Weitzman model:

MBpollution = 60 – 10Q (with 50% probability) ------- high demand (D1)

MBpollution = 40 – 10Q (with 50% probability) -------- low demand (D2)

MCpollution = 5Q

 D = 0.5*D1 + 0.5*D2
 D = 0.5 *(60 – 10Q) + 0.5*(40 – 10Q)
 D = 30 – 5Q + 20 – 5Q
 D = 50 – 10Q --------- True marginal benefit curve.

Consider the case in which the regulator has full knowledge of MC, but is uncertain about the
true value of D. Suppose that the true Demand is D, but that:

• 50 percent of the time policymakers overestimate the demand at D1, and

• 50 percent of the time they underestimate it to be D2.

(1)

MBpollution = 60 – 10Q (with 50% probability) ------- high demand (D1)

Set D1 = MCpollution

 60 – 10Q = 5Q
 60 = 15Q
 Q=4

The quantity level associated with a standard using the “high” marginal benefit curve is 4

And

MBpollution = 40 – 10Q (with 50% probability) -------- low demand (D2)

Set D2 = MCpollution

 40 – 10Q = 5Q
 40 = 15Q
 Q = 2.67

The quantity level associated with a standard for the “low” marginal benefit curve is 2.67

And

Range of pollution quantities associated with a standard is (2.67 to 4)

(2)

The quantity level associated with a standard using the “high” marginal benefit curve is 4

Substitute Q=4 in MCpollution

 MCpollution = 5Q
 MBpollution = 20
 Hence, the tax level associated with the “high” marginal benefit curve is 20

And

The quantity level associated with a standard for the “low” marginal benefit curve is 2.67

Substitute Q=2.67 in MCpollution

 MCpollution = 5Q
 MCpollution = 13.35
Hence, the tax level associated with the “low” marginal benefit curve is 13.35

(3)

D = 50 – 10Q --------- True marginal benefit curve.

Note: See the introduction part of this question for the derivation of true marginal benefit
curve.

The tax level associated with the “high” marginal benefit curve is 20

D = 50 – 10Q
Put D = 20
 20 =50 – 10Q
 Q = (50 -20) /10
 Q =3

The quantity level associated with a tax for the “high” marginal benefit curve is 3

And

The tax level associated with the “low” marginal benefit curve is 13.35
D = 50 – 10Q
Put D = 13.35
 13.35 =50 – 10Q
 Q = (50 -13.35) /10
 Q =3.665

The quantity level associated with a tax for the “low” marginal benefit curve is 3.665

And

range of pollution quantities associated with a tax instrument is (3 to 3.665)

(4)

The social optimal allocation occurs at D = MC

 50 – 10Q = 5Q
 50 = 15Q
 Q = (50/15)
 Q* = 3.33
 Optimal Q is 3.33
 Range of pollution quantities associated with a standard is (2.67 to 4)
 Range of pollution quantities associated with a tax instrument is (3 to 3.665)

As we can see, the imposition of tax leads to smaller deviation from the true social optimum,
Q*

Hence, the taxes performs better than standards.

And in case of inelastic demand, taxes performs better than standards.

Therefore, the demand is inelastic in this question.