Question

I need help with questions 3-5. Thanks!

Consider the case of an industry whose production activity creates substantial pollution in the local rivers, lakes, and groundwater. For example, it is convenient for chemical companies to dump their chemical wastes into nearby lakes and water bodies. This may not impose any cost on the firms. However, the dumping of wastes into the lakes imposes an external cost on the environment and áffects other members of the society. When the domestic firms ignore the external costs of pollution ($1 per unit) and the government does not have any policy to address that, in autarky, the domestic demand is P = 42 Q and the domestic 30 supply is 6.8 Q. The world price is $22. Answer the following two questions: 50 1) From the domestic demand and supply conditions, what are the domestic equilibrium price and equilibrium quantity in autarky? 2) When it moves from autarky to free trade, would it import or export the chemical and by how much? What is the true net effect on the country's well-being? Suppose the government wants the market decision-makers to internalize the costs to the environment. So it imposes corrective tax of $1 per unit on domestic firms. Answer the following three questions: 3) What is the new domestic supply function? In autarky, what are the new domestic equilibrium price? 4) When it moves from autarky to free trade, would it import or export the chemical and by how much? What is the net effect on the country's well-being? 5) Compare part 2) and part 4), when there is policy that force market decision-makers to internalize the costs to the environment, how does it affect the domestic production, the export, and country's well- being?

Answer 1

The equilibrium in domestic market is reached when supply equals demand.So, the equilibrium Q and P are -

=> 42- 1/30 Q _d = 6.8 + 1/50 Q _s

=> Q* = 660 and P* = $ 20

3. When govt. imposes a tax of $1 on suppliers, the suppliers cost of production rises and so does price.Therefore, the new supply equation is -

P = 6.8 +1+ 1/50 Q _s

Under autarky, the new equilibrium price is -

42- 1/30 Q _d = 7.8+ 1/50 Q _s

Q * = 641.25 and P* = 20.625

4. When the country moves from autarky to free trade, the suppliers would sell or export abroad.This is because domestically they have to sell at $20.625 whereas world price is higher at $22. So at $ 22 suppliers would be willing to sell =-

22 = 7.8 + 1/50 Q _s

Q _s = 710

Now suppose our country in question is a small country whose domestic prices get affected by world prices under free trade.

Therefore, when world prices are higher at $22 it will raise domestic prices to that amount causing a fall in domestic demand.

Under world prices domestic demand Q _d = 600 ( this is down from 641.25 we calculated earlier)

So, net quantity exported = 710-600 = 110

Net welfare for country is -

loss of Consumer surplus	- 825
Producer Surplus gain due to exports	151.25
Dead weight loss	-82.5
Govt tax	710
Net loss	-46.25

5. We now compare before tax and after tax situations under free trade.

Effect on	Before Tax	After tax
Domestic supply under free trade	760	710
Export quantity	160	110
Net well being for country	(120) = consumer loss 320 = Producer gain ------------------------------------------ 200 = net surplus At the cost of polluting the environment	(825) = consumer loss 151.25 = producer surplus 710 = govt. tax (82.5) = dead weight loss -------------------------------- (46.25) = Net loss While preserving the environment.

Therefore imposition of tax causes market distortions due to which production and consumption are affected.However tax so collected helps preserving the environment.