1 73 ‐ 100, Kesten, Sample Midterm 3, Solutions to Sample Questions/Problems 1. Consider the market for a good that generates a negative externality.a. Suppose first that no government action is taken to internalize the externality. Draw a graph and show thetotal welfare in this market.b. Suppose now a corrective tax is imposed and its size is equal to the size of the externality. Draw a graph andshow the total welfare in this market. 2. Are the following statements true or false? Justify your answer.a. Consider the market for electricity, much of which is produced by power plants that burn coal to produceelectricity. A tax on emissions leads to higher electricity prices for consumers and hence hurts society. b. Externalities lead to market failure because private prices do not reflect all the relevant information oncosts and values. c. Some externalities can be fixed without any kind of government intervention.
2 3. Fishing for certain fish species has been so intensive that those species are now threatened with extinction.After several years of banning such fishing, the government now proposes to introduce tradable licenses, eachof which entitles its holder to a catch of a certain size.a. Why does fishing generate a negative externality? b. How may the tradable license scheme overcome the inefficiency created by this externality? 4. The following table gives information about three industrial firms producing steel in Pittsburgh.FirmInitial Pollution LevelCost of reducing pollution by 1 unitA80 units$10B200 units$5C70 units$20The government wants to reduce total pollution to 120 units, so it gives each firm 40 tradable pollutionpermits (where 1 permit entitles its holder to pollute by 1 unit).a. Who sells/buys permits and how many do they sell/buy? What is the total cost of pollution reduction in thissituation?
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- Spring '10
- Economics, AFC