I &

e*

&
H**a*lffi' G
G
-Chapter 8
Gr

Cl
Extei'nalities Gi
l

G]
I'lxerci.s<: 8- l ")^lrlolie froln a dirties tJre lor:a.l irousing; :r.nrl
{at:t,or..y,
I
I

{:t'O1.x.'." I<k:rrt,il'1, L}ie natul'rr of'tlre ext,ern;r.lil,ir:r^ in tliis sl,ir.t,crr-rcrt.

lloistlr x;
C;
I
I

"ciol,ti,, 8-,1 'l')rt:t-tt ;.r.r.rt t,rv, r:xLerir:llil,ies irr l.htt SLlt.i,rlt ttcrrt.'l'lrr:
Llit: ktr:,1 lr,tisirr1,, is ;i rrt:1,;irtive (:otlslrr.irti,rr r:x[er
:;rrr,ht: r I it'1;.1,l11p- C
rra.lil,.y.''l'lrr: slrr<tl<t: l,lrir.L poisrtrrs I

t,lte <:t'ops is :r rrt.:11a,t,ivt: pr.orlur:{;ir>rr cx Lt:r.n alit.1,.

ci
q^t
I

I'lxercis<l E'2 II<lw ,vortltl rlesc:rit;c t,he protluctiorr {lrrrc:tiorrcl';r

.y<tu I;r,rrrrrJr.1, .t I

1rr>lhrtcd l;.y ti fi.r.t:ior-.y'l *q

Sohrtiorr 8'2 lf t,lrt: l:rtrnrlt'.y ir; P.llrrl,r-:rl b.y rr f:rr:t,or-y
l'ir''rt cxLernalit'.y' 'l'lte orrt;1.rtrt, oI tlrc itiruLtlr'1, will
tlrcrc is:i rrr:1,,ir.1,i't: Irr-r)<lrr:= q.l
bc retlu<r<] li,.,,r,y 11iyr:1 lsyr:,1 I
of irrputs fr>r tlltl lllurrrlr-y- Assurnc t;.}tc l:r.urrrJry uses tu,o
irrl;rrt,s irr rl iran{,iLics;:1
-l
tttt(l z2 l)etrol'e l;hC ot-ittrrttt oI t]rc {at;ilrry l.ry fui
lll aritl t}ie outJruL ,l t,}rc l:,r,<1i-.y I

l'y'yt' 'l-'Jtc 11t-'rtr:t-lrl fi;rrn ol 1;rorlr.r<:tiorr li.rrrci,ion fbr-the la,rr.rlr-.1, worrlcl irc
'!Jt "' f (zt, zz, gJ) , (,s t) ",'
*'
I

Xgtr
u,i1,1r
af .- f\
I

;r (8 2) 6.=l
(1lJ r

A ltalticulal e;:ar,t1,,k: could 1te +l

I

€,-
I
'112 .,.. ;:i zN,-l'-ut , /r, I \
{'
k
I

where a ), 0, 13 _'r, t), a.ncl 7 > i

i
*- l
j
l
_r 1..1:,1-(:l:..- ;l li Lct {.t ,,.., [211., lr,r,!/1, o , rvhr:re q is ilrr c_rl,crita-]it;y. I>^ t,his r-
'. r:-l \' ci:i,cr -
-:li i': i tf'a, or ncgalivr:'l Iiorv tlor:s jl, allect, 1,h<.: dc:rrra.nd Ibr good I r.cla.{,ivr: l
' i .::' iil,ll:r.1,.] f,.1y 1,1:t:d 2'l !
a,

t'" I
EI {
- i
156 , t t ', tl' j )I I'lI,
r'l,Ii .
L-XTtrRNA LITIT'S
)
Solution 8.3 ll.hr: rnargirral c{lect o[ the r:;;terriaiiiv is giveir
J b1,

t)u I lrl r
lri..-J lr: ui'.:
,l .,.

i 3*t r*!rti
itu
0y
=u ,r
-(Jl- - _/ (.)-
(8 4)

i Ihe externalitl, is positivg-

To see hor,,. it aflect.s relative dernan<l- co,sic.ler a consrtrner urho solves Lhe
probiem
)
rXll)l I''l' ["v)'-' s't' l"t : r)rrt * pzrz. (8 5)
) f'he first-ordr:r corrdilions arc

) ,Id'{trJ'-l
tt -)P, : 0, (B 6)
) rr br,J)'-"
I, ,,J _
.,1 lr',1'' ._,\/,r 0.
,;_ (B 7)
)
Dividirrg the Iir-sl, o{'thesr: }ry Llre scr:onrl
) u 12 ,[tt

| - tt t:1 ltz
(B ..!)
) The ext,r:rna.iity <loes no1, ,lli:ct 1,he r-lerna,rtrl lrrr 11.,rJ I rrrlrrl,ivt: {,<) g<torl 2
)

, Excrcise B-4 If the two conslrmers in the ecorrorrgr have

J.,rclerenr:es I/1 ::
,r.,cl LIz : lrl)- ,i,;;:
Iri]- [rlrt;l]r--* frlriJ'-", ;i,"{; t;}re cquilibriunr is ,-r
) flcient despitc thr: <:x1,erna1ity. Expi"i" ti,i, conciusion.

) Sr1Ju{,iolr 8.4 't'lit,rr;r.rginal utility of goc,<J I [9r.,.tlrrsrsrrt:r. I i

,'t.i:^ El., l'l'il'

!] !u] "
_--.-,
l

cl (8 e)
E
$

) and tire margin::"i ul,ilit-y of goocl 2 is .E

E
e

Y dttt= , - (YJ,i l1iJ"

,
' -r----t ' I) '
fr;r,?]
., s
E
iE

n.,t il t (8 i0) H
',^? ,l ffi

# ffi
ffi

l,ionr tLese Lhc rnargirra.l rate of s,bstii,.{;i.n for consrmer H

*'* I is TE

ffi
ffi

2- | .'-t-t)i '1
: ffi
L lt,sl
r-i-? ^t J (8 1r) #
) ffi
ffi
I Si*ril,r .,rlcr-rl,tjr-,rs fir. c.rsrrrner 2 *,.,: ffi
ffi

i-+ ,
#
ffi
ffi
i

-*
i A1 lt.s?,= l.ll
LJ C1 r.i) (8 r2)
ffi
ffi
ffi
:, #
2
ffi
i-#
:
ffi
ffi
 tsLl$s polH? $TUDrEs
Hudson Llne, A.
b,
F ^_,Bra.nghes;
n^ajourl Gardon, $atya Niketan
,' a+c.rr tsasement & 1st Floor.
.- -9Ig Nggar, Detht-l10009' 157
&
(M) S81 I 34 341 1, Saer ss}-sle
N,tice that each of thc r.tirginai rarcs
l'ernalit-y effect' Each .nr,.*r'r".
el)sures tliaL thc rna.igirr:rl .atcs
of sribs[itrition is inciepe.cle't
equates tlieir M RS to trrc pricc
of t5c cx-
ratio, u,hich
s
of subst,itutioll are
nalitv does not affect t,he fact that the eqrrilibriirrn "qrot.
This conclusion holds bccau.se the exi;erna)ity
ll.trr:refore
is eflicient.
thc extcr- s
does not a.fier:t the proportio,s
in which the t\a'o consumcrs purchasc,the
goods- (obsc,ve tirat iii'oi".nor,a.,
eflect can be factored out oi the utiiity
fir.ct;ions as a consi,ant.) 'rhc sarnc
cquilibriurn is reachecl with thc exLei'nality
are calied "Pareto irre1evant.,,
ix ir, is witlrout. s.ch cxternalities s
C

IJxercise B'5: consicier agrortp.f rz

C
stude,ts. srrprpo.st: Lh.t cac*rstiiclent z. puts
"irli
in h; hours o1'work on }ter cl,ssc:s rvhicli
clepend on how srre 1;crforrns rr:r:rlivc
i,r,oh,cs a disrrt;ilit, ,,,1i ,.! u"rr"ti,,,
s
l,o ]rcr lrcer.s:.ncl r;a.J<c t,irr:lbrln rr(i;,.)
Ibr
a"ll i' whi:re I =-- (,|)I, lr; clcrol't:s
l,hc:i.vcrage rtrinbr:r.of ht-rrrrs
1r,t irr l;y :rll
6
sLudents in ihe r:lass a.ntl z(-) is ir..
ir)<:r-ea,siu11 trrrrr (;o.(:rr\,o Iirrrr:t,icryr.
a. Calcrrlatr: thc n^yinrnc{,ri(: Na.slL c<ltrilibrirrrn- s
b. Caiculate tirr: f)zr.rr:1.'-r:flr<:ir:nt k-,r.etl of cffrirt_
o' Hxplain rvhy tltc txlrrilitirirrrn invol,es 1,or [ruch
Palcl,o-effiCicnt <:fiirrL ccinrJ,>,reci i,o r,]rr:
s
ou(,ct-rr r r c.
€
Solution B-E a,. A1, a. Na^slr rxprilibriirm the choir:r:
tn;rxiurizcs uLiliL.y 1iivr;y1 t,Iic ar;Lioirs
r:hoices of thr: strrde;nl,-^ otlrcr Lhan
of.<:;rclr ilrd ividr ra I sl,ucler:1;
of Lhc othci. t;t,ucltr,rLs. ] ct t,Lr: sui.rr r;f tlrt; 6
7 be given Ltv il. ,l.hcn
[/sing l,]ris. nolat,ion, .wtl wri1.t; 1;cnr:liL lcss (,1)1rr, + tt). i s
clisutilitv as

It :.: t,('/i_.:r \ I
lil 6
\ i, J
\ tL ./
'.t

.,, ( -!-)rD tii 6

\,l ft,r + ) , (8 13)

'flrc {irst-ordcr condition lor

6
thc chojcc of /r, is
s !
AU
dhi (',',,t',,,i") 'u'I\ -- t I
/ t.
ll.:
'- -
ll\ I --
L (lt.^ +. -.J,/
\ zt \
\t
I
hi -.. 11. (8 i4) I
I
I
At a symmetric i:qr.ri1i1;riru\) lL, ,.= h l1l j:prci 1i ._-. Izr e: I
1]lu. Solving thc filst;- ?
order conclitions i

n- l l,
{
=, J
:

