Economics 0105                Berger

                     Homework #4: Answers

 

 1. Suppose the paper market can be represented by the numbers in Table 1. Further suppose that producers of paper dump their wastes in nearby rivers and inflict an external cost of $4 per unit of paper on downstream users of river water.

 

                            Table 1   

 

           P           QD            QS(pvt)           QS(soc)

 

          $15           0            240               160

 

           14          20            220               140

 

           13          40            200               120

 

           12          60            180               100  

 

           11          80            160                80

 

           10         100            140                60

 

            9         120            120                40

 

            8         140            100                20

 

            7         160             80                 0

 

            6         180             60                 *

 

            5         200             40                 *

 

            4         220             20                 *

 

            3         240              0                 *

 

 

 

 

 

 

 

 

 

 

 

 

 

a. Graph the demand curve and both supply curves, labeling    all relevant equilibrium points with numbers from Table 2.

 

b. Indicate the area on the graph that corresponds to the     welfare loss associated with the external cost and explain       your graph.

 

                         SEE GRAPH

 

The welfare loss (WL) indicates that markets where negative externalities occur attract too many resources from other markets. That is, the overproduction that occurs because firms do not take account of all of the costs of producing paper attracts some resources into a lower valued use in this market. Conversely, other markets are using too few resources and are underproducing output (resources there would have a higher valued use in other markets than in this market).

 

 

 

 

 

 

 

 

 

 

c. If government imposes a pollution tax of $2 on the paper industry, show this effect on a supply-demand diagram and indi­cate whether this will solve the externality problem. Are their other more efficient methods of resolving externa­lity questions? Explain.

 

                            Table 2   

 

           P           QD        QS(pvt)   QS(tax)     QS(soc)

 

          $15           0         240       200        160

 

           14          20         220       180        140

 

           13          40         200       160        120

 

           12          60         180       140        100  

 

           11          80         160       120         80

 

           10         100         140       100         60

 

            9         120         120        80         40

 

            8         140         100        60         20

 

            7         160          80        40          0

 

            6         180          60        20          *

 

            5         200          40         0          *

 

            4         220          20         *          *

 

            3         240           0         *          *

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

       

Pe(tax) = $10 and Qe(tax) = 100 units while Pe(soc)= $11 and Qe(soc) = 80 units.

 

No, this does not solve the externality problem. The tax re­duces the inefficiency associated with  the exter­nality but does not eliminate the inefficiency.

 

Other methods of resolving the externality may well be rela­tive­ly more effi­cient (reduce the inefficiency associ­ated with the externality by more than the tax without eliminat­ing it). Such methods will work when the polluter can be identi­fied (the number of polluters are small) and there are a rela­tively small num­ber of parties suffering dam­ages from the pol­lution. In such cases, the common law of nuisance would allow the party suffering damages to collect these damages from the polluter or to impose an injunction on the pollut­er to cease and de­sist his polluting activi­ty. The common law thereby allocates property rights in the river to those par­ties damaged by pollution. Given this fact, pollut­ers may well be will­ing to negotiate a solu­tion to the pollu­tion problem out of court.

 

 

 

 

 

 

 

The Coase Theorem states that regardless of who holds property rights--the polluter or those parties damaged by the pollution--the negotia­tions be­tween these two parties will produce an effi­cient solu­tion. Such a solution is efficient because the low cost avoi­der of pollution is in­duced to take ac­tion. That is, if the polluter can install pol­lu­tion reduc­tion equipment cheaper than the water company (which produces drinking water for its custom­ers) can install water purification equip­ment then the polluter will voluntarily in­stall the equipment to avoid being sued for damag­es. If the water company can install water purifi­cation equipment cheaper than the polluter can install pollu­tion reduction equipment then the polluter's liability for damages will cause him to offer a bribe to the water company to install the purifi­cation equipment to avoid being sued in court.

 

Such a negotiated solution may fail if the trans­actions costs are too high--that is, if the number of complain­ing parties is too large or if the number of polluters is too large (making it diffi­cult to identify the party responsible for a given amount of damage). The failure of the nego­tiated solution in these circum­stances does not necessar­ily imply that the interven­tion of the government will solve the problem more effi­ciently. Why?