Question

1. The inverse demand for leather is given by P = 50 - 0.5Q. The industry supply of leather is determined by its marginal cost: MC = 0.4Q. Unfortunately, the production of leather casues noxious chemical residue to leach into groundwater supplies. The external marginal cost caused by these residues grows with the amount of output, and is measured as EMC = 0.05Q. (Graph the inverse demand curve, private marginal cost, and social marginal cost curves.)

1a) How many leather is produced int he free market if the externality is not corrected?

1b) What is the free market price of leather if the externality is not corrected?

1c) what is the social marginal cost?

2. Now suppose that the government wishes to reduce the externality to efficient levels by levying a tax on leather production. (Graph the amount of tax, tax revenue collected by the government and DWL.)

2a) How much should that tax need to be?

2b) What is the resulting net price paid by buyers once the tax is in place?

2c) What is the resulting price received by the sellers once the tax is in place?

2d) Who paid more of the tax? Why? Explain.

Answer 1