EC3351 Public Finance

2014/15 Semester 1

Tutorial 1 Suggested Solutions

Q1. A negative externality: Deal, tax or pay-to-reduce?
The market demand for a good is given by the equation QD = 120 2P, while the market
supply is given by the equation QS = 2P, where P is the market price in dollars per unit.
Production of the good creates a negative externality to third parties, and the marginal
external cost associated with the Qth unit of the good is given by the equation MEC = Q.
A. Find the efficient quantity, the market equilibrium quantity and price. Compute the
value of the deadweight loss associated with the market outcome. Use a diagram to
illustrate your answers.
Refer to the diagram drawn on the
left. To find the deadweight loss,
you need to find the coordinates of
the shaded triangle ABC.
Point A is the market equilibrium.
To find its coordinates, equate
quantity demanded with quantity
supplied: 120 2PM = 2PM
PM = $30 and QM = 60, where
subscript M denotes market. The
market quantity is thus 60 units.
Point B is the social optimum. Find
its coordinates by equating MSB
with MSC. The MSB equation is simply the demand equation with price (= $ willingness to
pay by consumers) as the subject1: MSB = 60 Q. The MPC equation is simply the supply
equation with price (= $ willingness to accept by producers) as the subject: MPC = Q. The
MSC equation is given by MSC = MPC + MD = 3Q/2. Diagrammatically, the MSC curve is
the vertical summation of the MPC and MD curves.
Equate MSB with MSC: 60 Q = 3Q/2 Q* = 30 and P* = $45. The optimal quantity is
30 units.
The MSC corresponding to Point C is given by 3(60)/2 = $90.
Thus, the area of the shaded triangle is (60 30)($90 $30) = (30)($60) = $900.

Since there is no positive externality, MSB = MPB, so I will use MSB throughout.

EC3351 Public Finance

2014/15 Semester 1

B. Assuming transaction costs are negligible, describe an agreement between consumers,

producers, and those affected by the externality, that would result in the efficient
quantity being produced.
Refer to the diagram from part A. If production shrinks from 60 to 30, consumer and
producer surplus will shrink by the area of triangle ABD = $450. But third parties would
gain $1,350, the area of trapezium ADBC2.
Third parties can offer to pay market participants an amount between $450 and $1,350 in
return for reducing production to 30 units, and market participants would agree to the
deal. This is a Pareto Improvement over the market outcome.
C. Suppose instead that the government imposes a $T-per-unit Pigouvian Tax on
producers. What is the value of T that would lead the market to produce the efficient
quantity? How is the Pigouvian solution different from the private solution in part B?
Since the vertical gap BD
between MSC and MPC at the
optimal quantity of 30 units is
$30, a $30/unit tax (placed on
producers in the diagram drawn
on the left) will shift the supply
curve up sufficiently for the
market to reach equilibrium
with 30 units produced. Thus, T
= 30.
As in part B, third parties gain
the area of trapezium ADBC =
$1,350.
The government gains tax
revenue = area of rectangle
DEFB = $30 x 30 = $900.
Market participants will lose surplus = area of triangle ABD + rectangle DEFB = $1,350.
Although gains outweigh losses by the same $900 as in part B, the result here is not a
Pareto Improvement over the market outcome, since market participants are worse off.

This trapezium is equal in size to the area under the MEC curve (not drawn) between Q = 30 and Q = 60.

EC3351 Public Finance

2014/15 Semester 1

D. Suppose instead that the government pays producers $S-per-unit to reduce their
production. Is there a value of S that would lead the market to produce the efficient
quantity? How does this solution compare to the Pigouvian Tax solution?
A payment of $30 per unit to reduce production will effectively shift producers supply
curve up in exactly the same way as the Pigouvian tax of part C, and will thus also result in
30 units produced. This is because each unit produced now incurs an additional cost of
$30 in foregone government payment.
As before, third parties gain $1,350. Government loses 30 x $30 = $900 in subsidy
payments. Market participants gain $450. Once again, gains outweigh losses by $900, but
the distributional implications are very different.
In practice, it is probably not advisable to pay producers to reduce production, since this
may attract more producers to enter the market!

EC3351 Public Finance

2014/15 Semester 1

Q2. Controlling Emissions in a cost-effective manner

This is a modified version of Question 12 in Chapter 5 of the textbook.
Suppose that two firms emit a certain pollutant. The marginal cost of reducing pollution for
each firm is as follows: MC1 = 300e1 and MC2 = 100e2, where e1 and e2 are the amounts (in
tons) of emissions reduced by the first and second firms, respectively. Assume that in the
absence of government intervention, Firm 1 generates 100 tons of emissions and Firm 2
generates 80 tons of emissions, and thus total emissions stands at 180 tons. Regulators aim
to reduce emissions by 40 tons i.e. to 140 tons.
A. Show that an emissions fee of $3,000 achieves the target at minimal cost. How many
tons of emissions will each firm reduce? How much would each firm pay in taxes?
With a fee, marginal costs are equalized, which is necessary and sufficient for cost
effectiveness.
As depicted in the diagram below, with a fee of $3,000, firm 1 cuts 10 tons while firm 2
cuts 30 tons. Firm 1s abatement cost is x $3,000 x 10 = $15,000 (triangle ABC), while
Firm 2s is x $3,000 x 30 = $45,000 (triangle AGH), so total abatement cost is $60,000.
Firm 1 pays a tax of 90 x $3,000 = $270,000 while Firm 2 pays 50 x $3,000 = $150,000.