^;u'
nlL
(1) - /r.- U, (8 r5)
f"';
t,_\
'ulJl tiL?.
-
n- I (,). IIt.7
 I
)
I i58
CITAI''T']|R S } -'XT'],)I(NA],],T'T]iS
;
I + b. Thc parelo-r:{Iicic,r; lcvel of ef{brt maximizcs {,rrc surrr
r, I,voki.g o1' utilitl,
s-ynrmetr.l', shou' th;it the pareto-effi.;; 1e'el solve.s
levt-.1s.
I ",T".t
(,,t,, ,:)
a nta"'' flU : n
I {i, } (8 17)
$ Tlrc dr:r-iral,ive of nlJ ,.vit.h rcspect to lz is
I
t a (nu)
:--h(0.
I dtt (s.18)
, is ,cgat,irze for a.1r posil;ivr: r.alue
I ,i1:.$:"at;i,c of )t,, sotlre I)a,ret;o_efticient
ievel
3 c- 'T'his exercise j.s ;irr cxanrple of
a race. A gain fbr nn indivicrua.r
I through exerr.i,g rera.tiverv .,ro*
t :?,,:i::ll;,.,IJ:il;yH:lcxert
1.at
effort than the other students. Rut
come.s
more effort
_o,o effort arr rv,r lo." rt is r;rrerefbre pareto
I
J
I
3 I4xc:r'cisr: Il'6 'l',c:re are' 4 students regisLered
exterr,rit;jes" fur Lirc ,:lii-ss ,,Irr{,r.,clucLion to
I r,hc rJ.iversity of Life. yf.hr:
;r.L
3 irnpJcnicnr';r simpre grzirrirrll- ,r;.,f,;;,r; is ht,z,y:,.ncJ .s, r,r:r:icles r,.
slrstem. No rccturcr r..,r'r,r,rr,
I but; t'herc is a [inzrr ,it., r.,, r"t.,
i'o1"' 'iirr" orp". reque^sts "^"..,is,,r
each stur]ent,,
J nrrrnbr:r zi 7 0 rrncr .ec,r.,t r.t,"
.iroi"e on the allswcr sricct .l.hr:
r., 1,<> choose a, sisgrc
gradc c,", rvir.h a rnaxir'urn .f rrcxr, rlay f,r: fi,ar
t rrrlcr (whiclr is p,blic infr;rrn,Lio,
'r'lu: cxar, il;
20 for each st,,,aent, ;s ,:",l.r.rr"a
bifo."
ti]" ;;;il i, _, to t Jzl" _
*si1.rr t;heir.op.wing

ira^ssctl if a gracre of r0 out of 20, or

nror-c, is .,;t.irrctl -
*))i:,
,-
",
3 :r- Sl.a.l,e t,Iret rnaxirniza.Lion prolrlem
facecl by each stuclent-
stutlent i'' tutoi-i,i,rg rri. ."o".r"i*.*,,,
*,r.,1';.,l,rfii wrr:r{; is r;hc <resirerj
)
'") '"' :l;",,j;i'l;lf|i;:;:
I1i;::l:#ll::ll:::cd
;;;;ffi grad,:, rvli:r,; is ,;ire n.al
grarJr:
:;:,T, T },:::l;ji: :, Lixi* ;i;;,';";il :;l'jffi :i; .: if ,,, n,,,,,,,
J'
i,'* l; il'j,Li,, ll.'i ,

js
tha.t;lj,' :r i;: i:',H:i,:;:
], I,:rr:to ::, :,r.i."
impr oveurr:rrL.
J
- "
t' Solution 8.6 zr, ,l.hc rn:rxjndzation problem {aced
'f by stude.nt f is
'4
* 1
\-,-,
7 .Lr-
-
(s 1fr)
j:..r
# b. 'l'be clesirecl gr:lli: i:; C,l c
if the graclc level rnal,ters. [r0, 2o], jf onry a pass is rccluirerl, arrrl
.q
G -.-
2i-)
\, (1. If t,he strrclcrrl,s i:iror_,scj
z' noncooperativelv, tal<ing i;he otircr
r-l rui, n: r- gii.,.il, st,udcn{,s,
ll1^ Jir:.j.,,rtlr:i. (
orrdjLioii lor
-{-'\c (E. t S) is

it
-.+ 2J;i 2-
.
rr
i-\
(B 20)

-*
'--+
 tl -el
ELISS POINT STUDITS ^o.l
Llne.
Branches: Hudson rb.
Raiouri Garden, SatYa Niker:'rl
- -
icsg, Eaeement & 1st Floor. 15{)
t - Afe Nasar, Delhi-110009 sl
I

(laieet 1343411, e891 5s5578

V which gir.es the solrit;iorr

zt - )-. sl I

In equilibrium
Gt:10-l 1 I x4:9.
sl
,2

That is. in the noncooperatlve equilibriurn the students rvill not achieve the
(sl
pa^ssing grade.
d. lllhc outcorne is not Part:to,efllcient: all strrdents are better off choosins Ti
zi - 0, u,]rich gives C,i =. I0-
ci l

Exercise 8-7 Graduate st,rt<lcnt / srnokes brit; his office rnate R h;r.te.s snrol<ing.
ci I

-2tr arrd il havti the iollowilig uLilitl, {unction.^: IJA : 100 -l- ]02 - 0.f z2 itn<l
(JB '' 100 - I0z. u,here z is the riumber of cigar-et,t,es srnol<ecl by A (.ancl llA
€l
sl
I
incluiles tirc-: <:ost; of cigaret,tr:s). Deternrine:
:r- -l'hi: tturnber of cigaret,t,rs srnoked by A r,,,lrt:rr Lhe <rxl,r:rrial elli:cl. on ll is
ignor ed. I

b. '['he sociilll.yol>1,itnal level o[t;igarett;es t,]ral, >^irouid bt: srrro]cr:<l b1, /.

c. 'l'he opt,inr:rl I)ig,ourria,rt i;;l,x nee<led to <lecelrl,r;r.lizc l;he srir:ia,l <11;l,inrrrnr-
cl- J'h<: ouLcorure n,il,]r Cloa^siilrr lrargaining rvheri Lhe protr.rerl.y rig;h{, is a^ssigru-rrl
'iel
tr> tlre srrrokcr'.
r:- 'l'hr: ou1,<;otne rvi{;h
1;o tht: nonsllokci:-
Coa^sia.rr }l:rrgaining w}x:n Lhe proltert,y riUirt is :issigntxl .l
SoJtltion 8.7 a. St,rrrlt,'rrL zL sr-.,lvas the utilil,y rna,xirnizatiorr 1;r-olrlcrn "i
6i
rrr:rx 1 tn (r) lo{} l'10i" 0.122. (.3.2r ) I

'I'hc first-ordcr condll;ion

{u'-ti}
€i
is
/r 6l
ig * Q"/2 "' 0,
LILI

i., = (8 22)
trl I
r',-hlch qives-the olrtirna.l riurnber of cigalettes It

rtr
Br
;." - L() (E.2li)
!
I

Fa&
L. 'l'Irc bE
socia.l11, o}r1,irr:Ll li'r',-l oi ciga.retl,t: srrioliing solvcs
tF
RE
r,,rr:
.fzlU] ]ttAt )I ll"(.tl
L
lu11 1 ir ().lzr.l l{,rr ltr- \-?-

2l)0 l).1::2 (s.za; f--*

L-:,

:.,,,. ltrtrrc{,ion rs rjr:r'.r',:1,:;lrLt: ili.:i, lr1(1 tlri:t'itj'irl-i: ,.j

1._',
.:l

1;-'"-' .-,, (i (ir 25)

:::,

ti -.,

t '"
 }.
I
*
I 160 CIf.\P'L'Ell t irr-\ J'l;lflAr AL,L'IIES
*
I
c. Assume t,hal student ,4 has to pay a t,ax ol / Ior eacit cigarelt,c LLcy srnohe.
J The utility rnaxirnization problem is now
I

I
t rrurx {,/
A (r; t) -- 100 * loz - 0) z2 - t.z. (B 26)

n The fi rst-orcler conditiorr becomes

I
dUA
9 -d;:10-o'22-t-o'
I
) ivhich gives the nurnber of cigarettes.
I

I
J ,. (t): ':#
J 'Ihus the sr-rcla.l oittimurrt of z"':0 is decentralizcd if f : 10.
I cl. Whcrr tirc propertv rigirt is assigned to the smoker- he choosss to smoke
,l 50 cigiucltes. '.I'he nonsmoker-'s utility ioss is UB (50) -- uti (0) ,. _500. .I.5e
smoker's ul,ility gain is U^ (50) -LlA @): 2.50" 'l'ire smoker wili r:r:c1,riri p^yrnent
I
of at lea^st; 250, iurd the rion.srn<ilier will bc wiiling to pay up to 500. I)c1>r:1rli19 on
J the b"rrg:rillittg lrorver, the otltcome of Coasian barga.ining is th:rl, tire lonsmoker
I

t pays 1,o thr: srnoker anylliinli t.retrvcon 250 and 500 for nonsnroliirrg, and the
srnoker will trcccpL. ',I.')tus, tlre socially efficient outcome will be rrciricvt:d-
I
e- Witt:it tlte propet'ty right, is assigned to tJre smoker he chrioscs to ban
J snroking. J.'hc smoker''s _utility lo-ss is Uo (O) - UA (SO; : --,)SA. .l.he po1_
I smol<cr's rrl,ilit1, gairr is UB (0) - IJI] (50) : 500. ltb rernove the snroking bap thr:

l
t nortsntokcr rvilI requirc pavrncnt of at least 500, but t]re srrrokel will be willing
to pay orrly utr.r to 250. 'I'hus, the smoking ban rvill remairr.irr 1>l.rce,:i.rid l;h<r
) socially cff.icienl, oirtcorne rvill be achieved-
I
,
I
Excrcise 8.8 Ooruider trvo {irrns, X and X, locatcd on tirr: :;ar1o river bank.
t'
i
i The two {irnrs produce paper for a printing u'orks, ancl t}re prorlrrr:l,ion of paper
requires tlte ttse of cheuric:rls. Firrn X is located upsli'earn h'orrr {rrl1 1z and
ll ,*
]ras tlic productiorr funcl,ion { - 1000 [l*l'/', rvhere !.a is t]re anrgunt of labor
used pel day zrnd z thc atnount of paper prodriced by firrn X. iiirrn y, located
,s dorvnstrcatn, ha"s a similar ltroduction functiolr br:t its oLr1.1tuL ca, be afleci,erl
bl't}e chetnical rTastc Ptorltrecd by lirnr X lleucc lirm Y li:rs tire follou,i,il
=* prodr,rction funct,ion:

,J I000 [/],11/' - r,,] -o il

t:,
1l :{
{, :r ), L:0,

t tooo VYt/2 if r{ rs,

!.

u,here ::6 is the nal;ural ca1.ri:cil,y lor al-,sorptic,in of polirrtion by the river; {y the
..I
iabor used, anci i,r i;lre anrount of pai er produceci by the firrn. Tire selling price
of :r unit of piri-,gr ii; i,r.-, I a.ncl thc rvlge ltct urrit ol labol i5 1i,, :,- 50. Each firnr
is :.1 prof it nia:iirnizei-.
l-\*
I

t-*
 74
B L,I
.B rE s
*,,,I:$"?,' f,,x :J,{D e
,orl i, oF; :; :,,.ii ;:.tA,,. I

,,fl?,i#d;l-;;ii,,,^
J
r{ir
e
a' Assume (T
ct: ' l)etc':rrnirre trre qr-rantity of papcr proclpt;e<.l
in eqiiilibrium. by ear;rr firrn q
b. Assume tirat:r0 =* g,000 arrcl that a:0_1. Ifo*,
<,lor.,s this rnodifi, t]re
result in (a)? What is the interpretation e
of a?
c' Assrrme tiia't thr: two firms merge- Does ttre new
firrn has a, incenti'e to
reallocate some lab<-,r frorl )'- L<t y? Exprain
the resurt. e
Solution 8.8 f.'he profit of firil X is
c
7tx .L'p:r; -.LLt!_; --. 1000 Vrlt/, -- 50lx- (8 27) \
The first-orcler r:onclitio, {c.,r- t,lr, prolit,-nlaxirnizzrtion prorrlcirr,
e
"::.
rl.l .y
- lt*;-ttz'
5)oo I "\ I 5o = o
\r) (s 28)
givr:s the solutioli e'
l:'y -- 100, r* : 10,000 (8.2e)
T'he pr.o{it, o{'fir.nr y is
c
.(
'r1' -= p,tt - tr(t,' -.. J trtrlrl [t ,')t /t' [:r -, rs]-" -- 1.,0(y) :r; :> .r.(J eI
L l (xro fr') Iil? ' 50{v (8 30)
t t: ... :1:o

