Question

2 (18 pts). Consider the market for oil A. Draw a market diagram for oil and make sure and label it completely. Show equilibrium price at $70 per barrel and equilibrium output at 19 million barrels per day. B. Fully explain why the market equilibrium output is efficient. C. Now, assume that burning oil creates global warming and a negative externality (social cost). Fully explain (using your diagram too) why the market equilibrium fails to allocate resources correctly. D. Recently, a carbon tax on suppliers has been proposed to adjust the oil market to an efficient output level. Explain the hoped for effect of the carbon tax. Also, explain why this tax may or may not correct the 'actual/ real' market failure.

Answer 1

A) The graph is below:

MSC MPC 1 \D= MPB 19

Equilibrium takes place at point X1 where price is $70 and quantity is 19 million

B) The market output is efficient because in the presence of no externalities, supply = demand

C) With a negative externality, an external cost is imposed on the society. This will shift the supply curve to the left, to make it MSC or marginal social cost curve where MSC = supply + external cost

Efficient equilibrium takes place at X2 where demand cuts MSC curve

D) With a tax imposed on the producers equal to the external cost, then the MSC curve will equal supply curve plus tax on producers, and the tax per unit of output equals external cost

This will shift free market equilibrium to X2, making an increase in P and decrease in Q to reach socially efficient outcome levels.

This tax can correct actual market failure only if tax = external cost per unit

This will eliminate all dead weight loss and maximize social welfare.