Intermediate Microeconomics

Problem Set 3: Externalities

In answering each question, be sure to explain your reasoning and show any
calculations.

Question 1 A psychotherapist has an office next door to a printing shop. The noise from
the printing shop makes it impossible for the therapist to listen attentively to her patients.
There are two solutions to the noise problem: (1) the printing shop can be sound-proofed at
a cost of $50,000; (2) the therapist could move her practice at a cost of $20,000. The owner
of the printing shop has initial welfare $100,000 and the therapist has initial welfare $70,000.
(a) Suppose that the therapist has the right to use her office free from noise pollution.
What does the Coase Theorem predict will happen? Assume the printer and the therapist
use the symmetric Nash Bargaining Solution.
(b) Now suppose that the printing shop has the right to create as much noise as it wants.
What does the Coase Theorem predict will happen? Assume the printer and the therapist
use the symmetric Nash Bargaining Solution.

Question 2 Suppose there are two firms,  and , that produce identical goods and have
cost functions
1
 () = 10 + 2
2
and
1
 () = 8 + 2
2
Each firm creates pollution, but firm  uses a clean technology that creates a marginal
external cost  = 2 per unit, whereas firm  uses a dirty technology that creates a
marginal external cost  = 4. There is perfectly elastic demand for the output of the
two firms at the price  = 20.
(a) How much will each firm produce in equilibrium?
(b) What is the socially efficient output for each firm?
(c) Suppose that each firm is forced to pay the same unit tax  on its output. What value
of the tax  would maximize total surplus?
(d) Suppose that each firm is told that it cannot exceed a common maximum level of
output ̄. What value of the quota ̄ would maximize total surplus?

1
Question 3 Suppose firms  and  have the same cost functions as in Question 2 but
they use a technology that creates a marginal external cost  = 2 per unit. There is
perfectly elastic demand for the output of the two firms at the price  = 20.
How will your answers to Questions 2(a)—(d) change with these assumptions?

Question 4 (for discussion) Comparing your answers to Questions 2 and 3, what con-
clusions can you draw about the use of quotas and Pigovian taxes to regulate externalities?