11'he fn'.^t-ortler- corr<lil;i<;ri Ii;i. l,irr; 1,lrofi L-rntr"xinr

e I
izatirlri probl r: ut,
dny. . I ri(){)
'l b; :r'OJ
[/1.r-
r/'z r-(}
ir(J _". (), .-,. eI
,t(r, -'
J. :t:0

t ,roo ir,, 't'.,' - 50

- 0, :{. .,.. :.;o
(8.31)
eI
.; i r-oc

(, -2'' e
(,\. :. ) ttltl l:r - ;r:ui 5o . g, .r. _, .r(.r
I t tlri, 2) <.- :r:11 t (8 32)
/ €
'y' - I ll)'{){.){)l't -e;o1-*= (.), z):;e
I to,ooo, rir11 (8 33) .a
rk'
:r. Fbr cI ,= 0 t;hr: s.lr-rl,i'rr is ..1:* =. g* 10,000-
=_
i,. J'br * '- 0.1 a.lri:;s ,-- 9,00U t5e.solutiorr i.s:;, _: .l(),000 a"nd u" -,= €
' '' []-00x 1,000--0'' = 5,0r 2- T'rrcre is a ncgativc extcr-nzrLit,y rj..r. LIrr: production
,,,],, ) rrl,orr l.lrc rr,l.Prrl r,f lirin ),. ,[]it: I

- 'i:::'
';:[elrt,a]iir': _a higricr
l):r.r,1trtcl.,,i.rr t,,,,,;;,r;..,; l,tre rlegree
of rr mca,irs a sLrorrgcr- r:_rLr:r.nal i1,.1' :]rrd
6 I

'aruc , there
': ':r') (r):i'c|nali{;.r' rv}rcr a - (). Ii'irin x ig,rxrrcs t,his c:.,t,,,r,rlrri1,_r, arr,'i. titr:r'cIore,
- .-,,,;y1..-,,a..:1:r"1tor;,.rrci ,
-hr,: 1-,t.<trlu(tclj nlor.(,p,,1r,,, t.ir,rrr iS s..t.iit_1i.v,ltLirrr;f1_
,-, ''l plofil oi i,ixr rrrr.,,; iirrrr i:;

. i|r jr r. I , r-j
(8 34)
iLI:,,
1 l;, l' .1 . rr,/rr tt '
r r" [ I00r)
'" l2
l l
li
] , ,1,,'' i ,r, , ' L

i :r:,1
,

/
I]ortr l
g * 75

*
t' )[].11t'1'1;t' Ii,-X Tlr'n /V AL l' I' I E S
*
T'he first-order conrlitiotis afc now
,
Olt
-llr ' :
J oLs -50 (8.35)
,]
# ,l
-1
500L[x)-
la
1/2
i' -
a[rv]r/'?
frooo l{11'/'
,,,] "_ ,
t-.ry
l rooo
12
l

-t
5AA{x'', ", {x{ f ,o l2
t r6ori
f, ( ,, ooa -
l

0n 5oo [/y] -1 /2 tx) Ito12

-50 J I ,,,l, l{ xl/2 ,,oJ
I roool (8.36)
f, alY
I soo 12"1 -1 /2
{x1
- xrt
I
t looo
-a
l

J In cquilibr ium tire labour de rrli ndssatisfies tlie lbllo,,ving, s;,sl.ern of e<;uations:

J - ?.

il1lL
I rorr [r ,,[t1.]'/2
frooo WT)'/', ,.,,i ,
NrIL
LX tu 1'2
-- ILloo-0 (B..ri)
J I r,,,,,' hII L
.-'- I .+n 12
L rooo I

tt -"nll o
J ,\.
n7n I Ir
roo ooolr,;f
'
r ->ld;,,i
rx l ru )?
(B 38)

J I r ()0, (.y <

[,];lin],
Compa"re thr:se expressions rvith the ones for li a.nd {:y. C)lca.rly, t,# < {.\ {or
J lT > lril[]i;]', artd, therefore, (p > t?. Hence, thr: ner.v lirnr ]ras zrrr incerrt,ive t<i
rcti.llocate solr]o la.bor from X {;o Y. 'llire reason is t,hal the new f irnr intern:rlizes
, tirc ncgal,ivo t)xLr-:rraliLy and so rcduces lhe labor irrl-irrL trrrci the ouLput of p;zrper
frtlrn X, wlrir:lt tnarkes it profitable lo incretise the l:rbor inpul,.ancl the outlrut of
t I)aper fiorrr 1'-.

J
; Exercise 8.9 'l'here is a large numbcr of commuters wlio de<:icle to use either
{;heil ca.r or thr,: train- Conrmut,ing by train takes 70 minrrtes w}r:rLevcr tirc 1urn-
G ber oI cottlrriu{,ers takirrg the train- Coinmuting b}, car La}<e;- C(L;).-,20+602
rninut,es, u,irele z-is tlie proportion of commuters ta.king ti-ieir cilr. 0 _{ r S 1_
G
d a. l'lo1; l,he curves of the r:ornmuting time by car and thc courrnuLirrg tiue
l.lj' 'Lrairi u^.; ;r [rrrrcLiorr cif tlrc 1,ro1 ,orLiorr oI car llscrs.
B
b \\rhal, is of co[tmuters vu,iro u,i]] ta]ie L]iejr car if i;veryr
1,ire prol,rr-rrtir.rrr
one ls taliirrg, lrer clecision frecll, ancl tndepenclentl;, so as to rninitlizc hcr-orvn
ConrnruLJrrS, 1nrtrj!
c- \\ihat, is Lhe proportiort of cir-r users tirat rriininrizes the trtl;a.[ cornmrri,ing
Li r nc?
d. Conrp;-rlc Lhis u,itli your a))s\\,er 1,,iven in part (|). lrrtctprrrt Lirc <-ljf|ererrr:e.
IIorv largc is t.lte dea<1weighl. los:; fronr tfre exl.er-na1il,r.'i
c- lit:p1a.in ltou, it 1,r.,ii croi;l,j lrcirlcve llic c:lLLlcictrl, allocli,lorr of'r:orirriulL:Lr;
i
ite{,r,r,eerr il;,r.irr a.rrcl car irld i;c Itcitellclal 1or evel\i()r.re.
 76

"l
" 163
.l
Conunuting
tirne
*l
80
el
70
*l
60

50
*l
40
*l
30 e

20 ^T-TT^TI TIT'TTT'I TTT-TI-I _T-TT

I I-TI e
0 0.2 i).4 06 0z 1 Proportiolr
til'czrr uscrs
e
["i11ure 8.l: (iorrmuting t,irrrr:s e
e
Solutiorl B-1) a. 'lhc <;orrurtrrt,itrg; t,irnr:s are showrr in ligrirc 8.1- '[ilir.; (,in1g [y
trtllrt is c()nst.inll, lrrrl, l;hr: {,irrrc Llr.kt:rr ily car ilrcrea^st:s zLs c?}r rrsc ilr(:r'r::Lsr:s- Q
Il- ll'irc 1.rt'oirort,itin o[car lri(]rs iI indeperrdent clroiccs i].i'o rrra<Jc wiil lir: srr<*r
that thr: tinrr:s of travci [r.y, l,u]rc ancl by car are <x|rated e
70 .20 -l- 60r.r,,. (8 iie) e
Solving fr>r'r.,, givcs e
5
r,,,--" (8.40)
6'
'llhis solrrtion corresponds to thr: intersection point of the two coilrrlrrrt;ing titrc
E
curv()s.
c. f_he total commuting time is (20 + 60r) r + 70 (1 - r),
e
is the whc;re r I
proportittlt of car users. Setting tl-re <ler:ivative ivith respect t<-i :r eqital to zero qi I
gives z
I
,z
l20ro - 50:0. (8 41) trtr
Solving fol eo tlie {.ir-nr:-nrinimizing car use is

5
*n - /ti /?)
12'

d. 'l'hcfrce markct oirl;conrc for l.hc proportiori of car uscrs is glcrrLcr tl'ran
the sociall), optimal orttcorni: lrr:cairse the individuai contrnrrl,crs tl9 rr91, i,ake
into account tirc ncgativc cx{.crralit.y gcrrelaferi by clrr t.ravel. 1;li:.rl, is- l,hc t;ra,f{ic
congestion. lhe rlcarlri,r:iglil, 1r.,ss J-rorn 1,he extcl'rri-rlity is the diffcrr:nr:e 1;r:l,.v,,cen
tr fl
# 764
b CIIAP'L-ER 8. 1' X'.t- ]i R, N A 1, I 7: I
L: S

a the total comrrnrt,ing times. Llsirig 1,he earlier result,s obtairls

€
T,n: ZO + OOrl r- ro!
6
: ?!s
31 (8 43)
and
s 'l'n
-- 'to r 69: + Z0s1 : 515
1,2 12 (8 44)
it The di{Ierence is
,'t- otr
L\)
6

m
;l Lrtt--I0---

e' If ihe cornmuter.s attach nronetary'value

() (8..15)

to their travel time, then a 1.oll

i, may induce theur to swilch fi'o,r car to
the benefits of sliorter tr:avei tir'e.
tube if the amount of the toll
excccrls
Given inforrnation on the nronetary
of travel tirne the:rrnou,t of thc tor.can val,e
* b".or;;;d so trrat tire proportio.
nnd it beirefici,t to t..,oi^il;.
:#:iil:TffijiiTtill i.s exzr*ry nq,,.r ro the
a
s Excrcise B--ro liecto the previ..rs.probienr.by
)

t and assumirrg that c'*rrnuting ti,re

reprar:i,g the {,r:rirr r>.y a bus
by brs i. i;.";;.g with trre propor.t,io.
commurcrs usi.g car (rraffic co,gestion). of :
I

Let rhe ;;;;";; ;;#;

I R(r) - 40 f 20rarrd the .orrr.r,,liing time
is thc prcportion of commuters t,aking
br.rs be
by car be C(r): 20 l- 60:r_., u,here
z i
i

their car, 0 :i z < 1.

a
I
I
I
Solution B.l O a. llhe commuting times j
are shown. in figure g.2. l.he
bus is increasing il^s car -use increases. time
it
l
b.y I

b. Thc prolror-tion will be .s,ch t'at it; eguates I

I

arid by car, the times cif i,ravel b.y bus I

J
I
I

40 + 20r,,r. == 20 * 602;,,,. (8 46)

3 .:-0

1
,n".:
s This solutiorr corresponds to the point
,- (8.47)
rvhere the tu,o culvOs of corrrrrrul,ing
in tersecl- time i

# c. Thc i,oi,al conrmuting 1;ime is (20 I

+ 60r)z + (40 + 20r) (.'l - :1,), ,"yhere i
is tlre proportion of r:ar users_ Sr:ttlng z I

thc deriltrtivc witlr rcspercL l,o {

zer'{.r g,ivcs :r: eqLl2j 6c) I

i
-*.
(\ .
80:r, -20:0 (8 48)
1
,)()J \'l ng
I
1
r
",) - 4 (B 4e)
i-
d' TLre free-rrl'rrket outcome
for the pr:oportion of car users is gi.catcr
socially opf imai otttcome because the trran .hc
iirciirriclrut.o**uter:s c]o rr.{, t:rk<',
.:
account rhe.cgarli*t: extcrnaritl'gensr-aterl into
b-rz car travel, that is,
l,rre tra{Tic
 D
7B E
E
g

