Question

Problem Set 2. Market Failure: Externalities and Common Pool Resources EconS 326 1. Cigarette production requires use of energy, water and other resources. When planting tobacco leaves, fertilizer is used that creates runoff and water pollution in waterways. Tobacco smoke pollutes indoor and outdoor environments and remains a pervasive and persistent source of toxicants long after the cigarette is extinguished. a. Is there too little, too much or the correct amount of cigarette produced or consumed from a socially optimal perspective? Prove your answer by drawing a graph representing the market for cigarettes that correctly identifies private and social marginal benefit and marginal cost curves along with the market equilibrium price and quantity versus the socially optimal equilibrium price and quantity. Also, identify any deadweight loss in the graph if any. b. What is a good regulatory policy that can be used to reduce deadweight loss in this case? Briefly describe the effect of this policy in the cigarette market. 2. The private marginal benefits for education is estimated to be MBP = 175 - Q where Q is the number of months enrolled in school. The private marginal cost of education is MC' = 25. Because your education also benefits others in society when you pass on your knowledge, there is a positive external benefit of MB= 100. No other externalities exist in the market. a. Solve for the market equilibrium price and quantity for education. Solve the socially optimal level of price and quantity of education. b. Graph all the curves and identify the deadweight loss area. Given the deadweight loss area you have identified in the graph, calculate the deadweight loss in the market. 3. A river passes through a town and people who live in this town use water from the river. A steel factory located in this town discharge sewage and pollutes the river. a. Explain how the Coase theorem could work to achieve the optimal level of sewage emissions. Explain how the achievement of the optimal level of sewage can be hindered in reality for this particular problem. b. Assume that the true marginal abatement cost curve for the steel factory is not known to a regulator, The government tries to estimate the marginal abatement cost but it turns out to be higher than the true level. Consider the marginal damages from sewage as relative steep where if it exceeds a particular level, the marginal damages suddenly increase. What is the better type of policy to implement, a quota or a tax on sewage emissions? Give a brief explanation of why you have chosen that particular policy. Use a graph to support your explanation.

Answer 1

Answer to part 1 :-

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Smoking cigarettes create a negative externality to the society as its consumption not only affects the smokers but have a major impact on the health of non smokers. Thus this is a case of negative consumption externality.

In the above figure the marginal private cost curve is below the marginal social cost curve as it does not include the cost Borne by the society . Now when there is no intervention ,the free market equilibrium has formed at Q1 quantity where the marginal private cost curve intersects the marginal private benefit curve at point A . However the society is at equilibrium when the the quantity of cigarettes produced is Q2 and the market is at equilibrium at point B where the marginal social cost curve intersects the demand curve .The deadweight loss borne by the society is represented by the shaded Triangle.

The difference between Q1 and Q2 represents the over allocation of consumption of cigarettes which can be reduced through government intervention where the the government can put per unit tax which will lead to shift in prices of the cigarette from P1 to P2 bringing the marginal private cost curve equal to marginal social cost curve thereby automatically decreasing the quantity of cigarettes to Q2 due to rise in price. The Per unit tax will amount to the difference between P1 and P2.