 16
So, the excise tax t = 20 – 16 = $4

Question 4

Assume that scientific studies provide you with the following information concerning the
benefits and costs of sulfur dioxide emissions:

Benefits of abating (reducing) emissions: MB = 500 – 20A

Costs of abating emissions: MC = 200 + 5A

where A is the quantity abated in millions of tons and the benefits and costs are given in
dollars per ton.

a) What is the socially efficient level of emissions abatement?

To find the socially efficient level of emissions abatement, set marginal benefit equal to
marginal cost and solve for A:
500 – 20A = 200 + 5A
A = 12 million tons.
b) What are the marginal benefit and marginal cost of abatement at the socially efficient level of
abatement?

Plug A = 12 into the marginal benefit and marginal cost functions to find the benefit
and cost:
MB = 500 – 20(12) = 260
MC = 200 + 5(12) = 260.
c) What happens to net social benefits (benefits minus costs) if you abate one million more tons
than the efficient level? One million fewer?

Net social benefits are the area under the marginal benefit curve minus the area under
the marginal cost curve. At the socially efficient level of abatement this is equal to area
a+b+c+d in the figure below, or
0.5(500 – 200)(12) = $1800 million.
If you abate one million tons too many, the net social benefit is area a+b+c+d–e, or
1800 – 0.5(265 – 240)(1) = 1800 – 12.5 = $1787.5 million.

If you abate 1 million too few tons, then the net social benefit is area a+b or
0.5(500 – 280)(11) + (280 – 255)(11) + 0.5(255 – 200)(11) = $1787.5 million.

Question 5

The market for paper in a particular region is characterized by the following demand and supply
curves

QD = 160,000 − 2000P and QS = 40,000 + 2000P,

where QD is the quantity demanded in 100-pound lots, QS is the quantity supplied in 100-pound
lots, and P is the price per 100-pound lot. Currently there is no attempt to regulate the dumping of
effluent into streams and rivers by the paper mills. As a result, dumping is widespread. The
marginal external cost (MEC) associated with the production of paper is given by the curve MEC
= 0.0006QS .

a) Calculate the output and price of paper if it is produced under competitive conditions and no
attempt is made to monitor or regulate the dumping of effluent.

The equilibrium price and output would be where quantity demanded is equal to
quantity supplied:
160,000 – 2000P = 40,000 + 2000P
4000P = 120,000
P = $30 per 100-pound lot, and
Q = 100,000 lots.
b) Determine the socially efficient price and output of paper.

To find the socially efficient solution, we need to consider the external costs, as given by
MEC = 0.0006QS, as well as the private costs, as given by QS = 40,000 + 2000P.

Rewriting the supply curve, the private costs are P = 0.0005QS – 20 = MC. Therefore,

MSC = MC + MEC
MSC = 0.0005QS – 20 + 0.0006QS
MSC = 0.0011QS – 20.

Setting marginal social cost equal to the demand curve, which is the marginal benefit
curve,

0.0011Q – 20 = 80 – 0.0005Q
Q = 62,500 lots, and
P = $48.75 per lot.

c) Explain why the answers you calculated in parts a) and b) differ.

The equilibrium quantity declined, and the equilibrium price rose in part (b) because the
external costs were considered. Ignoring the external costs of paper production will result
in too much paper being produced and sold at too low a price.

Question 6

In a market for dry cleaning, the inverse market demand function is given by P = 100 − Q and the
(private) marginal cost of production for the aggregation of all drycleaning firms is given by MC
=10 + Q. Finally, the pollution generated by the drycleaning process creates external damages
given by the marginal external cost curve MEC = Q.

a) Calculate the output and price of dry cleaning if it is produced under competitive conditions
without regulation.

Set demand equal to supply to find the competitive equilibrium. To do this, set price
equal to marginal cost (which is the industry supply function):
100 – Q = 10 + Q,
Q = 45, and P = $55.

b) Determine the socially efficient price and output of dry cleaning.

To find the answer here, we must first calculate the marginal social cost (MSC), which is
equal to the marginal external cost plus the private marginal cost. Next, set MSC equal
 to the market demand function to solve for price and quantity. When all costs are
included, the quantity produced will fall and the price will rise:

MSC = MC + MEC = (10 + Q) + Q = 10 + 2Q.

Setting MSC = MSB: 10 + 2Q = 100 – Q, so
Q = 30, and P = $70.

c) Determine the tax that would result in a competitive market producing the socially efficient
output.

If there is a unit tax, t, then the new marginal private cost function is MCΝ = (10 + Q) +
tQ. If we now set this new marginal cost function equal to the price of $70 and substitute
30 for the quantity, we can solve for t:
10 + Q + tQ = 70
Q(1+t) = 60
1+t = 2
t = $1.
The tax should be $1 per unit of output. Note that with the tax equal to 1, the new private
cost function is the same as the marginal social cost function.

***The End***