Handout 19 Externalities, Public Goods and Market Failures, and Tax Incidence This handout contains exercises of - Externalities, Taxes and Subsidies - Public Goods Things you should know - What is the marginal private benefits/costs? What is the marginal social benefits/costs? - How to find the equilibrium outcomes under private decisions? How to find the socially optimal outcomes? - How to achieve the socially optimal outcomes? - When taxes are imposed, what are the burdens borne by each side – the consumers and the producers – of the market - What are the properties of public goods? What are excludability and rivalry? - How does the existence of public good change the total demand? What are the differences between market outcome and socially efficient outcome for public goods? Who should contribute how much towards the public good? Exercises Question 1 (Externalities) Demand for cigarettes in a casino is given by P = 400 – Q. The consumption of cigarettes in general causes the negative externalities of MDC = 2Q. Suppose the supply curve of cigarettes is P = Q. 1. Give the equations for marginal social cost and marginal social benefit. 2. Without consideration of societal consequence, what is the market equilibrium quantity of cigarettes consumed? At what price? 3. If consumers and producers think about the societal consequence, what is the socially optimal quantity of cigarettes consumed? At what price? 4. Observing the devastating result from firms neglecting the social cost, the government wishes to step in and imposes the regulation so that smokers consume the socially optimal quantity. Design a regulation to dis-incentivize smokers from the market outcome. 5. If the law says the non-smokers have the rights to clean air, what would the smokers do? 6. If the casino owner and the smoking law say the smokers have the rights to smoke in casinos, what would the non-smokers do? Question 2 (Public Good) In the town of Prince William Sound, there are only three people – Alice, Bob and Charlie. Their valuations for a public park are provided in the table above. Suppose a public park would cost $6. The town holds a vote to determine whether or not to build the park. If most vote yes, each person must contribute $2 towards the park. Otherwise, the park is not built and no money is spent. The valuation of each person to a public park is summarized in the table. Assume every citizen votes according to their own self-interest. Citizen of Prince William Sound Valuation to a Public Park Vote (Yes/No) Alice $4 Bob $1.5 Charlie $1 1. Can you tell who will vote yes or no for a public park to be built? 2. What is the total valuation to a public park? Should the park be built? 3. Does voting result in the socially efficient outcome? 4. Repeat this question when Alice, Bob, and Charlie value a public park at $3, $2.5 and $0, respectively. 1 Question 3 (Public Good) Consider the problem of dorm room toilet used by two roommates: Alice and Bob. Alice has the valuation towards the cleanliness of toilet as P = 10 – Q, where Q is the cleanliness score and P is the per-unit price of cleanliness, i.e. time-value in cleaning. Bob has the valuation of P = 14 – Q. The marginal cost of cleaning the toilet is MC = 8. 1. If Alice decides to free-ride Bob in cleaning, what would be the market outcome? 2. Clearly the bathroom cleanliness is a public good, find the total demand for toilet cleanliness. What is the socially optimal cleanliness? At what price? 3. Compare the answers from 1., 2., and 3., is there the problem of under-provision of cleanliness? 4. To implement the socially optimal outcome, what should be the scheme of time-value contributed by Alice and Bob? 5. What would happen if the MC = 16 and Alice decides to free-ride Bob in cleaning? Question 4 (Tax Incidence) Suppose there is no externalities from consumption or production of this good. The market demand is given by P = 120 – Q. The market supply is P = 2Q. The initial market equilibrium is P* = 80 and Q* = 40. Suppose the government imposes a unit tax of $30 to this good. 1. Write down the new supply curve after the tax is imposed. Sketch the demand, the supply curve before and after taxation. 2. Find the new equilibrium price and quantity. What is the price that producers receive? What is the price that consumers pay? 3. Calculate the deadweight loss, the incidence borne by consumers, and the incidence borne by producers. Who bears the higher incidence and why? 2