Question

Alford’s Awesome Abs workout studio provides workout sessions (a). It is located next door to Hulbert’s Hacking Hookah bar which provides hookah sessions (h). The total cost function for Alford’s Abs is a^2 + ah. The total cost function for Hulbert’s Hookah is 2h^2

We expect the socially optimal amount of __ to be __ than the equilibrium amount of h.

a) h; higher

b) h; lower

c) a; higher

d) a; lower

If the equilibrium and socially optimal solutions are the different, which of the following government actions could induce these two companies to achieve the social optimum in equilibrium.

a) Tax Hulbert’s Hookah

b) Subsidize Hulbert’s Hookah

c) Legally assign Alford’s Abs the rights to clean air

d) Legally assign Hulber’ts Hookah the right to pollute

Answer 1

Solution-

We know that there is a negative externality associated with Hulbert's Hookah. The negative externality is in the form of pollution which harms the society. So the social cost is above private cost for Hulbert's Hookah.

Hulbert's Cost/Benefit ? Hookah s'=MSc (Marginal Social cost) S=mPc=Marginal Private Cost 12 D-MPB = marginal Private Benefit gs or quantity of Hookan TL > Ove-voduclon. socially less amount of Hookah) should be provided at the optimal levell

So option b. h ; lower should be correct. That is, we expect the socially optimal amount of h to be lower than the equilibrium amount of h ( due to the negative externality associated with hookah)

2) To achieve the social optimum in equilibrium, government should tax Hulbert's Hookah. As we can see in the diagram above, there is an over production of hookah by Hulbert. To tackle with this overproduction of hookah, higher prices should be charged by the consumers so that they reduce their demand of hookah. So in order to raise the price of hookah government should tax Hulbert's Hookah. option 1 is correct.

option b is incorrect because already there is overproduction of hookah due to negative externalities associated to it. Subsidizing Hulbert's Hookah will induce Hulbert to produce more of hookah. It will adversely affect the society.

c) Yes, option C is correct. As government will legally assign Alford's And the rights to clean air, it can regulate the amount of pollution produced by Hulbert's Hookah. As a result, there would be reduction in the level of pollution produced by Hulbert's Hookah.

d) No, option D is incorrect. If government will assign Hulbert's Hookah the right to pollute, it will have the right to produce as much pollution it wants. This will adversely affect the society as pollution acts a negative externality for the society. Thus, government should not assign Hulbert's Hookah the right to pollute.