€ E
I
E

165 I
5 T

Oomrnuting iffi,t' A.
b
time
80'
e
70
€
60
6
JO

40
6
A
rL
30

A
2l 5
04 0.6 03 Prol;ortion
o1'cal rlscrs
L
Ir'igur:c ,3.2: C'ornnruting by car atrt'l bus e
€
<;ongestiotr. '.I''hr: ,.1ca<lwciglrt loss frorn thc ext,ernality is t,he clilli:rr.:n<:e l>el;ncerr
ttre total r:ornmil t,ing; l.irnt-'s e
'r'n, '.20 I 6o ), ou , ,o! , io9, (B so) ei
anrl CI
'l',, -.,'211, norl I 40 I 2ol -.80 (8.5r )
a
b
' l'hc <lifli:rt:ucr: is
7.r,, 7'o :20- (8,s2) €
e- If thc rlt)irrrrruLels altirtir uronelary value to Lheir tlavel Lirrie t,]ir:n a t<tll
_ ntay inducr: l,ltcrn to s'r,itch Il'orn crr,r' 1,o bus if t,he a,mount, of t,hc tr>ll cxcceds e
tire bcnefit ol shorter trar,cl tinre. Civcrr ther information on the rnonetzrry r,:rluc
of travel tinre tirc a.mount of tul] (:rrrr be conrputccl, so that Lhe irroportiori of'
cotrLmutels that still Iind it bt:lcIi<;ial l,o Llavel b1, 6'r,- is e>l:rctly r:qual tr> t,he
-l
roci2ll;. oIl irrrll lcr r;1. ei
I!
€* I
T
Itxercisc 8.11 Consirlcr:r birrirry choicc rvhcther or not, to I
ol pol1utant,s. 'l'irr,:
a,lioiv t,hc r:rnission
cosi, t,r'r <;orx;rtrncr':; cif allowing t,ire 1iollu1,ion js (.,' ' 2,U00, tr I
buL this cr,rsL is onl-y ob:;crvalrlc i,o t,lrc (lorlljurrlcrs-'Ilhc bcrrcfit for tlrr: p<;11ulcr of t
al1or,,,ilg t,hr: e,.:t,cru:rltl-1, i:; ll .,, 2,:i0l) ard onl1, tlrt: poliutr:r- )'rrrtrvs 1,1ris itertr:lii. ej f
CieaLl-y,, olrLirrraitl,-1, rcquircs tlri:; r:,,:Li:riLa1it,1, l5 a.lir:r,;c,l sitrcc 1l i (,'. T-Iorvcvcr. a

i,her final cli:cision nrrrst, trr: irirsr:.<l orr.:,,llr,it, ea"cit 1-xrr1,;'r;lroos:i::t i,ri rc:vt:ri. d
I
e*"l
r s
*
166 (.)IL\ P'l'E]l 8 I1XI:liRl'{ALIT'fltS
#
a.
Construct a tax-subsldy rcvclation schclne such thiit it is a dourinant
# strategy for each party to report t,ruth[u111, Lhcir private irrfcrrrnation.
b- Shou,Lhat this revelation scheme inclrrr;es the optir.na,l pr-oductlon of the
i' crt,ernalit-r,.
c. Shorv
that this levelation scheme is unbalanced in the sense ttraf given the
equilibrium reports the tax to be paid by the polluter is less than the subsicly
a paid to the pollutee.
st
Solution 8.11 a. The scherne should be as foilou,s: (i) allow the pollution if the
s cost announcetl by the cotr.sumers is belou, or equal to the benefits announced
by the producer, c1o not a.llou, othern,ise: (ii) if the pollution is allorvecl pay each
party the arnount announced bl, the other party, if the pollution js not allo,,r,ed
s pay nothing.
Given annoilncement R,, of the lrroduccr [he nr:t payoff of tire conspmers
!
i3 is U.:0 if the externality is not allowecl and Lf '- Bo C it Lhc cxtcrnality a

I
I
isa1Iowed.lfl:],,>CtheConSumersreceiveU.:0forannorrncingC,> I
!

* llo, and ur' ', Llu - C > 0 {br any annorurcen=rent c, { Bu (incltr<iing thc i
trutlrful arrrlorlncornent Co - C).lf 8. ( C, the corlsurner-s receive l_1".-- 0 for I
t

* announcinl C,, ? lJ. (including Oo - o), ancl [/. lJo - C < 0 {or a.nnouncing
Co { -Bo- I{elrt:e,.'rtrttoultcilrg trut}rfi.rlly is a (rveakly) d<lmirrant straLcgy f6r t}re
I
* consurners.
Sirrilarly, given allllouncerrrent C'; of Lhc corrsumer) the ncl payo{I o[ t]re
producer is {/, .=, 0 if the erxternalit,.y is not allorvccl t:"nd L), }j C',, il' 1;he
* '= -
extcrrraliLy is rllorvcd- lf Co < ll, thr: producer reccives (i, -= e for arrnouncing
Bo { Cu, antcl (/1, - Bu - (;,, --' 0 for announcin g 8,, --7 Cu (including t}re
* trutlrfui anllorrncelrcnl 8., '. I]) It (:" 7 13, tlre prorlucer receives (Ir, -- 0 f6rr
announcinE B" i< C, (irrcluding -13.. - B), arx|U7, ..: Bu- C < 0 for arrnouncing
* llo > C.. llenct), :{tlrlour}cing t;rtrt}rfully is a (v,,eakly) clominant s{;ri\teg.y f-or the
(:onsulTtel's
* b- Ilecausc tht: players will play dorninant stratr:gies, in the equilibri6rl t|e
externality will be produced, rvirich is i,tie socially optiin:rl outcorng.
* c- Ry const,rttct,ir:rt, this schenre r-equires paynrent to each parly eqrral to the
arnount zrnriounccci by thc olhcr triart;,- Becirusc cach par i;y rvili rnakc truthful
wE announcement,, thr: sul;sidy to the pollutee (the consumers) equals the b,enefit
received by tlti: prr:ducur, B :.2,300, and in this problerl it is greater thap the
€, cost to the consurners, C : 2, 000, rvhjch is t,he tax to bc paid hy the poiluter
(t)rc produccr ).

11",,
Llxercise E.l2 Iloivcanlicensesbcusi:cll,oresolve l.hetlagedl,olthccornirons?

Solution 8'-I2 l-'hc tlagedy of t,hc coulnlol)s is arr exaruple oIa ncgativc cxler*
nality. A gl orrlr o[:rgenl,s lrave a con] nrori right o[ arcess Lo r r r.sorricc ;rrtr:l irr Llio
rnarkel equilitrriu;rr thr: aggregatr: quanLiLy ol the lesourc{j useri by t}rr: agents
excr:erls the opl.itn:t.i lr:vr:i-'j,'he gover-rrmcrr{, can regrilate t,lre quirnlit,y by issling
 BO w

B L,
;r:^ I e:s
g r*fr
l.lf;r*
l
.1ii,:{;iil''.= r"""'" 167
s.
licenses thai. perrnit Lrsa.ge of the r8Hij,rrcc up to a certain lirnit.
'1-he government
€*
can thcrr sct lhe licensed arrtount so that the aggregate usa.ge equals thc optirnal
level. ln th<: example with fishing boa.ts, the governinent cart calculate tlie. opti- e-:
rrral rrutnber of lislring boats, Bo, and issue exactly B" licenses for fishiilg- T[is
poiicy trt.tst, be enforced by, say, prosecution anrl penaity lor the fisiring boats e:
l,hat operzrtc without llcenses.
(E-'

Exercise 8.13 il insuflicient abzrternent is very costlv, which of t;ax:lti<)n or e

licenses is prefr:ralile?

'Solutio1 8-11.] Wit[ a ]iccrrse sc]rcrne the lcvcl of polliiliort abatcmenl, u'i11 bc e
Sltr:e -' 15ere is tro uncertairtl;y about the ortl,u>rne- Wlth a tllx, t'hc level of
abatel,eirt wiil <lepend on lhc rea.lized level of cost since l;he lirrn cllooses after
e
t;his is krrou,n- 'l'hr:refore, if i;lrr: c;os{, tttrns ottt to Lre lr.rw, tlrc firrn w'il} c}loose a
irigl *btrt;t)g1)11; level. If the r:ost is high, a low :rbtrlcuterrt level is t:]Lo.sr:tt- 'I'w<l e
obscrv;:.l;ir,ins ft,illolv l'rour I.rirst, licenses a.nrl l;a.xlrtiotr rvill rrot Lrr: t'tltlir':rlcrt1,
this.
rvlen t;herr: is gticcrt,ilinty. Sccorrd, r,vlien the t:ost o[ abaterltciti, is rea]izr:rl to e
'I.'hc (:ollvor.s(l holcls rvhctt cost is
br-: low, t:rx:flion lea.rls t<t r.rxc:ttssivr: abatemenl;-
higli a,d til:rc is irrsullit;icrri; alra.tcurent- Thcrcft>re, wiu:tt iristrfli<:it:nt; ;rll;lt;ctnr:iit e
is ,rery c<lst,1.y, Iiccrrscs will br: ltrefr:rred beca,ustl oi' thc <;crtir,int.y of tltc
(lt-tt,<:<)tutl-

e
Ex<:rcisc 8-,14 Are t[e fol]1;wiltg statenrents tnre or [a,lse'? Iixl;]ail wh.y-
C
a. )['y91r r:<tlsrirnptiop <>f cigarette^s prodtt<:os nega,{ive r:xt,tlrrta,lil;itls lor yolir
p.r-t,,er-(rvliir;lt.you lgirorc), therl you are cr>ttsttrrting lllol'c <;igut-t'tl,r:s Lhirn is e
I'a.rett> t:{-li,'icrr1 .
b. Jt is gelct.;llly r:fliciel{ to sr:1;:rn ernissiott st,a.nda.rrl allowing zr:ro llolltti.iotr- e
.. A tit>: 9n r;igarettes inihicr:s Lhe rnarkct; for cigzrrctt;cs t;rl pt':rforrtt Inore
eflir:iently. s
d. A ban strtokirtg is rtccessarily effrcicnt'
orr.
e. A cornl;ct;1t,ive nra,rket witir a negative externaliit' produces lrtore orttprit rF-
*
lhan is cffici<'rrt.
f- A snoS elfcct is a negative (netrvork) externalil,y fronr consumption- &
Solutiorr 8-14 a 'Iruc. Wilil negative exlcrnalitics tlic tnarket, cqirilibrium
tirrarrliL;' r g,"11i'1', I r:xt;,'e' ls tl rc l'at c{'o cfi-iclent levcL'
it
q
b. I'a1si:- lI sorrrc procluction pr-ocess genctatcs a Do]]zct'o levcl r-,f 1;ollutlort
brrl, tix: bcnellls i:xceecl l,he cost then thls proihir:tion is sociaii-y oPtirlai ar,rd
q
slor:lci bc 1liou,ctl. llcrrcc tlie ernission staudar,fs sliould a.lLor','for a cer-taiu
#
I

r1or1z(lro 1;olirrtion leve1.

