1 Price vs. quantity

Assume that the estimated marginal cost of a technology to purify water is EMC = 2 + 2q. Assume that the marginal benefit of one unit of cleaner water is M B = 14 − 2q.

- What is the estimated optimal quantity of cleaner water?
- What is the estimated optimal price, pe, to pay for one unit of cleaner water?
- Now assume the true marginal cost is MC = 6 + 2q. What is the true optimal quantity of cleaner water?
- If we use the former optimal estimated quantity (in a.) to coordinate, how many units of cleaner water will be generated? Do we over-generate or under-generate cleaner water? Draw a graph and show the welfare loss.
- If we use the former optimal estimated price to coordinate, how many units of cleaner water will be generated? Do we over-generate or under-generate cleaner water? On the same graph, show the welfare loss.
- Is the price signal better, or is the quantity signal better in this case, in terms of having smaller welfare loss? Why?

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