PS2AnswerKey - Economics 131 Problem Set#2 Answer key Part...

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Economics 131: Problem Set #2 Answer key Part I of Problem Set #2 A. Consider a pollution control policy that offers a polluter a subsidy of s per unit of pollution reduction from its pre-policy level, Q_m. Question 1: How much pollution will the firm produce if given the subsidy s for every unit less than Q_m that it does not produce? Explain. Answer: Firm will produce pollution at the level Q such that the marginal benefit of pollution equals the subsidy, s. If it were producing a larger level, it could reduce its pollution and receive s per unit while giving up the marginal benefits, which for these units are all less than s. If were producing a smaller level, by increasing its pollution it would receive a marginal benefit that exceeds the subsidy, s, that it gives up by producing the extra units. Question 2: What is the optimal or efficient subsidy level s*? How does s* compare to the optimal tax t*? Answer: The efficient subsidy level s* is where MB(Q*)=MC(Q*)=t*, that is, at the level that induces the firms to produce the efficient level of pollution Q*, which, by Question 1, is at the point where MB(Q*)=s*. But MB(Q*)=MC(Q*)=t*. Question 3: Since the optimal subsidy s* and the optimal tax t* both lead to the same quantity of pollution, Q*, total social surplus is maximized by either policy. Show in a graph how the total surplus is shared between the producer (the polluter) and the public (the pollutees). Assume the public receives any revenues raised by the optimal tax t*, but pay (through other taxes) for any subsidies given to the producer under the optimal subsidy s*. Answer: left to reader (if you have a problem with this, see one of the instructors during their office hours) Under the tax policy, the total surplus is the “triangle” under the MB curve and above the MC curve from 0 to Q*, and the total tax revenue is the rectangle t*Q* which goes to consumers. Under the subsidy policy, the total surplus is the “triangle” under the MC curve and abov e the MB curve from Q* to Q_m and the total subsidy (paid by consumers) is the rectangle s*(Q_m – Q*) which is paid to the producers. Can you explain why the total surplus is different for the two policies? [Hint: Consider the “status quo” defined by the “property rights” in the two cases. See next Question 4.] Question 4: Given your answer to Question 3 which policy (tax or subsidy) would be unanimously supported by both consumers and the producer under the alternative assignments of the property right to pollute or to be free from pollution? Answer: If the property right to pollute is assigned to the producers, then both the
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producers and consumers would be better off under the subsidy policy. (See answer to how surplus is divided in Question 3.) If the property right is assigned to the consumers (i.e. they have a right not to be polluted, unless compensated) then they and the producers would both be better off under the tax policy. Question 5: (Hard): (a) Suppose Q_m is not known, but estimated as Q° so that the
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This note was uploaded on 12/09/2009 for the course ECON 131 taught by Professor Groves during the Fall '09 term at UCSD.

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PS2AnswerKey - Economics 131 Problem Set#2 Answer key Part...

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