tltttcome I
c- J\ue- Srlo[i1g l1cLir:ra1,r:s rreglative exterrrllilit:s, and tLrc nlat-]"r:t, #d
i-, -l: i; i, l, trl. Ew'a
:*

d. ir4.lsc. A ba.u,rr srrrirliliLl! re{,:llrijcs lhc ui.ilit,.y o1-t,ire st'tiol',^c;.'i; lllr.r.l Lltc i-lt'ofi1,.r i
,*";
r,rl ilr,: r:i1]l,it r,:t,t,c-tla.iictt's. ,/r llirorrgh thc rli,ilii,r",i' ritrttstrlol''ers il'tl11 1'1lr: 1ir''llii's o' tri'r
?
.*
#-g
B:I:
7-. B B1

-*' I#.ii*'lri'l IIJI

tr
168 CI{APTILR. B irxl, Efi.ArALt'l.tES
ilrilill*"j,$';t:
*
-* the produccrs of substitute goods (e.g., cheu,ilrg tobacco) rvould incremc, the
s aggregate ',r,elfare furrction rnay changc either v,,ay.
e. True. A snob eflect is a negative networl< externalit.y- The snob efl-ect
s t'*

refers to the desire to on'n exclu.sivc or uriique goods- l'hc fcrver tire people w]ro
((sps|l" good, the higher is l;he quantity
own a dernanded of this good.
B
*
Exercise B-15 A chemicai f'actor1, produces a product that is sold at the price
of $10 per Lon. Thc cost o[ production is C'(,il : 0.5y2, where g is Lirc nurnber
*
of tons of prodrrction. Iirr each ton of production, the factory produces 1kg of
pollutzrnts tha.t are cither disperscd iirto thc atrrosphere at a cost of $0 to tlie
* mine ol captured anrl stored at a cost of $2 for each kg of pollutant. Tlte arnount
'ip of dispersant pollut;rnt is dcnoted r:. T'he pollutiorr causes a nearb.y textile firrn
to }rave to rv::sh its prociuct,s trvice rr,,ith zrn additional cost of ()":0.5a2, rvhich
-* <Jotx not clcJ>crrd on thc arnourrt of out,put, rn, produced. I'he iurit price of tlx:
orrt,pr:t of {;he textile firm is $5, and thr: cost of production C7' .= 0.0'2rrf .

a. 'Del,crntirre ttre valtres <)['L1,rL, zrnrl e in the competitive equilibriirrn. Iiorv

* mur:h cloes t,l're coal mine syrerncl on capturing the pollutant'l Whal; Icvel of
'r. ettl,irorttnt:tital cost does thc chcrnical ltrclory irrflict orr t]re textile fir'in?
!r b- Wlry is Lhc cornpetitivr: t:quilibriurn incfiicient frorn a soci.rl lrcrspcc{,ivc?
<:. Wh:rt is tlre sor:iirily o;il,inr;rl lcvcl <tf g?
h d. Assurie t,hat the exterrrality is internaiized. Determine the values <>f .q, rn
and e., tltt: expcndil,ure ort c;,r.1rtrrn:, and lhe additional cost for thr: tcxl;ile lirtn
* causcd by tiic cnvir'oninentzrl p<>llution.
E-
riB Solution 8.1.5 J,et .s be the antount of <::rirtured pollutant in kg, so that e --.-
s. ',1'hc profi{,
q '!/ - of the ciiernical factor.y is
fls nI' : pyll * Co (u) -_ (.,.' (.s) (8.113)
& ,

FB and the pro{it of the textile {irm is

&
#
&
vT .,= ,pt)LrrL - C:r 0n) * C,. (") (E.s4)

#
@*
Ilere p.o =- 10, J),n:5, and C" (") '='2s.
a. Irt tire colnpetitive equilibrlurri eaclr firrn rriaximizt.s its profiL. Tlrc chen-i-
w ical factoi'y cltoosr:s Lllc arrlouLl, trf output, y, :rnd the arrrount of c;rpLrrrerl pcll-
& lriicrrL, s.'i')1,' lilst-urtlr.r CutrrliLic,rls ar,'

ffi
ffi
,:
t.Jir'
..,
l-'

: :' (8 55)
-
ffi
HEi
(il1

ttn'
't [:
P'v !1 {),

fu** ,/n
ru
&r:,:!
i) ;;
\o.ru,r

a+ ;,ircl llrr: .solitt irtn r:r '.11" .,- 'i,,, --., i [i, .5"-0
ra;
t-'-
t_-
=**,.^
f,=,'i.'
 OZ

s1 rUDIE$
lson lne.
latYl r Niketar
or FlOOf.
169
"l
.l
:ii,'ff*
textile f'actoly ci'rooses
1l'he
T'hc first-order r:ondit,ion is
t,he rrz, Lo nraximlzc its pro{it. .l
q'l
() lt' s"i
. =11 ,r-'lll-L), (8.57)
oTTL
fl
and tire SOlutiori iS zn= - prrr: b- Since e* -.,!J" __.s* -- 10, the envirOrtrneir[trl
cosf inflictcd by thc circrnlcal ftrctory on the tcxtile fii'rrr is C" (".): 50-
€
b. 'Ihe competitive equilibririm is inefficient beca,use of'the productiorr ex-
tcrnality: the act.ivity of the chcmical factory reduccs. tire 1;rofit of the l.extile
firm. lheexternaiity is negal,ive so t,he level olact;ivit,y chosen by t;hc chernical
€
fa.ctory is inellicicntly high; that is, l,hc- levcl of output, ol thc cirenricr.i.l I'actory
in the competitive eqriilibrium ls higher than 1,he socri:i)ly optim::) lt:vr:l. e
c- To find the socially optinral icvcl of outiltL, wc trr:cd t,o rri:rxirnizr: the surn
of t,he profit;s of the chernical facl,ory :ittrJ o[ tltc t<tx{;ilc firrn: €
1t :'tt l1( i (s 58) €
iii);i'l'r
r,,rl tere €
n't' .l n't' ..- ptt'u -C'"ll) (," (.r) r yt.,,,nt, (rn (v .,\ (.8 5e)
)
e
'f irc first-orcler <:<.ittclit;iotrs :rL<: it<lrv

0r .
e
oy
P.t, lt lY .tl t), (8.(j0)

0r C
()s
) t ll, .rl .- 0, (8 61)
Olt €
(8.62)
0rrt
s
ol g (8 Lons) is lt)r,,,cr l,han Lhc corn1.,cl.itivr: cqrtilii,lriurtt lcvcl (10 torrs).
rl. Wtrcir r:x{,clnality is intt:r'na,liz,e<\,:r s<;c:ial}y oplirnirl ou(.(:orr}e is :r.chir:r,ecl- €
Jllrc ciicnrica.l f:rcl,ory's cxpendifrrrc orr calr{,ule is C-' (s") '- 72, atrd t,}rt:1ro)iut,ion A
cost for the l;ext,ilc firrn is C" (e") - '2. b

6i
Ilxr,,r:i:ise 8.16 Cionsidor tr'"'o corlsrlt.r)ers u,it,lt r;t,ilii,y l'ttttcl,ions t\l
I

t'"
I

[.JA : Iog(rf ) I L,* - l] ,'*1,11,1, {rR '-'log(rf) t rl - *JI

I
I

tll "'*t't' I

Both consurrlcrs harvc incorta M :lrd 1,lre (prc-tax) prir;c o1 bolh goorls is l. f\.;
I

a- Ca.lcuialt: l;hr: rla.rket eclriilibrirrm. .?

j
{
b. Calculate l.lre social <iptirnunr {or a ut,iiitariaut soci:rl u,clfat'c l'rtrtcLiol. f.l
c.- Shorv 1,1'rat i,hr: optirnum <;a.r ire srrst;zrlned by rl. t,iur 1;Iaced ort gottd 1 :
j
(so Llie posL-1,a-r irticr,: beconres 1 l- i) u,itlr tltc rcv<,:itLtc t'cturned cqua.ll.y tu l,hc -.. l
i.4,.
c()nsumers in a, lrilnll st.lill ilra,nner. ',.i

,'i
] (:Il,\P7lt R s. Iixr-IrIl.ArA l'l'fILS
t70
rt
giveir lli'
cl, Assurltc rtolv that preiereilccs arc
t UB - iP togQ,f) )- rY - f,bs,'{1
frA : p^rus|zf ) t ,t - | togtr'f ),
:*
the optimurn
calculate the taxes necessary to decentralize -: 20' contra^st the or,rtcome
'* e. For preferences of part (d) and income AI consullrcrs'
betrveen
trhen ta-xes can arld cartnot be <lifferentiated
i)
Solution 8-16 tr- Consrtrner A solves
:J
max IJA s.t-
.}
,! + 'N - A4 ' (8 63)
,3 t'f ''f
The Lagrangian lor this optimization probiem is
r.i
ri 1-.=lri;(:,f) + ,N'-i
"*('f)
+ xA (t'r -'f -'t)' (8 64)

r3 and I'r,rttr tlrc Ilrst ottler corrditiorrs

OL 1
,_:- ,- \ :0 (8.(15)
* 0rf ^-A
J,1

AL
1 -'- )A :0, (8.06)
& Ar*
AL
= x,I * t:! * rt :0, (s.(i7)
@ 0,\

d we find ]ris optirlrill cotrsumJrtion:

r! -:7,
A
q"'': M-1. (s.6.s)
d
Slmilarly
€ r?:t. tl:I/t*l- (8.6s)

G sum oI the individual utililry

as the
b. A utilitzrrian rvellare functiorl is ciefirrcd a symmetric
trn.tlonr, i. geireial, r,r,,ith indivi<lual u,eiglri,s. Here-rve a-ssume
tr] rri,ilitar.ian urelfare Iurrction, th:rt is, I4r
: [lA I LIB' T]re socially optimal
consr-rrnptiori in tiris case solves
L-l (E 70)
rlax UA t-UR s'i''
( ^A .-A -B ,-'2
-g\
f rt ,az ,*1 )
t-:l
'iilLe L:rgraiigiatr fol {,hc sociiil plantrct-'s pi'obiem is
1 ...1

t : ,1r"gi'f )":rros(,-f)
rr{+rl
+)'1 {l,q - ,,1 - *N) + \a {ttt - "! -'i) (8.7r )

i,'
 B4
BLTSS POINT STUtrIES
Branches: t{udson Llne. ,k
Ralouri Garrlon, SatYa Niketan L
2453. Basernent & 1st Floor,
GTB Nagar, Dslhl-tl000q t71
(Iql sE1l 94341 1, g89r S$ss?g- *
lironr itions we find l;jre socially optiinal cormumption
prolilc- e
| : ;, ,rl =- on -;. (8.72) rs
'
ri? 1-
= i,:,
.,,1t - ll
r?' : t\'l -
rP:M--! )

(8.73)
c. WittN*i{{
f1-- 2 €-
ptaceri on good 1 ancl rvith lump-sr
li. solves /
trausfcr 7'{ consllmer
€"
,rt)r,l^.l,n s.t. (r t tA)tl (8.74)
l'r '{'-' i e
T'1ie Lagra{rgizu-- fq{,is optirniz.rLion pr.oblr:rn is
e
t- --- Ios (Yil t ,l - i,", (,f ) I )'1 U4 '7'A (t + tA) ,.1 - r!). (E.7s)
e
1

arrcl ,conrlil;ions
I e
br!
,.4
.,_v - ^ (t t- i.r) -,- o, (8.76)
dL
"7
e
;.. ) '- )A ,, {i, (8 77)
dt:i,'
OL
e
A
ful t't'/l (t -t tA) r'| tl
tn)
e
rvi: Iirrd his opLirnal tii rtit-rrr:

