Question

2. Refer to Figure below and answer the following questions. The figure plots the domestic market demand and supply for cigarette. Assume that the size of external damage/cost per unit consumption of cigarette is estimated to be 3 dollars. 1P 10 20 30 40 50 60 70 80 90 100 110 120 2 (a) What is the equilibrium price (without any interventions)? Calculate the consumer surplus, the producer surplus, and the total surplus. (b) Find the socially optimal quantity. (c) What is a price ceiling that achieves the social optimum in (b)? Cal- culate the consumer surplus, the producer surplus, and the total surplus.

Answer 1

A) without intervention, at eqm

Demand = supply

P = $ 5

CS = .5*(11-5)*60 =180

PS = .5*(5-2)*60 = 90

TS = CS+PS = 270

.

B) socially efficient eqm is when, MSC = PMB

MSC = PMC + MED

MSC : marginal social cost

MED : marginal external damage

MSC = PMC + 3

So at eqm, Qs* = 40

.

C) now Price ceiling

Is the maximum possible price, so that efficient output is achieved

Price ceiling P = $4

CS = (7-4)*40 + .5*(11-7)*40 = 120+80 = 200

PS = .5*(4-2)*40 = 40

TS = 200+40 = 240

.

D) price floor, minimum possible price

So P = $ 7

CS = .5*(11-7)*40 = 80

PS = (7-4)*40 + .5*(4-2)*40 = 120+40 = 260

TS = 80+260 = 340

MSC 1 price floor price.ceiling 10 20 30 40 50 60 70 80 90 100 110 120 8

E) corrective tax = value of MED at socially efficient eqm

= $ 3

CS = 80

PS= 260

TS = 340