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Problem Set 0 - Copy

The document presents a problem set for an economics course, focusing on externalities in competitive markets, optimal production levels, and government interventions such as taxes and subsidies. It includes questions on chocolate and widget markets, analyzing equilibrium production without intervention versus socially optimal production with external benefits and costs. Additionally, it explores the impact of grading on student effort and the challenges of achieving socially optimal work levels without collective action.

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Azowad Abrar Jaheen
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4 views2 pages

Problem Set 0 - Copy

The document presents a problem set for an economics course, focusing on externalities in competitive markets, optimal production levels, and government interventions such as taxes and subsidies. It includes questions on chocolate and widget markets, analyzing equilibrium production without intervention versus socially optimal production with external benefits and costs. Additionally, it explores the impact of grading on student effort and the challenges of achieving socially optimal work levels without collective action.

Uploaded by

Azowad Abrar Jaheen
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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ECO 301 Problem Set 0

1. Amityville has a competitive chocolate industry with the (inverse) supply curve P s = 440 + Q. While the market (inverse)

demand for chocolate is P d = 1200 − Q, there are external benefits that the citizens of Amityville derive from having a

chocolate odor wafting through town. The marginal external benefit schedule is M EB = 60 − 0.05Q.

(a) Without government intervention, what would be the equilibrium amount of chocolate produced? What is the socially

optimal amount of chocolate production?

(b) If the government of Amityville used a subsidy of $S per unit to encourage the optimal amount of chocolate production,

what level should that subsidy be?

2. The demand for widgets is given by P = 60 − Q. Widgets are competitively supplied according to the inverse supply

curve (and marginal private cost) M P C = c. However, the production of widgets releases a toxic gas into the atmosphere,

creating a marginal external cost of M EC = Q.

(a) Suppose the government is considering imposing a tax of $T per unit. Find the level of the tax, T , that ensures the

socially optimal amount of widgets will be produced in a competitive equilibrium.

(b) Suppose a breakthrough in widget technology lowers the marginal private cost, c, by $1. How will this affect the

optimal tax you found in part (a)?

3. Assume that a firm produces a single output with the differentiable and strictly convex cost function c(q, h) where q ≥ 0 is

its output level (which is then sold at price p > 0 per unit) and h is the level of negative externality generated by the firm.

When maximizing profits, the firm chooses the levels of both q and h. The externality affects a single consumer, whose

utility is of the form u(w, h) = w − ϕ(h) where w is simply the amount of money she has. Both the firm and the consumer

are price-takers.

(a) Assuming an interior solution, derive the necessary first order conditions for the firm’s profit-maximizing choices of

q ∗ and h∗ .

(b) Assuming an interior solution, derive the necessary first order conditions characterizing the socially efficient (which

maximizes social welfare) choices q e and he .

(c) Show that if the government imposes a per-unit tax on the firm’s output, this does not lead to the efficient outcome.

However, directly imposing a per-unit tax on externality can lead to the efficient outcome.

1
4. Once upon a time students in economics received no grades and worked only for the pleasure of learning. In those days of

yore, each student received cardinal utility based on the continuous and differentiable utility function G(x) from working

x hours per day.

(i) At what level of effort did each student choose to work?

Then one dark day, grades were introduced. Now each student cares not only about learning, but also about her relative

standing in the class. If y is the average of hours worked per day by all the students, each student now has a utility function

of the form:
 
x
G(x) + F ,
y

Assume from now on that F ′ > 0, G′′ < 0, F ′′ < 0, and F (1) = 0, and focus on interior solutions.

In this modern era, each student maximizes her utility with respect to the variable under her own control, x, for a given

level of y.

(ii) What are the equilibrium values of x, y and utility?

Suppose now that all students get together and hire a consultant to plan for the socially optimal level of work.

(iii) What is the socially optimal value of x, and how does this differ from the decentralized case above?

(iv) Why is it difficult for the students to reach this solution by individual choice of hours of work, without collusion or

coercion?

(v) If hours of work were publicly measurable, how could the socially optimal hours of study be achieved by a quota, or a

tax/subsidy scheme?

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