A I ,J
€
:L1
) ' (8 7e)
-1- 1tt I -1 1.,t
€
simii,rly we firrd thi: ripi;iin,r co,surnpt,ion o1-(iorrsilrrnor
lJ rvlro ;-rr..ys La>r l.tJ <tn
goorJ I and rr:cciv.r:.s 'I'B ;* a ]pdrp_surrr {,rerrrslirr.
6
I ,/)-,. - At 1 ,1., 1,
r\
\\ 't.,
,/ ) ltt-J) ,.1,
-":
,,tl €-
\\ /'
OrunperingT\q[rr lrnr oorisurnill,ion letrcls t,rj tli t.he ,r,r, l,\,,,11,;.,,,\),,
\sstt) \
u,',\ ri,,, &
tF.
tlir' scL of La>:,,r,,,i]-f]iln-"fr;ps thai, c,leccntral jzes tireISo ,'ir,II,'1fti-r I
1.

ulM,r,,.
f.,
rL>
lA'lt l, (ssl) =-
I

'l'^,, .:: \\ s:)

:
:

) \-.--
--(; €*' -"!
,l \\'rLlr il,> /A .: '/ --..-, .,i}J
I

1,);, ,,'\l ,,r r,r1,II :,rr,l r,.ilir Irrrrilr t, -"- ,l

1 r:
),,{, "\ . 1;, S'="1
-1 , , ,1i., t.:::
I

I\ l|:lx . ,\,' r.r I i i/t).t,, l r.n li i '1"" (lr 8:t) jPr-t:

c-.. - '.
,, i-:'l '2 /\
'_ l
- 11,
'::'l
I':.,- j-,. , ,:,r',.r,i.rir 1'trr. ,h i:,,l,ritrri : ri,
{,1-t i ;,r',1,1,,r,r i tr.,
\ '
I
\.
A ti
,1,,.1;.,/' t; ,l
-\
,),
' r'1') ,-li'). (it it i)
l
-'

\'.. =" , ..
t=
* B5

;* cH.,ll'lEli 6 lrIl-ltRNA l,l'l'l li,5

1.72

*
; and from the fi rsL-orclt:t' couditions
*
y. = t^-r^(i
ti' +tA):s. (8.8s)
0rl
ar. r )a-r), (8 86)
3 0'4
nr t")'f - rl - o,
-: I\4 -r'rA - (t -r- (s.87)
3 =0^
u,c Iind iris o1;timal coll:;utrtpliotr:
3
r! :
.A
a l' (s
et--11/4, A'I +T'A - #t^ BB)

Siurilarly u,e {rnrJ the opt,irnai consumption of consumer R rvho pays tax llj ot't
il goriri 1 air<J receives TR as a iurnp-sttrn tratlsfer:

t ,P ---
'Ll
ttD
l tt.,rt
,,, ,f =' h[
*2 ) TB -
..8
l)"
11tD'
(s 8e)

,l.lre sor:i,ll.y o1;tinial consrrrnpt;ion for a (symmetric) utilitariern rt'elfa,re frrr-rcl.ir>rt

t
' solves

rrrax LIA +III3 s-t- ,!'" l-*l'o : M +TA'R (s e0)

iF {'f ''t ''? ''l)
'1'he l-,agrangian lor thr: sor:ial plaririer's pl oblcrn is
*

* L -. (r"- i) '"*(,f) + (o'-i) ,*(,f) + ''!+"1

IAA(^4 -,l *"i)) + stj (tl -,f -,t)- (8el)
*
Frorn thr: first,-or<ler con<iitioris rve fincl Lhc socialll' optinral consumption
profilc:
*
-e { - ,u- ;-, r!-'tt-n^+), 1ss2)

=s
of
Coi,pa,rirrg Lliesi: r.;iLir i,iir: rtrarlir:1, otttcorne t't: firlcl the s,:L taxps
arL,l lt;ltlsk.)t-s
-e tlrat clecentr-aiizes tlrc socia,ll)' optirrra-l oulcorrlc'
l
ffi t,A'D .- ----t
2Prt'tt--. - , '
(,q.9'i )

ry ,1,/t,li _::
I
2
(8 9I;)

& ,' Ta>:es cltt ac]]ieve el1icielc1,, tirat is, the e{iect ol extettraiity cau be
onl-Y
jt
r;ornp)ete)1' rctrtovcd, if tlrc collsunrers c;:.n be clifferentlatecl. l1' is not
possiblc
w
n-e
%se{ *J
 B6 Yl

bt lss PoINT sruBtEg

Branches: Hudson Llna,
€l I

Rajouri G?rslerrr, Setya Nilratgn I

2453, Easement & lst Fl,oor, t7:1

GTB Nagar, Delhl-tt000$
e-1
(Nl) s811343411, 9891 555578
c
I

to levy individrral i,ax rates on in<lividua,l consumersT a uniforn tax late cait be
used rvlriclr rvili reduce tlic el{cc{, of the externality. Suppose pA - 3f 2- pB ':1, I

A4 - 20, the tax rate is set to f - 3/4 for both consur-ners. and the tax revenues G-J
are divided ec1uaily" \A/itirout taxes the nrarket equilibriurn outcome ri,ould be
l
e*d
rl .)
,,
nA :18--. I
2',
(8.e6) I

."8 t, lL2
B : 19. (8.e7) e-J
1

i
J'he filst-best soclall), optirnai outcoure is Q,r
rl :
l

l, --A
&2 - 19, (s eB)
i

r$;
l

_D-t
l
JI -= 19 (s.ee)
i, "ll 2

J'h<: optimlrl outcorne can ire achieveri with

C

I,A l,l] ,",- 1., 'YA'l-) :-- 1

(B.l oo) G
2

Wi{;h the l;ax r:lte t : * the orrl;comet is G

._A
tr
12A ::: i9
l
(8. r o1) e
J,7
i, '28'
4 15
,,.
.tl
l] B
-c2 -' 19--. (8.I02) E
I 28

(t,o{;al l,ax r)v(:nue is / (rf r ,rf ) 151 14, so t,hal, ear:h r;(lnslirnor receives e
..
'l'A'tt 15f '28). i\p,grega{;e w<:llarc rvil;hout, {;axes is vlli' -- :37-90, aggregate
rvcll,ru'c wit,h [irc unifortn t,ax is I,('' - 38.13, and thc sor:ial optirnrtm lta-s E
l,V" -:.t8 l5
e
Ilxr:r<:isc 8.17 n competitive re{inirrg in<lustry reieases one unit of rvrlste intrr s,
l;hc i;.l,rnosphere for t:ach unit of refirrecl 1;roduct-'llhe inverse deniand function for
gr '1
u,]rerc q is the quanl,ity corrsurned u,hen tire consumers pay price pd - 'lbe itrverse I

srrl>1ilycur:ve for refiningis M I-'O ,:.2*e" rr,]'ric]'r represents the marginal private €j
(;ost, r,:rinrc lvhcrr tlre iriclustry ltroduccs q units. The margirtal extcrrtal cos{; curve
I
is MItC-.0.1,rQ, rvlrere MIIC is thc nrarginal e>:terna-l cost u,hen t,he irr<lustry
li:ltri-rscs q urril,s o[ r',,:i^slc, N4arginal socilrl cost is girrcn by A,( SC : A/[ PC 1 AI EC -
e E
ji
:r,. Wli;rt ar-t: i,lre eqrriiibriurn price and qua,n1.i1,y fol the refinecl prodrrct when
t,hcrrc is rro corrccl,iort for thc cxtcrnalily?
tr* #
lr l{orv much of the chernical sholrlcl l'lte mar}iet siipp}f at' the social opti-
rltllllr/ €
ffi
c ltlorv 1a,r'ge is the dcach',,etighi, loss ltorrr l,ilr: cxteinality'/
il itriltitOSC tlrr., 1,,rlC..t,irri.ttL itirl)C),ccl lrtr rtiLrit,r..itll fee Ol 7' 1-,ei llitil, Of ertlt:;- d H
t:i;rr:ii:li, alir-rutt1, ttl tltr-: r r:lilti:ii fT-*
1.iroclr,r c;t.'i -#B&
{*
r.:
'si
ffi
rw
f +'b

.la
*
174 C]IAP'I'ER, 8. EXTDIIN A],]' Iil'S
*
q Solutiorr 8.17 a. The equiiibrium price arld quantity wlthout correction for
tr the exterrlaiitY equate the inverse demand a.nd the marginal private cost:
2 + q"' : 20 -- q'", (8.r 03)
€ (l't : : )l-
9, 'pm (8.104)

s b- At the social optimum the inverse dr:rranci equals the marginal social
cost:
t
!r 2 -f qo * 0.5qo : 20 -- t1", (8 r 05)
q,o '2, (8.106)
s<h 7 P" --= 1'2 '5 '

c. '['ire deadweight loss frorn the externality is the difference between t;he
& r.telfarc lcvcl at the social optirnunr (the sum of tire consumer surplus ancl the
pro<lucer surplus) and 1,he welfare level ;rt; the market equilibrium (the sum of
i& thc cottsurncr surplr:s, tltc producer surplus, irrrd Lhc differerrce bet,ween thc tot,al
soci:rl r:o.sl, a.nd the tota,l private cost):
f q"' t'9
t)w t, livt 'sc; (,il
r,u (q)l .l,r
r- t.sq) - (2tt q)],t,t
Jr" lr r[(2
Is
,r, -- I 8) rlq 4 .0i:. (8. r 07)
J, ,Q
cl. \\zith tire ernission fer: the nrarhet, e<1rrilil>riurrr is determincd by
21-q1-7' 2A q (8.108)
'1'
9,- (8 10e)
;
T'his <ylantit,y equals l;hc socia.liy opt;imal lr:vr:l, r1o -. f .), rvlien ?' .-, 11.6.
'-I']rcsi: rcsuiL.s are sunrrrar-izcd ln ligurc 8 11.