B.
If regulators instead
command each firm to reduce
emissions by 20 tons, how large,
if any, is the resulting
deadweight loss?
Compared to part A, firms gain
by not having to pay tax, but
government loses by the same
amount. If each firm does 20
tons of abatement, Firm 1
incurs a total abatement cost of
x $6,000 x 20 = $60,000
(triangle ADE), while Firm 2 incurs abatement cost of x $2,000 x 20 = $20,000 (triangle
AFE). Total abatement cost is thus $80,000, which is $20,000 more than in part A. This
$20,000 is the deadweight loss of inefficient pollution reduction.3

An equivalent way of explaining the issue is to see that by moving to 20 tons of reduction each, firm 1 incurs
additional abatement cost of trapezium BCED, while firm 2 reduces its abatement cost by trapezium FEGH. The
former is larger than the latter by $20,000.

EC3351 Public Finance

2014/15 Semester 1

C. Instead of an emissions fee, the regulatory agency introduces a tradable permit system
and issues 140 permits, each allowing one ton of emissions. Each firm is given 70
permits. Assume that the firms act as price-takers. Show that equilibrium permit price is
$3,000, and that the two firms will reduce emissions by the same amount as in Part A.
If both firms act as price-takers, each firm will reduce pollution until the marginal cost of
reducing a ton of pollution equals the permit price of $3,000. Thus, Firm 1 will choose to
cut emissions by 10 tons. Firm 2 will choose to cut emissions by 30 tons. This is identical to
the result in Part A.
The diagram to the right shows
the market for permits, with
individual firm demand curves
and the market demand curve
(which is the horizontal
summation).
Firm 1 will want to buy 20
permits, since it will emit 90
tons but it only has 70 permits.
Firm 2 will want to sell 20
permits, since it will emit 50
tons of emissions but has 70
permits. Since 20 = 20, the permit market will be in equilibrium! Thus, $3,000 is the
equilibrium permit price.
D. Suppose the marginal damage of emissions is found to be constant at $2,000 per ton.
How should the government alter the number of permits, if at all, to obtain the optimal
quantity of emissions?
The marginal damage of emissions is the marginal benefit of reducing one ton of
emissions. The optimal amount of pollution is obtained when this is equal to the marginal
abatement cost. Thus, Firm 1 should reduce emissions by 2000/300 = 6.67 tons, while firm
2 should reduce emissions by 2000/100 = 20 tons. Total abatement should thus be 26.67
tons. The government should issue enough permits to allow for 153.33 tons of emissions.

EC3351 Public Finance

2014/15 Semester 1

Q3. Applying the theory of externalities

Assess the following situations and answer the following questions: (1) Does an externality
exist? (2) Does the Coase Theorem apply? (3) what (e.g. legislation, regulation, tax, quota,
etc. or do nothing) is the appropriate government response?
A. Crying babies in a restaurant
1. Crying babies in a restaurant create a negative externality, because the noise disrupts
the dinners of other patrons but the babies parents do not need to take this into
account.
2. Rights on noise can be assigned, and negotiation costs may not be prohibitive given
the small number of parents with babies in a restaurant, with other patrons being
represented by the restaurant management, which has a strong stake in maintaining a
good dining environment. The Coase Theorem may thus apply, and a viable solution is
to grant the rights on noise to restaurant management. Restaurants are free to ban
customers with crying babies or to ask mothers to bring babies outside until they quiet
down.
3. Government should not do any further intervention.
B. Smoking in indoor indoor public areas
1. Smoking indoors in communal areas affects others negatively because of a number of
reasons such as damage to health form passive (second-hand) smoking, irritation from
the smoke, and increased risk of fire. Because these effects are not taken into account
by the smoker and are not transmitted by market prices, they qualify as externalities.
2. As there are too many smokers and non-smokers, it is probably too costly to use the
Coase Theorem to allow for negotiations after assigning legal rights in public
communal areas. Yet the damage to non-smokers is substantial.
3. Some options for government response:
a. A tax placed on cigarette purchases would harm smokers even if they smoke
outdoors (where the external costs are much smaller).
b. A tax placed on smoking activity indoors, operating akin to an emissions fee,
would be more suitable, but it is extremely difficult to implement as it requires
tracking the number of cigarettes each person smokes in all indoor public
areas.
c. A third option is to do nothing (in effect giving non-negotiable rights to
smokers). This places the burden of adjustment on non-smokers they have to
endure the smoke or walk away from it. Second hand smoking is extremely
harmful to health, and the added risk of fire is not trivial.
d. A fourth option is to impose a ban on indoor smoking in public areas. This
places the burden of adjustment on smokers, but it is not a heavy adjustment
because they can still step outdoors for smoke breaks. This is likely to be the
least costly option.
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