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Tax Impact on Welfare and Pollution

Economics problem set

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11 views5 pages

Tax Impact on Welfare and Pollution

Economics problem set

Uploaded by

CUNNSOME OPTICS
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

1

Problem Sets 1 & 2 Combined


Solutions
Question 1
a) False: When a tax is imposed, the loss of consumer surplus and producer surplus as a
result of the tax exceeds the revenue raised by the government because of the deadweight
loss of the tax.
b) True: When calculating deadweight loss, the deadweight loss is actually an area of a
triangle. When the size of the tax is increased (let’s assume we double the size of the tax)
both the base and the height of triangle will double and therefore, the area of the triangle
will increase 4 times. Therefore, when you increase the size of the tax by a factor of 2,
deadweight increases by a factor of 4.
c) True: When there is a negative production externality, for example, pollution emitted by
a factory, a Pigovian tax on producers can internalize the external cost. When pigovian
tax is imposed on producers based on the quantity of pollution, they have the incentive to
reduce pollution, which ultimately maximizes social welfare. On the other hand, when
there is a negative consumption externality, for example, smoking cigarettes, tax is
imposed on consumers, which increases the price for such products. With higher prices,
consumers have the incentive to reduce consumption, which ultimately maximizes social
welfare
d) False: the welfare loss of ignoring a negative production externality is greater when the
demand curve is more elastic. Ignoring a negative production externality with demand
curve being more elastic leads to a larger increase in output leading to a greater welfare
loss.
e) True: According to the Coase Theorem, when transaction costs are zero, firms can
negotiate and reallocate permits among themselves until an efficient outcome is reached.
This implies that with zero transaction costs, firms can trade permits freely until the
allocation of permits aligns with the most economically efficient outcome, regardless of
the initial distribution.

Question 2
With no taxes, the equilibrium price and quantity will be:
Qd = Qs
100 – Q = Q
100 = 2Q
Q = 50
P = Q = 50
Social cost = $1 per unit
2

Before tax is imposed, total welfare = producer surplus + consumer surplus – Deadweight loss
due to externality = (1/2 * 50 * 50) + (1/2 * 50 * 50) – ($1 * 50) = $2450
After tax, Price will increase to 51 for buyers, and producers only receive 49. The quantity
produced will fall to 49 (100 – 51). Therefore, the total producer and consumer surplus will be
(1/2 * 49 * 49) + (1/2 * 49 * 49) = $2,401
The total tax revenue collected by government will be $2 * 49 = $98 and the deadweight loss due
to externality = $1 * 49 = $49
New total welfare will be $2,401 + $98 - $49 = $2,450.
Therefore, the new total welfare after tax intervention is equal to the total welfare before tax,
meaning that overall welfare does not change.

Question 3
a) Firm A has an initial pollution level of 70 units and it has only 40 permits from the
government. Therefore, it will need 70 – 40 = 30 permits more permits
Firm B has an initial pollution level of 80 units and it has only 40 permits from the
government. Therefore, it will need 80 – 40 = 40 permits more permits
Firm A has an initial pollution level of 70 units and it has only 40 permits from the
government. Therefore, it would need 50 – 40 = 10 permits more permits.
Assuming that all the three firms will need to buy permits.
Firm A would incur a cost of 30 * $20 = $600
Firm B would incur a cost of 40 * $25 = $1,000
Firm C would incur a cost of 10 * $10 = $100
Ideally, the firm with higher cost of reducing pollution will want to buy the permits from
the firm with lower cost per unit. Therefore, Firm B which have the highest cost will
want to buy the 40 permits from firm C at any price below $25.
Therefore, Firm C would sell their 40 permits while firm B would buy 40 permits from C.
Firm A would not buy or sell.
The total cost of reducing pollution will be:
Firm A would incur a cost of 30 * $20 = $600
Firm C would incur 50 *$10 = $500
Total cost = $600 + $500 = $1,100

b) If the permits were not traded, the total cost of pollution reduction would be as follows:
Firm A would incur a cost of 30 * $20 = $600
Firm B would incur a cost of 40 * $25 = $1,000
Firm C would incur a cost of 10 * $10 = $100
Total cost = 1,700
3

Question 4
a) If the government knew the cost of reduction for each firm, then the government would
want the firm with lower cost of reducing pollution to reduce more/ eliminate all of its
pollution. From the data given, Cyber Port Industrial has lower cost of reducing glop
emissions than HKU chemicals. Therefore, government would want Cyber Port Industrial
to eliminate pollution completely and HKU chemicals to reduce the pollution from 100
tons to 50 tons. Cyber port would therefore incur a cost of 100 * $10 = $1,000 and HKU
would incur a cost of 50 * $100 = $5,000. The total cost = $1,000 + $5,000 = $6,000.
b) If the government imposes uniform reductions on the firms, then each firm would have to
reduce pollution by 75 tons. Cyber port would therefore incur a cost of 75 * $10 = $750
and HKU would incur a cost of 75 * $100 = $7,500. The total cost = $750 + $7,500 =
$8,250
c) The cost calculated in (a) equals $6,000, therefore, this cost is lower than the one
calculated in part (b). The government could achieve therefore need to use tradable
permits to achieve the goal of reducing pollution to 50 tons. This would work as follows:
the government would offer 50 permits to both firms but since the cost of reducing
pollution is significantly lower for Cyber port, HKU chemicals would claim all these
permits and by doing so, it would reduce its pollution from 100 tons to 50 tons, therefore,
eliminating 50 tons of pollution and incurring a cost of 50 * $100 = $5,000. Cyber port
would eliminate all of its pollution and incur a cost of 100 * $10 = $1,000. Total cost of
eliminating pollution would be $6,000 (same as calculated in part a).