Exercise B.18 lliscuss the f<rllowing statemcnt: "A fax is a fine lor cloing sonle-
thing rigirt. A fine is a tax for doing something rvrong."
Solution B-18 llie irnposition of a tax or a {rne for undertakirrg an economic
zrctivity raises the relative cost of the actir.itJ, and, in general, will reduce the
clcgree to rvhich il, is undertahen. In this r*;pect the tr,,,o are identica.l from an
economic perspective. Wher<; taxr:s and.{ini:s diiler is in the degree of certiiirrty
ol payment. If taxes are paid honest,ly. t,licn there is certalrrt;, in 1Lc pricc oI thc
actlvit)r- In contrast, lf somethinr; "rvroll!,,)r ,r donc, lLere may be a probabilit.y
oI not being deter:ted and avoiding anJr fine 'f iie impositlon of a fine becomes
a rilndom event and the price of thc aclivit.1 is urrcer{,ain. ll-}ris irlg}rlights t}re
'betrveen
cr:r-,nornic dlstinctiorr chooslrg irncler c.r:r1,ai nty u'hen tar:cs are paid, :rnc1
citi.rositrg u,lth risl; r','lrt'ri Lhnrc is tlre i;oi,crr[,i1.,] f, ,r a firre J'he a,r'ral.r,:tis of pollution
pcrtnil.s u,itir linccl i.l.inlv sltor-,,s lto.,i. 1,]ri: <:l roices can difier 'i-ret,r',,i:i:rr casi:s oI
 ;1
'H*ffi#fffi I / i) sl
5

Pricei
ei
cost

30
MSC si
-t4
MPC+'I' si
2A
MPC
si
C
c
(luantity
s
){ ltJ
if
l,) 26
s
rigrrrrt ol t:rnissions fcr:
I tJsc r"r.rr
s

Ilxerc.ise tt.1 9 Su1r1"r<>sc tht: governrnent issues t,radable 1;ollut,ion pet'rnit,s'

a. Is il bel,l,t:r for t:r:orttxiric eflii:ierlcy t;r> <lisl,rlbutc t,lrc pt:rnriLs attr<>ng 1>tll-
Iut,ers <tr t.tl :ur<:tion t,lienr'/
ir. I1't1i: govorrrmcnt de<;idt:s to clistribut,i: Lhc Perinit,s, docs tlte;rllocat'iotr *R
t
ol' pr:rrnil;s i),rnorrg; {ir-nrs rna,tl;el fbr ecorri>rnic <:{liciency'/

soluti0rr 8-19 'l'hr: issues ilt tlle helarl, <>l t}-iis question zlre tltt:,,,,,t](*', ol ot'll-
s
'-['hc g;ovcrtltncnt scts
r:rwisc, of thc tlar[ct, ip a]iocatir]8, scilr(lo cornrnodities.
zr limit, on tlit: totlrl rltt;rtrtit;1' of polirition that can be ernit't'etl
by linritirrg 1'htr $t
tlffit:icrtc.y
number of pernrits- ',l'he pcrirrits ilro a scarce resource an<1 ec;onorric
'Jlhe goverrirncttt
requires tlra,t 1,he1, a,rr: used lly those u'ho Vaiue thern tlie most-
is unlilleiy to be in possession of in{brrnatioll on t}re va}ues placed on permits'
.d*.
I)irc<;t <tistrlbution by the government \\'i]l not succeed in placing thc
permits b,
go to
u,ith the correct,.r..., T'he'benefit o[ an auction is t]iat l]re pertnits u'j1I
l

tlre lrighesl birlclers s,lio by definitiorr arc 1,1rc users who valr:e them most'
If a'n t-
aricLion is ncit use<l but the perntils ir,re ttacla,trle, iL does trol
tnalter hot'1'1ie i

permits arc i*it,ially clisl,ribuied. provi<1etl 1,6ere is a rnarlet lor the

perrnits' If L".
tlr" go.r,,.rutrent dislributcs a pertrrit tci a, user rvho piaces a lorv value upon it,,
.a

FllTicienct' 1s not
th.en tlre pr:ruiil. rviil be solcl to a user x,1t,h a hig ier va.iua-tiou'
a'-' .

{._.. ,

alTectecl by t)rc init,ia.l distribution 1lu1 tlre ailoca.tion

ol irLcorne is allcctccl' 'l
'i'her. a,rc <.a.r,eats to t,he a,rgtrt't'tt:tt1,i; i.i.llove' 'l'hc r-"illingneSS to Pal'lr.rt a
lroL llrr: socia'l
pcrilli1, l-i:flcc1,:-; i,]rC 1;rir,:rLi: L,.:iicil l,l; ltorrl or','riini', lhc pcrrrlit' attd
lteireiii,. 'l'1ri: r:s:.enr:r: O1' cxtelnalilic:: is t,Ire tlcvia'tlon Ol 1)ilYali: itorn s;ilcia'l
br,ritr:ijLs. Scliiriir, l,i.i t,1irl hii;lrt:sL L,i,-iilCr ':''ili aliocat'c;;cct'rrlitl11
to priYl-lc lri:llr':Ii'
 i lrlrr ffi
ffi
176 CTIAPTT'R 8. L:X7'ETTN AI,]'] ffi
ffi
]
not social benefit. l-Jtr: argurnert that trade in permits is necessarily efticient
) needs 66 be judged cm<r by case taking accourt of tire nature of thc exter,alit,ies-
ffi
w'ffi
c

.3

s Exercise B-20 A chcmical ptoducer dumps toxic waste into a river- The waste
reduce^s the population of fish, reducing profits for the ]ocal fishery industry by
g $150,000 per year- The firrn could eliminate the rvaste at a cost of $100,000 per
year- The local fishing industry consists of many small firms.
a' Appiy the Coase 'fheorem to explain how co.stless bargaining rnill lead
€ to a socially efficient outcome, no matter to whom property rights a,re assigned
(either to the chernical firrn or the fishing industry).
€ b' Verily the Coase Theolem if the cost of eliminating the waste is doubled
to $200,000 (with tire benefit fol the fishing industry unchanged at $J
50,000)-
€ c' Discrtss thc following :ugumcrrt: "A community heicl togct5er by tics of
obligation and mutual-interest can mana€le the local pollrrtion problems.,,
d c1- Why might bar-gaining not bc cost;lqss?

d Sohltion B'20 a' A sciciallv efiicient outcorne il this case is to cease the exter-
nality, tha[ is, to allorv t]re chenrical firrrr to function after it eiiminatcs
tirc ;;;;"
d Suppose l;he iri'opert.i' t'iglrts a,r-c zrssigned to the chemical firm, t5at
a fuil r'ight to produce chernica.ls, even though the production process
is, jl; li:rs
involves
a dumping toxic x'zrsLe itrto tr rivcr. Thcn thc fishing industry.rn pry the
ical firrn to have it insta.ll thr: lircilities 1;h:r1; l,,o,rld eliminate the wast;e.
cher,-
)-ircc:
tlte cost of eli[ri[ating thc rT astc to t]rc {irrn ($10,000) is less ttran
€ thc profits Lo
bc received by the fishing inclustrl, afLer l;he wa^ste is eiiminatea ($ts,br)0),
thr:
fishing irdustry rvil) pay the ftrll cost ancl still urake a positivc profit.
@ Supp.rsc
now tha't the propertv rights are assigned to the fishing indqstry.
T5e cSer,ical
firrn wiil then be fcrrced to instail the waste-refining lacilities"(znrct
I d full cost); otherwise, the fisliing industry wili insist on shutting it ao*rr.
pay t;,herir
Jn arr
in1;crrnedia{,e case the c}remica,l firrn and the fishing industry
t (i the shares of cost of the wir-stc-rcfining facilities. Irr-any casc,
can bargain ovel
a socially efficient
outcome rvill be achieved-
* b- In this case a socially eillciettt ciutcorne is to continue tire externality,
that
i>-, to allovr pollution. Suppo.se the proper:tJ, r-ights
are assigned to the chemical
q} {irm- !f}re cost of tlre poilutir, cxlcr.allL.y to the fishing industrl, is now
smaller
thar"n the cos1. of eliminating the rvasl,e 1;o 1,he flrm. l{ence
t}re {ishing indust* i5
d unel'lc t''' oiTct tlrc clrcnrica] firm criortgir r:urrr1rcirsaLic.rn {o lravc it c,l inrilratc
\r,este, aird the externality lvill r:ontirrte. grrpp6rjc irow that
Llrc
tlie p.op"rty rig,hts
s are a^ssigned Lo thc fishi,g, i,clusrry. 'I'irc, tiic 6rrn r,.,ill be r,,.iliing.
f:shlng itrclusti.y compensation o1'anrount $i5,000 ancl continue its prod.ciion
to pay tire
_ .- -l rvlthout elirninating Lhc \\'irsL,o. ln;irr irrl,cl-rricrli:Ltr: c:1ge, v,rlisl boih pa,rties
a
have
(Iimiterl) property riglrts, 1;he1, 6;1n barga.ir ovei tSe arnount of compe,.si,.l,ior-
r\gai*, in i:.rr.1, cilsc a socia.llv c{ircicii{, ouLcoinr: r,,rill br: aclileved.
c, ilrti.l:Linirg i:; onr: sr:.luilrtl trt 1lr, o,.j,,,r.;riljll prtibleil. Ap
a.]i,cr-1it.1,rr,,.r
s;oht{,itltl i:; t,r.r itii,cr-rn.h'zt:1.lre c-.:tcrria}it1.. ,j.lte r:,llccl of iiij,r:rnai
iztttjctnjs i,o r;nsr, p
 9U

1't'/ i1
Lliat all p:rrticipants f:rcc the social bcrrefit and social cost of their actions. If the
chemical firm and the fishing inciustry are scen zls a single cornnrurrity then prrofit
e
rnaximization b1' the chcrnical firnr will take account of how its choices affect
t;he fishir-rg industry (and vice versa). "Ties o[ obligation and nruLual-interest"
€
cair bc interpreted as channels through wliich infolrrraLicirr on external effects l
can be cornmunicated and lead to a,ppropriat,e intelna.lizat;ion-
d. Thc process of bargairring takes timc and resources. While the negoti- l

ations are going on either party could be incurring losses: because of ceased s l

pro<luction or conl,inuing pollution, etc. Ilccausc o[ the legal issues involved,

both palties woulcl have to hire lawyers and pay legal expenses. C
s'
Ilxert:ise 8.2f A film, S, produces sleel but, trlso Jrrorluce^s was[e t]rat conta-
rninat;es zi. near:by liver. Steel can be solcl for $10 pr:r ton- '.1.'lrr,: cost function o[
e
tlre sti:cl flrrn is given by cg(s) == b2, w]tere.s is tlrc outl;ul o[stcei in tons. 'I]hc
icvel of wrr.r;tc, :.'. is r:ela,ted to outy>ut by r : [).1.s. A fish ta.rnr, .I,', is locatcd
s
<lorvrtstrcaut ii.n<i is ncg:rtively .rffected by thc rvastc polluLing 1,hc walcr. Every
fish l;r<;rhrced by tlrc farm ca.n lle sold for $2. 'l'hc r:ost, frrnc.t,ion <if the fish firrnr c
is givcrr lx r:1,,(f ;r): f J-:r2. 'fhc lish firrrn hzrs a crilr:lciL.y corrstraiut,f a= t0.
iL- (Jornpute tltr: optirna,l outJrrrt rif the stecl lirrn if it rnzrkr:s its clr-'cisiorr e
withor-rt trriy ccirrstrairrt.
Assrrme nr.iw that the firm ntust compensal,e tlrtr fish fa.rrners zrn a,mount $r7 e
pcr rirrit, of wtrste that is produced.
b- (-)orrrprttc 1;he optimum value of q, the optirn::l steel orri;1iu1;, anrl 1;lrr: prolit s
Icvt:ls of t,he stcel firrn a.rxl thc fishcry.
c. (Jorttpare the solutions txi (a) arrcl (1>), :inrl extril:rin any rli{Iercnccs. €
Srilrr(,iorr B.2l a.. 'fhc stt;cl lirm's olttintization 1;roblcm is C
max?rq: J)..s CS(s). (B.l I0)
6'
{"J

'"1.'irr: f ir s1,-or-rler corrditioir, T

dns
d.s
7),, - 2s -, O, (8.1 I 1) s
11ilr:s thc optimal output, s
' ')lt.
'I'he prolit ievel trt this outprrt is s
ri..; (. ) ..
-;
Lr- \li ii.h cornpcrrsatioii, thc s1,cel firm's optirnization pr oblern becorncs f

I]t:t): ?-i'.9 : 1)..5 ,',,(.'r) - ,,r t' (.r) , (8.I l2) t''
{l l
I

.'.r,l l lr,r illsl.-o;r1r-:l c,x;rlrli, rr ls 1,.r"',, ,..']

d,n s '2s'
GS
-- ll.. 01r7 - il (E ir3) ."'i
I
-

i.
aj-
F-B 91

1/5 cE|LPl'ER E ]lri-rnr\r,t l,L'|lqs

*
'I'hc lcvel oi output tvith corrillellsatioir is givert tr1,
s
.{b.

