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Unformatted text preview: the production of each unit of blecch produces enough air pollution to cause $2 in damages. The production of blecch is taxed at a rate of $10 per unit. [4] (a) Draw a partial equilibrium diagram illustrating this initial situation and indicate the quantity with the tax (QT ), free market quantity (QM ) and the socially optimal quantity (Q∗ ), respectively. Be sure to label the curves in the diagram. P MSC MC MSB T Q [13] Q Q* QM (b) Do partial equilibrium welfare analysis of a proposal to replace the $10 tax with a subsidy of $2. Hints: • Draw a new diagram to reduce the clutter because you can leave out the lines associated with the market equilibrium and socially optimal equilibrium. • Your final welfare change may be messy, so you don’t need to determine whether it is positive or negative. Please do try and simplify it (via cancelling). 4 P MSC P1 I A E P2 F B P3 MC J K M G L C H D P4 MSB Q ∆CS ∆PS ∆GS ∆ES ∆W = = = = = S Q T Q (A + B + C + E + F + G + I + L) (33) (B + C + D + F + G + H + K ) (34) −(B + C + F + G + K + L + M ) − (A + B + C + D(35) ) −(G + H + I + J + K ) (36) E + F − (J + K + M ) (37) If you drew this to scale, it would be clear that this is positive. [3] (c) State whether welfare would rise or fall if the initial tax ($10) was reduced to $6. Very briefly explain the intuition behind your answer. Note: You do not need to draw a diagram OR do welfare analysis of this case! Welfare would rise. The intuition is that the $6 tax is moving us closer to the optimal tax of $2. 5...
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This note was uploaded on 01/17/2014 for the course BUSINESS 121 taught by Professor Na during the Fall '12 term at Wilfred Laurier University .

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