Externalities Sample Question

Suppose a firm has a downward sloping MB schedule associated with producing pollution emissions, given by MB(e) = 5 – e. Suppose the marginal private cost (MPC) for the firm is equal to zero at all emission levels, and the marginal social cost (MSC) is equal to a constant k = 2.

a) Draw the relevant curves in the space below.

b) What emissions level will the firm produce? Please label the diagram and write the answer in one sentence.

Now the government imposes a tax t on emissions, as shown in the diagram, where t > k. To answer the following questions, you will have to label areas of the diagram appropriately.

c) Say what are the effects of the policy on the firm are in terms of total gains or losses, relative to the initial situation.

d) Say what are the effects of the policy for users of the environment are in terms of total gains or losses, relative to the initial situation.

e) Say what are the effects of the policy on taxpayers (not counting the firm).

f) What is the net gain to society of the policy relative to the initial situation? The net gain can be negative.

g) As k rises holding t fixed, what happens to the net gain to society of the policy?