1
Spring 2003
Solution Set to PS #2
When problem sets are corrected, if a mark S is made that means that you should refer to
these “
S
olutions” for more explanation.
Total points: 100
Problem 1 (50 points)
Part I
(16 pts) Uncertainty about Demand
Q is ecological services or area of the park. MC is the marginal cost of running the park
or of displacing farmers. MB is the benefit of watershed protection to farmers, such as
drought mitigation. We can think of taxes in this case more as consumer taxes on the
farmers because they are the ones who benefit from the park. The positive externalities of
the park to farmers can thus be captured and a tax in this case can be used to cover the
costs of running the park. As in real life, alternative interpretations are possible such as
producer subsidies to the provider of the park so that we can increase the quantity of the
park (a public good.) Alternative interpretations of the problem are valid and will be
given full credit.
(a)
Standard

3 pts for graph, 3 pts for calculation of DWL. Total
6
To calculate the DWL of the standard, we need to find first where the economy will be if
it is regulated by a standard. First, if policy makers believe that MB is at MB
L
, then they
will set the standard where MB
L
intersects MSC. This is point B in graph 1. Similarly, if
policy makers use MB
H
, they will set the standard at the quantity corresponding to point
C. The deadweight loss of being at point B, as opposed to the social optimum p. E, is
triangle ABE (Note! Take the true MB curve to calculate DWL). Similarly the DWL of
being at C is triangle CDE. We can calculate the area of these two triangles by taking the
base of each times the height.
To find the quantity at this intersection point, we equate the expressions for those two
functions:
MB
L
= MSC
10 + Q
L
= 80 – 5 Q
L
from this Q
L
= 10
Similarly Q
H
= 16.6
To find the actual MB for Q
L
and Q
H
acres of park, we need to find the corresponding
price from MB
T
.
Point A on the graph corresponds to MB
T
(Q
L
) = 50 and point D – 16.66
E is at the intersection of MB
T
and MSC
Q (at point E) = 13.3
Therefore AB = 50 – 30 = 20
The height is the vertical distance from p. E to AB = 13.3 – 10 =3.33
DWL
L
= 33. 3
Similarly DWL
H
= 33.3
EV (DWL) = .5 DWL
H
+ .5DWL
L
= 33.33
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(b)
Tax
 3 pts for graph, 3 pts for calculation of DWL
Total
6
For tax regulation, it is important to remember that the policy makers set the price in the
market and the actual quantity of acres demanded will be determined from the true MB
curve. Therefore after we find the regulated price, we need to find the corresponding
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 Spring '07
 Wood
 Economics, Pollution, Monopoly, Supply And Demand, Externality, DWL

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