Microeconomics (Fall 2024)

Problem Set 7: Public Goods, Externalities and the Monopolist’s Problem

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Part I: Public Goods and Externalities

1. Manufacturing processes that rely on fossil fuels create carbon dioxide and other greenhouse gases
that may contribute to global warming. Suppose you are in charge of designing an economic policy to
reduce carbon dioxide emissions.
The inverse demand function for fuel is:
P = 18 − Q

The private cost of producing the fuels that emit carbon dioxide is:

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CPriv (Q) = 12 + Q2
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Atmospheric scientists have computed that the external cost of fuels (due to greenhouse gas emissions)
is:
CE (Q) = Q2

The market for fuels is perfectly competitive.

(a) What is the market-clearing price and quantity if only the private cost is considered?
(b) What is the efficient price and quantity if firms consider both the private costs and the external
costs (on the environment)?
(c) What is the deadweight loss (aggregate social cost) if firms do not take into account the external-
ity? (Note: it helps to draw a diagram and label it, then get the number!)
(d) How much should the government tax this good to arrive at the efficient quantity of fuel produc-
tion? [Hint: the government needs to know the marginal external cost (MEC) when setting a
tax]

1. A small island, known as Dark Island, does not have a lighthouse. The citizens of Dark Island are
trying to persuade the governor of the island to build one. This would help those in the fishing trade
return home safely after a night of work on their boats (which is the most popular activity among Dark
Island’s workers). However, not everyone shares the same interest in the creation of a lighthouse: there
is a group of citizens (denoted as Group 1) who own a farm and do not value the use of the lighthouse
for work. They will only use the lighthouse for leisure boating. The rest of the population (Group 2)
does not have any other work activity and is in desperate need of a lighthouse for their livelihood.
Given the relevance of the request, the governor decides to accommodate it and to start the construction
of a lighthouse. However, having it running all night is too expensive for a small island, so the governor

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 has to compare the benefits and costs of the activity and choose the socially optimal amount of hours
of lighting to provide.
Denote by Q the amount of hours in which the lighthouse works at night. The marginal cost the
governor has to pay for every extra unit of Q is constant and equal to $6. The marginal benefit of an
extra hour for Group 1 is described by the function:

6
M B1 (Q) =
Q

while the one for Group 2 is given by:

12
M B2 (Q) =
Q

(a) What kind of good is the lighthouse? Explain.

(b) Given the marginal benefits of the two population groups and the marginal costs faced by the
governor, how many hours should the lighthouse work at night? [Hint: You should look for the
efficient level of Q, Q∗ ]
(c) Due to an unexpected heat wave, the farm activity becomes less valuable in Dark Island. This
changes Group 1’s marginal benefit function, which becomes the same as Group 2 (i.e., M B1 (Q) =
M B2 (Q) = 12
Q ). Do you expect a change in the level of provision of the good? Will Q increase or
decrease? Explain and compute the new efficient level of Q, Q∗∗ .
(d) Due to an increase in the price of electricity, the marginal cost of running the lighthouse goes from
$6 to $12. Even if the heat wave is still devaluing the farm activity (i.e., the marginal benefits
of the group are as in part (3)), the governor is forced to revise his previous decision about the
hours of operation of the lighthouse. Do you expect an increase or a decrease in Q compared to
part (3)? Explain and compute the new efficient level of Q, Q∗∗∗ .

Part II: The Monopolist’s Problem

1. Suppose a monopolist’s costs are described by the function C(Q) = 20 + 3Q2 and the monopolist faces
a demand curve of Q = 12 − P .

(a) What are the monopolist’s profit-maximizing price and quantity? What is the resulting profit?
(b) If the monopolist could enforce first degree price discrimination in this market, what would be
the lowest price it would charge and how many units would it produce? What would be the profit
and consumer surplus?

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 (c) How much consumer surplus is absorbed by the monopolist in moving from a system of uniform
pricing to first degree price discrimination?

2. A monopolist faces the following aggregate demand function: Q = 44 − P . Total production costs for
the firm are T C(Q) = 40Q.

(a) Calculate marginal cost, marginal revenues and the equilibrium quantity produced by the monop-
olist.
(b) Calculate the consumer surplus, producer surplus, and profits in equilibrium.
(c) Suppose now that the monopolist decides to spend 6 to purchase a patent that would allow her
to decrease total costs by 4 per unit. Find the new equilibrium quantity and price in this case.
(d) Find the new consumer surplus, producer surplus, and profits to the monopolist after the purchase
of the patent.
(e) From the point of view of the total surplus in the economy, is the introduction of the patent a
positive improvement or not?