Econ

2 Section Questions

1. For each of the following, use a graph to show the private market equilibrium
and how it differs from the social optimum.
a. The market for natural gas when the process used to extract natural
gas from the earth leads to environmental damage.
b. The market for cigarettes when one persons consumption of
cigarettes can harm others (because of second-hand smoke).
c. The market for solar panels for peoples homes given that the use of
solar panels can help reduce pollution by reducing the demand for
electricity from coal plants.
a.
MC to society
P

S


The private market

will produce too much

P*
natural gas relative

the social optimum.


D


Q

QS Q*
b. P

S


The private market

will produce too many
P*

cigarettes relative the

social optimum.

D

MB to society


Q
QS Q*

c.
P

S


The private market

MB to
will produce too few

P*
society
solar panels relative

to the social optimum.


D


Q
Q* QS

2. Is the following statement true of false? Explain. There are externalities in

every market because when consumers purchase more of a good, it drives up
the price for everyone else. This imposes an additional cost on society and
implies that all goods are overproduced.

This is false. In perfectly competitive markets, each individual consumer has
no effect on the market price because there are assumed to be many buyers
each of whom purchases only a small fraction of the total quantity
exchanged.

3. Suppose that The Lakeside Caf and Camp Canoe are both situated along the
banks of Lake Dreary. Unfortunately, for the campers at Camp Canoe, The
Lakeside Caf regularly dumps garbage into Lake Dreary, and this makes the
lake smelly and dirty and negatively impacts Camp Canoes profits because
parents dont want to send their kids to a camp on a dirty, smelly lake. The
table below shows the daily profits for The Lakeside Caf and Camp Canoe
when the Lakeside Caf does and does not dump its garbage in the lake.


No Garbage
Garbage in
in the Lake
the Lake
Lakeside Caf
1000
1100
Camp Canoe
600
400

a. Is it socially efficient for The Lakeside Caf to dump their garbage into
Lake Dreary? Explain.
b. If the The Lakeside Caf and Camp Canoe cannot negotiate with each
other, and if The Lakeside Caf has the right to dump garbage into the
lake, then what will be the likely outcome?
c. If the Lakeside Caf and Camp Canoe can costlessly negotiate with each
other, then what will be the likely outcome? That is, will The Lakeside
Caf dump their garbage into the lake?
d. How might this agreement be reached if The Lakeside Caf has the right
to dump garbage into the lake?
e. How might this agreement be reached if Camp Canoe has the right to
decide whether The Lakeside Caf can dump garbage into the lake?
f. Should it matter to an economist who is only interested in economic
efficiency whether The Lakeside Caf has the right to dump garbage or
whether Camp Canoe has the right to stop The Lakeside Caf from
dumping garbage? Explain.
g. Should it matter to Camp Canoe whether The Lakeside Caf has the right
to dump garbage or whether Camp Canoe has the right to stop The
Lakeside Caf from dumping garbage? Explain.

a. No because total surplus is maximized when no garbage is dumped in the
lake (1600>1500).

b. The Lakeside Caf will dump garbage into the lake since 1100>1000.
c. The Coase Theorem tells us that the social optimum will be achieved, so
no garbage will be dumped in the lake.
d. Camp Canoe could pay $150 dollars to the Lakeside Caf every day to stop
dumping garbage into the lake. The Lakeside Caf would then have
$1150 per day and Camp Canoe would have $450 per day (so they would
both be $50 better off than when the garbage was being dumped in the
lake).
e. Camp Canoe would simply demand that the Lakeside Caf stop dumping
garbage since they have the legal right to do so.
f. The economist wont care. In either case, the efficient outcome is
achieved.
g. Camp Canoe does care. They will get $600 a day if they have the right to
stop The Lakeside Caf from dumping garbage, but they will get less than
this if the Lakeside Caf has the right to dump garbage because Camp
Canoe would have to pay them to stop.

4. Suppose the supply curve for jet ski rentals on Mission Bay is given by
P=2+0.1Q, where P is the daily rental fee per jet ski in dollars and Q is the
number of jet skis rented each day. The demand curve for jet skis is given by
P=20-0.2Q.
a. If each jet ski imposes a $6 per day cost on others (because they are so
noisy), by how much will the equilibrium number of jet skis rented
each day exceed the socially optimal number?
b. How would the imposition of a tax of $6 on each jet ski rental affect
efficiency in this market?

a. The market equilibrium will occur where 2+0.1Q=20-0.2Q => 0.3Q=18
=> Q*=60. The socially optimal quantity occurs where 8+0.1Q=20-
0.2Q => 0.3Q=12 => QS=40. So the equilibrium number of jet skis
exceeds the social optimum by 20.
b. This would lead to the efficient outcome since the tax would imply
that marginal cost of production to sellers would be equal to the social
marginal cost curve.

5. A village has 6 residents, each of whom has an accumulated savings of $100.
Each villager can use this money either to buy a government bond that pays
15 percent interest per year or buy a 1-year-old llama, send it onto the
commons to graze, and sell it after a year. The price the villager gets for the
2-year-llama depends on the quality of the fleece it grows while grazing on
the commons, which in turn, depends on the number of llamas sent into the
commons, as shown in the following table:

Number of
Price Per
Llamas on the
2-Year

Commons
1
2
3
4
5
6

Old Llama
122
118
116
114
112
109

Assume the villagers make their investment decisions one after the other,
and their decisions are public.
a. If each villager decides individually how to invest, how many llamas
will be sent out into the commons, and what will be the resulting net
village income?
b. What is the socially optimal number of llamas for this village? Why is
it different from the actual number? What would net village income
be if the socially optimal number of llamas were sent out into the
commons? Why might it be difficult for the villagers to agree to send
the socially optimal number of llamas into the commons?
c. Suppose the village decides to auction the right to graze llamas on the
commons to the highest bidder. Whoever purchases the right to graze
llamas on the commons can resell this right to another villager in the
future. Assuming the villagers can both borrow and lend at a 15
percent annual interest rate, how much will the right to graze llamas
on the commons sell for at auction. How will the new owner use the
right, and what will be the resulting village income?

a. See the table below: 3 villagers will send llamas out into the commons
and 3 villagers will buy the government bond. Total village income will
be 3*$16+3*15=$93
b. See the table below: the socially optimal number of llamas is 1. This is
less than the actual number from part a because in part a, the villagers
did not take into consideration the fact that when they send a llama out to
graze on the commons it negatively impacts the sales price of all the other
llamas. If 1 llama were sent into the commons, total village income would
be 1*$22+5*15=$97.
c. The right to graze on the commons will sell for at most $46.67. To see
this note that the total expense of grazing on the commons will be
$100+X(1+.15), where X is the price paid for the right to graze on the
commons (which has to be borrowed at an interest rate of 15 percent). In
addition, the total value of this investment at the end of the year will
equal $122+X. This implies that the net income from purchasing the right
to graze on the commons equals ($122+X)-[$100+X(1+.15)]=22-.15X.
Since no one will be willing to purchase the right to graze the commons
unless they can earn at least $15 (what they can earn if they purchase a
government bond), then we know that 22-.15X15, which implies that

X$46.67, so the most the right to graze the commons will sell for is
$46.67. The new owner will graze 1 llama on the commons and total
village income will be 6*$15 +0.15*$46.67=$97.

Number of Price Per
Net
Total
Marginal
Llamas on
2-Year Income Village
Income
the Commons
Old
Per
Income
Llama
Llama
1
122
22
22
22
2
118
18
36
14
3
116
16
48
12
4
114
14
56
8
5
112
12
60
4
6
109
9
54
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