Question 5
a) When a small country is abundant in rare metals, it means that domestic prices for those
rare metals are low and below the world prices. When the country is open to trade and
exports those rare metals to the international market, it does so at higher prices and
therefore, the domestic producers gain from higher prices in the international market and
also the government gains because of the export taxes or fees on exported rare metals.
However, domestic consumers will lose because they will face higher prices due to
reduced domestic supply. Overall, the social welfare may increase due to higher producer
surplus and government revenue which may be higher than the decrease in consumer
surplus.
b) Pollution is a negative externality and it reduces social welfare.
Before International trade:
4

Cost and Benefit


a

MSC
MPC
P1 b e
P c f

d MSB
Quantity
Q1 Q
P and Q is the price and quantity that exist in the market without regards to pollution. If
we take pollution into account (negative externality), the marginal social cost is higher
than marginal price cost, hence the marginal social cost curve is above the marginal
private cost curve. The new price is P1 (which is above market price P) and new quantity
is Q1 (which is below the market quantity). Initially, consumer surplus is area acf and
producer surplus is area cdf. With pollution, new consumer surplus is area abe and new
producer surplus is area bec. The shaded area represents welfare loss due to pollution.

With International Trade:


Cost and Benefit
a

MSC
MPC
P1 b e
P c f

d MSB
Q1 Q Q2 Quantity
5

From the graph, P represent the domestic price and Q represent the domestic demand without
international trade. P1 represents the world price and therefore when the country opens to trade,
it is able to supply a quantity of Q2. Of this quantity, Q1 is sold in the domestic market and (Q2-
Q1) is exported. Since the price in the international market is higher, this means that the
increased cost due to pollution can be offset. If we assume that international price (P1) is greater
than or equal to MSC, then the deadweight due to pollution can be eliminated, meaning that total
welfare before trade = total welfare after trade.
c) It is possible that opening to trade decreases the social welfare of the country when the If
the gains from producer surplus and government revenue outweigh the losses from
consumer surplus and external costs, social welfare may increase. Due to increased
production in order to export more, pollution increases due to metal extraction, and this
negatively impacts social welfare.

Cost and Benefit


a MPS

P1 b
MPC
P c e

d Demand
Q1 Q Q2 Quantity
From the graph, the deadweight loss due to increased pollution increases. The consumer
surplus decreases significantly due to increased price, which decreases quantity. The
producer surplus increases as well as government revenue but the effects of the decrease
in consumer surplus and increased social costs of pollution are larger, meaning overall
social welfare will decrease.

Common questions

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If the demand curve is more elastic, ignoring a negative production externality results in a larger increase in output, leading to greater welfare loss. This is because elastic demand causes larger changes in quantity when price changes, thus exacerbating the inefficiency and the resulting welfare loss .

The government can minimize costs by requiring the firm with lower reduction costs, like Cyber Port Industrial, to eliminate more pollution. By understanding cost structures, the government ensures that pollution is reduced most economically, achieving a total cost of $6,000 compared to $8,250 under uniform reduction policies .

In the scenario, firms buy and sell pollution permits based on their respective costs of reducing pollution. Firm B, with the highest reduction costs, buys permits from Firm C, which has lower costs. Firm A incurs costs to meet its needs without trading. This process minimizes total pollution reduction costs to $1,100 through efficient permit allocation compared to non-trading costs of $1,700 .

According to the Coase Theorem, when transaction costs are zero, firms can negotiate and reallocate pollution permits to reach an efficient outcome. By allowing firms to trade permits freely, the distribution adjusts to align with the most economically efficient allocation, regardless of the initial distribution, maximizing overall welfare .

International trade can affect domestic welfare by altering the balance between consumer and producer surplus and the costs of pollution. While trade increases producer surplus and government revenue through exports at higher prices, it can decrease consumer surplus and exacerbate pollution, reducing overall welfare if negative external costs are significant .

In the presence of a negative externality, imposing a tax can neutralize the deadweight loss due to the externality, as reflected in equal total welfare before and after tax intervention. This is because the tax revenue collected offsets the welfare loss due to the externality, maintaining overall welfare at the same level .

A Pigovian tax incentivizes producers to reduce negative production externalities, such as pollution, by internalizing the external cost. For negative consumption externalities, like smoking, a tax on consumers raises product prices, thereby reducing consumption. Both approaches aim to maximize social welfare by correcting the market failures associated with externalities .

The deadweight loss of a tax increases by a factor of four when the size of the tax is doubled because both the base and the height of the triangle representing the deadweight loss double. This implies that increasing tax size can significantly reduce economic efficiency due to the larger deadweight loss .

Opening to international trade can increase social welfare if producer surplus and government revenue gains from higher international prices surpass consumer surplus losses. However, increased production to meet export demand can escalate pollution, potentially decreasing social welfare if negative externalities outweigh trade benefits .

Enforcing uniform pollution reductions leads to higher total costs, as firms with higher reduction costs are forced to cut emissions inefficiently. In contrast, tradable permits allow pollution to be reduced by firms with lower costs, achieving the same environmental goal at a lower total cost by redistributing permits efficiently among firms .

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