Question

Exercise 1: Primary and Secondary Markets (20 points) Imagine a policy that increases the toll on a highway from $0.40 to $0.50 and would reduce the use of the highway by 10,000 cars per week. (a) (10 pts) Because of the reduced use of the highway, demand in the secondary market for train rides increases by 20,000 passangers per week (at any price level). Assuming that the price of train rides is set equal to the marginal cost of operating the train and marginal costs are constant at $1.5 (i.e., the supply schedule is horizontal), and no externalities result from the reduced use of the highway and the increased use of the train system, are there additional costs or benefits due to the increased demand for train rides? Why or why not? If additional costs or benefits exists, how large are they? (b) (10 pts) Because of the reduced use of the highway, demand in the secondary mar- ket for gasoline falls by 30,000 gallons per year. There is a stiff tax on gasoline, one that existed prior to the new toll. Assuming that the marginal cost of producing gasoline is $1 per gallon, that these marginal costs are constant (i.e., the supply schedule is horizontal),

Answer 1

(a) It is given that due to the increased toll, the use of highway has reduced. This makes people to use public transport more and thus, the demand for train rides increase. However, none of these transitions causes any externalities on the economy. Since there are no externalities, there are no additional costs or benefits from the transition. Further, due to the increase in toll prices, people have shifted to using subways, however, an increase in the demand for subways does not affect the price. Therefore, there is no additional cost that is borne by the society. Also, reduction in highway use gives benefits in the primary market. However, if the benefits are counted again in the secondary market as an increase in the consumer surplus, there will be a problem of double counting. Therefore, no, there are no additional costs or benefits due to the increased demand for train rides. (b) Since the use of highway, and so the cars, have reduced, the demand for cars and the gasoline used in it reduces, reducing the price of the gasoline. However, if there is a tax imposed, then it will shift the supply curve and will lead to deadweight loss. Due to the tax and the reduction in demand, the government will lose 30% of the revenue generated from the sale of gasoline. The total reduction in the demand for gasoline is of 30,000 gallons, therefore, the total reduction in government's revenue is of $9,000 (30% of 30,000). Therefore, this is the social cost that will be imposed on the society due to the shift from the use of highway to the use of public transport.