Exercises on Externalities

Exercise 1 Road traffic.

Solution exercise 1.

1. In equilibrium, the number x∗ of cars satisfies

60 = 20 + 0.1x∗ ⇐⇒ x∗ = 10 × 40 = 400

More precisely, if 60 < 20 + 0.1x∗ , then one driver prefers to take the train (and vice-versa).
If 60 > 20 + 0.1x∗ + 0.1, then one train rider prefers to take the car.
So in equilibrium
60 − 0.1 ≤ 20 + 0.1x∗ ≤ 60 ⇐⇒ 399 ≤ x∗ ≤ 400

There are thus two equilibrium values: 399 and 400 which are roughly the same.

2. When there are x cars on the road, the total commuting time is

F (x) = (1000 − x)60 + x(20 + 0.1x)

At the minimum
F 0 (xo ) = −60 + 20 + 2 × 0.1xo = 0 ⇐⇒ xo = 200

3. If each commuter has to pay a toll t for the highway, the new equilibrium is such that

60 = 20 + 0.1x∗ + t ⇐⇒ x∗ = 10 × (40 − t), x∗ = 200 ⇐⇒ t = 20

(x∗ = 200 up to one unit).

Exercise 2 Barbecue.

Solution exercise 2.

1. Consuming c = 1 is a dominant strategy. Everyone has a utility of 0.

2. If everyone agreed to consume x, the utility would be x(1 − x) which is maximal for x = 1/2 and
everyone has a positive utility of 1/4.

Exercise 3 Free riding

Solution exercise 3. There can only be one student voting For in equilibrium. Suppose that m > 1
students vote For, then each of them pays 100/m and gets a net utility of v − 100/m where v is her
valuation for coffee. Any such student has an incentive to free-ride and not vote, thereby enjoying v
without paying.
The machine will thus be bought only if at least one student prefers buying it alone (v − 100 > 0)
rather than not buying it. Thus, Student 5 votes for and all others free ride.

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Exercise 4 Free riding 2

Solution exercise 4.
We have D(8) = 18 − 16 = 2.
When the bill is split and the quantities are q1 , q2 , student 1 pays 8 q1 +q2
2 . His net surplus (utility) is
Z q1
q1 + q2
S(q1 ) = P (q)dq − 8
0 2

where P (q) = 9 − q/2. At optimum, the derivative (marginal value) of this expression is 0 so,

S 0 (q1 ) = P (q1 ) − 4 = 0

So 9 − q1 /2 = 4 ⇐⇒ q1 = 10. In other words, the marginal benefit of consumption is P (q1 ), its

Exercise 5 Tragedy of the commons.

Solution exercise 5.
There are 2 firms, each chooses how much to produce. Each firm i’s production activity consumes a
quantity ki of clean air. Let K be total amount of clean air (common resource). The payoff to firm 1
resulting from strategy profile k = (k1 , k2 ) is

v1 (k1 , k2 ) = log(k1 ) + log(K − k1 − k2 )

(Symmetric payoff for firm 2)

1. Calculate the best-response function of each firm and find the Nash equilibrium.

2. Is it socially optimal?

1. Fix k2 and maximise log(k1 ) + log(K − k1 − k2 ) with respect to k1 . Taking the derivative (w.r.t.
k1 ) gives
1 1
− = 0 ⇐⇒ k1 = K − k1 − k2 ⇐⇒ k1 = (K − k2 )/2
k1 K − k1 − k2
So the best-response of firm 1 to k2 is k1 = (K − k2 )/2 and symetrically, the best-response of firm
2 to k1 is k2 = (K − k1 )/2.
The NE is such that k1∗ = (K − k2∗ )/2 and k2∗ = (K − k1∗ )/2. The solution is k1∗ = k2∗ = K/3. The
payoff for each firm is 2 log(K/3) = 2 log(K) − log(9).

2. Suppose that one chooses the pair (k1 , k2 ) in order to maximise

v1 (k1 , k2 ) + v2 (k1 , k2 ) = log(k1 ) + log(k2 ) + 2 log(K − k1 − k2 )

For simplicity, suppose that we choose k1 = k2 = k and maximise 2 log(k) + 2 log(K − 2k) with
respect to k. Taking the derivative gives
2 4
− = 0 ⇐⇒ K − 2k = 2k ⇐⇒ k = K/4
k K − 2k
If k1 = k2 = K/4, the payoff of each firm (say firm 1) is

v1 (K/4, K/4) = log(K/4) + log(K/2) = 2 log(K) − log(8)

which is better than the NE payoff.

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Exercise 6 Perfect competition, pollution and taxes.

Solution Exercise 6

1. For each firm, profit maximization gives p = M C(q) = C 0 (q) = q ⇒ the individual supply is
s(p) = p. The economic cost is C(q) = 21 q 2 +50 and the average economic cost is AC(q) = 21 q + 50
q .
∗ 1 50
To calculate p = min AC, we set AC(q) = M C(q) ⇒ 2 q + q = q, which gives q = 10. Hence,
p∗ = AC (10) = 10.
Firms will keep entering this market until the price decreases down to p∗ = 10 which is the long-
run equilibrium price, and the individual quantity supplied is q ∗ = 10. From the market clearing
condition S(p∗ ) = D(p∗ ), we have 10n = 1000 − 10 × 10 ⇒ n∗ = 90.

2. The optimal tax is t = m0 (q) = 12.

3. With the tax, the new cost function for an individual firm is CA (q) = 12 q 2 + 12q + 50. From profit
maximization p = M CA (q) we get p = q + 12, and the individual supply is s (p) = p − 12 provided
that p > 12.
The average cost in country A is now ACA = 21 q + 12 + 50
q . If we write ACA = M CA ,

1 50
q + 12 + = q + 12
2 q
∗ = 10 and hence p∗ = 22. The long run equilibrium price is thus 22 and the individual
we get qA A
quantity is 10. The equality between supply and demand in country A gives 10nA = 1000−10×22
and nA = 78.

4. Short run: we have nA = 78 and nB = 90, global demand is D (p) = 2000 − 20p. From q.1
the individual supply of firms B is s(p) = p and from q.3 the individual supply of firms A is
s (p) = p − 12 for p > 12. We check whether all firms are active at equilibrium. If all firms are
active (p > 12), then:

78(p − 12) + 90p = 2000 − 20p ⇐⇒ p = 2936/188 ≈ 15.61 > 12

So this is the equilibrium.

5. Long run: Let’s examine whether some firms enter or exit the market.
Enter. From the previous question, firm enter in country A when the price is > 22, so no entry
in country A. In country B, firms enter when the price is > 10. So starting from a price ≈ 15.61
firms will enter in country B and the price will go down.
Exit. But now, firms from country A will exit the market. When will this process stop? Only
when all firms in country A have exited, and so many firms have entered in country B that the
price stabilizes at 10.
In the long run equilibrium, industry dies out in country A and entirely delocalizes to country B.
The selling price is 10 again, there are 180 firms each producing 10 units. The main difference is
that country B suffers from the all the pollution of both countries (thinks of textile industry).