HE3001 Tutorial 7
1) Consider the paper industry. Suppose each paper mill produces in a way that pollutes the environment
which imposes a negative externality on people living nearby.
Denote the market output by Q. Suppose the inverse market demand function for paper is P=330−2 Q
. There are 30 paper mills in the industry. The marginal private cost of an individual paper mill is
p
M C ( q)=20+2 q . The marginal external cost, resulting from the pollution of paper production, is
e 1
M C (Q)= Q.
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(a) What is the competitive equilibrium?
(b) What is the social optimum?
(c) Is the competitive equilibrium the same as the social optimum? If not, what is the tax rate that results
in the social optimum?
2) An airport is located next to a large tract of land owned by a housing developer. The developer would
like to build houses on this land, but noise from the airport reduces the value of the land. The more
planes that fly, the lower the profits that the developer makes. Let X be the number of planes that fly
per day and let Y be the number of houses that the developer builds. The airport’s total profits are
2 2
48 X−X , and the developer’s total profits are 60 Y −Y −XY .
Let us consider the outcome under various assumptions about institutional rules and about bargaining
between the airport and the developer.
(a) “Free to Choose with No Bargaining”: Suppose that no bargains can be struck between the airport and
the developer and that each can decide on its own level of activity. What will be the number of houses
built and planes flying?
(b) “Strict Prohibition”: Suppose that a local ordinance makes it illegal to land planes at the airport
because they impose an externality on the developer. What will be the outcome in the market?
(c) “Lawyer’s Paradise”: Suppose that a law is passed that makes the airport liable for all damages to the
developer’s property values. Since the developer’s profits are 60 Y −Y 2−XY and his profits would be
2
60 Y −Y if no planes were flown, the total amount of damages awarded to the developer will be XY.
What will be the number of houses built and planes flying?
(d) “Merger”: Suppose that the housing developer purchases the airport. What is the profit function for
the new joint entity? What will be the number of houses built and planes flying?
(e) Explain why each of the institutional rules proposed from (a) to (c) does not reach an efficient
outcome and has lower combined profits.
(f) “Dealing”: Suppose that the airport and the developer remain independent. If the original situation
was one of “free to choose,” could the developer increase his net profits by negotiating with the airport
to cut back one flight per day if the developer has to pay for all of the airport’s lost profits? Assume that
this is legally enforceable.
(g) The developer decides to get the airport to reduce its flights by paying for all lost profits coming from
the reduction of flights. To maximize his own net profits, how many flights per day should he pay the
airport to eliminate?
3) Tom and Jerry are roommates. They spend a total of 80 hours a week together in their room.
Tom likes loud music, even when he sleeps. His utility function is U T (CT , M )=C T + M , where C T is the
number of cookies he eats per week and M is the number of hours of loud music per week that is played
2
M
while he is in their room. Jerry hates all kinds of music. His utility function is U J ( C J , M )=C J − .
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Every week, Tom and Jerry each get two dozen chocolate chip cookies sent from home. They have no
other source of cookies.
We can describe this situation with an Edgeworth-like box below.
Music
80
48
Tom Cookies Jerry
Since cookies are private goods, the number of cookies that Tom consumes per week plus the number
that Jerry consumes per week must equal 48. But music in their room is a public good. Each must
consume the same number of hours of music (≤ 80), whether he likes it or not.
Recall that each point in the box hence describes an allocation of cookies and music.
(a) Suppose the dorm’s policy is that you must have your roommate’s permission to play music. What will
be the resultant allocation if Tom and Jerry can make no deals? Mark this allocation ( A ¿ in the box and
draw the indifference curves for Jerry and Tom passing through it. Shade the points, if any which would
make both roommates better off than at point A.
(b) Suppose, alternatively, that the dorm’s policy is “rock-n-roll is good for the soul.” You don’t need your
roommate’s permission to play music. What will be the resultant allocation if Tom and Jerry can make no
deals? Mark this allocation ( B ¿ in the box and draw the indifference curves for Jerry and Tom passing
through it. Shade the points, if any which would make both roommates better off than at point B.
(c) Who effectively owns the “property rights” over playing music in each of the cases a) and b)?
(d) Suppose in each of the cases (a) and (b), they are now allowed to make deals and that any deals can
be enforced. What kinds of deals are possible for each case?
(e) (Optional) After any deals, will the music outcome in case a) be the same as case b)? Explain why.
(Hint: this requires you to make an accurate drawing of the edgeworth box)
4) In El Carburetor, California, with a population of 1001, there is not much to do except to drive your car
around town. Everybody in town is just like everybody else. While everybody likes to drive, everybody
complains about the congestion, noise, and pollution caused by traffic.
A typical resident’s utility function is U ( m, d , h)=m+ 16 d−d 2−6 h/1000, where m is the resident’s
daily consumption of Big Macs, d is the number of hours per day that he, himself, drives, and h is the
total amount of driving (measured in hours per day) done by all other residents of El Carburetor. The
price of Big Macs is $1 each. Every person in El Carburetor has an income of $40 per day. For simplicity,
suppose it costs nothing to drive a car.
(a) If an individual believes that the amount of driving he does won’t affect the amount that others drive,
how many hours per day will he choose to drive?
(b) If everybody chooses his best d , then what is the total amount h of driving by other persons?
(c) What will be the utility of each resident?
(d) If everybody drives 6 hours a day, what will be the utility level of a typical resident of El Carburetor?
(e) Suppose that the residents decided to pass a law restricting the total number of hours that anyone is
allowed to drive. How much driving should everyone be allowed if the objective is to maximize the utility
of the typical resident?
(f) The same objective could be achieved with a tax on driving. How much would the tax have to be per
hour of driving?
Conceptual Questions
5) If there is a negative externality associated with production, can the government tax consumers to
solve the problem? Try illustrating your explanation in a diagram.
6) When utility is quasi-linear vs not-quasi-linear, what will be the difference in the effects of assigning
property rights?
