Winter 2021
Microeconomics II
Externalities
Dr. Wided Hemissi
Exercise 1:
Suppose that a producer of commodity Y is located on the upstream of a river. The MC of
producing the quantity QY is given by the function MC=10 + 0.5 QY.
In addition to this MC, however, an external cost is incurred. Each unit of product Y produces a
pollutant that flows to the river, which caused damage valued at 10. Suppose that this external cost is
borne by the wider community rather than by the polluting firm. The MR obtained from Y is given
by MR= 30 - 0.5 QY.
a. What is the market equilibrium output?
b. Find the marginal social cost equation.
c. What is the socially efficient level of output?
d. Which market-based instrument should the policy makers use in order to reduce emission of
pollutants?
Exercise 2 (Problem 11 in the textbook):
There are 3 industrial firms in Happy Valley. The government wants to reduce pollution to 120
units, so it gives each firm 40 tradable pollution permits.
Firm Initial Pollution Level Cost of reducing Pollution by 1 Unit
A 70 units $20
B 80 units $25
C 50 units $10
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Winter 2021
a. Who sells permits and how many do they sell? Who buys permits and how many do they buy?
Briefly explain why the sellers and buyers are each willing to do so. What is the total of
pollution reduction in this situation?
b. How much higher would the costs of pollution reduction be if the permits could not be traded?
Exercise 3 (Final Fall 2019):
NOTE: PART 1 AND PART 2 ARE INDEPENDENT
PART 1:
Suppose that the marginal cost (MC) of producing chocolate is given by the following equation:
MC = 440 + Q. The marginal revenue (MR) obtained from chocolate is given by MR = 1200 – Q
where Q stands for the quantity of chocolate. There are external benefits that the citizens derive
from having a chocolate odor wafting through town. The marginal external benefit (MEB) is the
following: MEB = 60 – 0.05 Q.
1. Without government intervention, what would be the equilibrium amount of chocolate
produced?
2. Find the marginal social revenue equation.
3. What is the socially optimal amount of chocolate production?
4. If the government used a subsidy of $ S per unit to encourage the optimal amount of chocolate
production, what level should that subsidy be?
PART 2:
A town has three steel factories, each of which produces air pollution. For each of the three sources
of air pollution, the following table lists the current amount of pollution being produced along with
the constant marginal cost of reducing it.
Source Units of pollution Marginal Cost of
currently being produced pollution reduction
Factory A 20 $10
Factory B 40 $20
Factory C 60 $30
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Winter 2021
1. The town City Council is currently considering the following policies for reducing pollution:
Policy 1: requiring each factory to reduce pollution by 10 units
Policy 2: requiring each factory to produce only 30 units of pollution
Policy 3: requiring each factory to reduce pollution by one-fourth.
Calculate the total costs of pollution reduction associated with each policy.
2. Another policy option (Policy 4) would create pollution permits, to be allocated and, if
desired, traded among the firms. If each factory is allocated 30 tradable permits allowing it to
produce 30 units of pollution, which factory will buy, and which factory will sell permits?
3. Suppose that the seller will sell all the 30 permits. Calculate the total cost of pollution
reduction associated with Policy 4.
4. Indicate the category of each of the four public policies as command-and-control policy or
market-based policy.