(8 114)
*
The optimal value of q x,ould result in the soclally optiinal level of outi-iuL
1
Y ' s (q") : ,o- (8'115)

Y
- To firrt1 tire sociall), optima,l lerrel of otttput N,e need to maximize tTte sum of
profits of the steei firm and of the fishing fartn:
,*
(8.116)
[,?i. -
7, .s -t' tt 1,

{}
urherc
s r.^ f- tro' ::: J)5s - cs(s) 1 pt J - .f [, (t)]' (8.r 17)
'.1'1rr: iirsL-order conditions a,re
T 0n
at
r:: rn.u _ 2s -- {).{)'2s 0, (8.1 r B)
3 ( ,.s
/)
on
1\r PJ - 1>0. (s.t 1e)
3 u.l

'f inrs t,lrc socially optirna.l lcvr:l of steel output is given b5,
I --o Ps
,LU2.
*
(Jsing; (8.1 l4) and (8.i15), wr: obt,airi
'i ?r:!'"1q" P"
(8. r 20)
2 2.02'
,iil P"
qo (8 121)
10.01
iE 'l'lre opi,irnal arrrorrrrt of comJ)ensation is, therelor-e q' :: 1. The output of the
st,ccl fact,or.y is s (q') = 4.95, and Lhc prcifit lr:vel is
s
zr5 (.s(q")) : 7.t"s(rf ) --cs(s(q")) - q"r. (r(q')) ;t24-5. (8.122)
'd
rGl

ConcliLion (8.f f 9) ini1,Iics 11;rL lirc 1ishcr.r, plocluccs at ful1capa.cit1,, ./ .-, i(1, ;rnr'l
s cirl'nrjj. r,"'it,h conrpens;atir)rt, Lhc i-rrofii, of

-.. <ts ,r,(J;q") =-,i)t J .I - lz b fu")')l' ) rt":r: (" (q")) = 10.25. (E.f 23)

\\ritlrorrt coi])pcnsir.fiori ti,..,,,ould prodr.icr:;rlso:ri, iullcalteciii. a,trri e;rrn i,he ltlo{it

i)l

"r.U)- 1t1.1 - | - [,c(.s')]2,.9.71,. (ii 12.1)

{:. f}re:rctivit.y of t}re st,eel fa.ci,or.l, r'crluces t}re pro{rt of 1,ite fis)rery- 'J'hus
a ncgativr: prr-iduction cxtcrralitl, is prescnL, and the level of the activily is
 92

BLI$S POINT STUDIE$

Hudson Lins'
Branchas:
GatiJen, S']tya Nlketan

;l
Raiouri
'iiil. Basement & 1st Floor'
- Aie Nagar, Oelhi-110OOg - t79
tilrfssri3&a11, e891 555578
inefficie*tly high; that is, the out,put of steel
ievel' whe, the steel lactory has to cornr)errsate
is higher than tlie soc;ially
opti,ral
the fishery to. tir" iuurage it
eJ
i,te,ralizes the externality, anrl so decreaies its
profit of the fishery increases. 'lhc externality
level of output. As a res,it
is fully internalized u,'en
thc
the
*J
is chosen so rhzrr r.he -sociauv opriurar
:Tl}1,::.compensatioir r."J ,r our;prir E"l
I

s; i

Bxercise 8'22 rt is often usecl as an objecl,ion Lo

lution abatement that the.y place a moncLary value
market-based policir:s of pol-
creaning up au1- e111,i- o,
s-'
ronrneirt- Economists repl.y that society ir,plicil,r.y
praces a monet,ary varue
crea,up even u.cr.r.comrnanr,l-,,.,,cI-co.rror policies. orr
I,liproi, *,1,y
T
il,,"J1:lll"Jrtar

Solutio, B'22 The objccliorr

e
to placiirg a., r,rirrt:t,rl.y v,lue
is usu;rll.y one of principle r:rl,h<:r t;lran be:irrp, bn.,r.i on .n tht: environr.crrt e
a, r.ea.s6rred clnirl Lii:r{,
t,lic rrrr:thod Ibils. h{any r)rrvir.onrrrr:ntal IoLrlryi_,,, ,i"*
Lhc clrvironnrenL a^s .sorn()-
t'hirrg urtiqut: and bevoncl econornic valuatiorr- 'L'trere
vierv r:art bc su'st'ainccl' r'itr bcttr:r oi' worsc) lnrrrraris
are lirnits to ho.w I,r l,,is $:
arc forccd L. irrtcra<:l, u,itlr
Llrc cnvirortlrtertt, arttl <;ortsc<;uent)y aft'ect
llverr fbr extrerne ettvironinenta.lists there has t,o
t;hc envir<)nll)r)lrl,, in orcler t. s,r.viva-
be a 1roi,t r,vhcre tlic ju<1p,
I
utettt' is rttade Lltat sut:r'ival is trture inrporLarrL
e,virorrr,t:.ta.rly corl)^oiors pe,Pl, economic a.r:tivity
l,harr tle e,vi.onrrr,,rr,,-" I,b. l"r,
t;k; g*;;".'ir.,".,,,,r ovor
e
t)rlvi.,rttllt-'ttL- coltscqucrttly cvcllr ccororrly
t>n r:lr:il'nirlg uJ) t'he ertvjronrttt:rrt, i.r,Irich
is l.,ou,d to pl:rc;c a. n,on,:l,a.ry va.luc
rr:ilcc1,s some ag65regii,te of ttic
ilrcli'iclria.I
e
'a'luaLiottri' As &ir arty othcr <:corronric ciecisiorr corrcctry cvalu*ti,g
a'rl<l <:osts of :ut :tct;itlrt rvill result in th. ti.,c[its €:
arr eflic:i.rl, r-ler:isiorr br:irrg
rr' 1-r.icirrg i's ,pparc,t whe, a oorn*ir,cr-i,rr1-c,.tiol poricr,:i,-rrj". Altlioug,
,,rlurroyecr, tht:
:ri'rs ol'ttrc polic-y represent 1,he ,ut<;orrre <>f a, l.ie.efit
polir:-y it'se:lf is equi'.lent to a ta,x-basecl
- cost calcrla,tiorr a,. tlic 8;
solution (if there i;- rlo 1rr)(jcrtainLy).
e;
ei
I

IJxercisc 8'2ll Ilse examples to answer u,hel,her

the externa.lities rela.tecl t,
colrrrrtoll r-csources ai-e gcrlct.ally positivc or negative-
Is thc frec_rrrar]iet rrse o1. i

contrnorl resources greliter or less than the

socially optlnral rrse?
ei
l

Solrrtion E.23 T,hc i:xl,ernalilies rclat|rl tr) et.,trrrrrulr resoltrces

ilre f{cnel.a.}ly nr:g_
er
a'tivc' 1'1'1liCal].i" atl.. illc|ei:se in usagc oI tlrc Uorr,,Ion i

resor]rce by arr iltclividual

e
l
llirtclcr s lhe usiage oi' lhi-^ rc:jourcc b),
r:lsr:
"o".yu,re jr,t,r becarise of congcxtion a.rrcl/or-
ciepletioil- ller:a.Use t,he users clo lrot t,a.I:e t,his r..o,rnt, rlre1, tcncl to use t1rc: l

'lornll:li)rl Ie-sollr(:e excessirrci-i', so tLa-t Llte fi-i:r:-rra.rki:L use of co.lrno, l-'i-()rir-(:c

sc.rcialll'optinral r?lr:t,:. Arr .xampte ot o:reina1irl,
tr I
-i::;,:T,:;::'1,11i
i. 1-: u,:lljetr,'rl ,)i
1cadi,3, r,' I
1,Itc COIDInOII. I-CSOLLice ls 1,]ri:1,rtged1,oir:lirtrloiis
' j::r 1'''r Iisilirrg or gri'l.ziltfI, eti:
(trllirLtit,r:rl l.t.r;,
) - car:lr irrrli',,jclrr:r.l usei is r:oncer-rccl orrl, rvii,lr jris e j
,:.,-iri-itlri.r.1 1,'irl,s i-,.r11 cioi:s ,,crl, Ll,],,,: lri,r., lr.r;,,:r.r1*rl, l,iral,'il;,r;,;;,;;:;'il'.]a.t,.,1,i,,i1 @
ft
g
 o?

180 oi I A p1't,lll I EX't'F)ll.N ALI'I'IIIS

k more fis1, he rec1uces tlie arnount of Iish and rnakes fishing morc difficult for
* others- An exampje of an externalif leacling to the congestion of the comrnon
*
resource are traflic jarns on frce public roads each individual comrnuter is con-
* cerricd only u,ith hrs olvn commuting tirrre and does not take into :rccount that
his car corrtributes 1;o the roa.d congestion and thu.s tnakes travei more dilficult
B for other car users. An cxarnple of a positivc exterrrality is u.licrt a group of
people jointly enjoy socializing during the use of a common resource such as a
su,immirrg lake.
€

'i*
IJxercise B-24 \A/hv there rnore litter along highways than in people's yarrls?
&
Solutiorr 8.24 One reasorl rnay be ttrat litter aiong highways is rentoved by the
s local government a,utirnrities p:rid fbr from tax revenues. The individuals do it
exce.s^sivcl.y, because the1, de lrol, L:rke inl,o account tirat increasing Lhe amount;
,3 of litt,er along; trighways mal<e.s clea.ning rnor:e expensive and wiil probablv resuh;
in an irtcrea^sc ilt Lax-to covcr l;It-rs expi:ttsc.
An alterna.tive erxplanation could be ttrat drimping litter on the highrv:iy is
a a comrnor) r'csource problenr, In conlrast, Lhe bach yard is vicwecl :rs a privaltt
s resorr r{:o :r.n<i not overexploitecl.

t Ilxerc'-ise 8.25 liva.luillx: the fr>llowing s1;a1,erne:n1,: "Since polluLion is iracl, i1,
a would lrc s<.rcially optirnal l,o prohibii the usc of any production proccss l,hal
creal,cs 1r<rllut;iott.') '
* 'I'he si,aterrrerrL, in gencral, is not true. In every case Llte cosl, o[
Solution 8-25
pollr,rtion rnust be compa,recl 1,o l,tre benefits lrom the ;rroduct,ion tha,L gr:nera.tes
& this pollution, ancl Lhc losscs thc socieLy nray irrcur if Lhe ban on polluLicxr u,ill
carrse t,his producLion to stop- Iiconomics focuses on colnparing mlrginal costs
* to rrrzl.rginal benefits to guide choices. As long as the benefits and costs are
corrcctl.l, rncasured an efficient choice u,ill be rnadc. One important, issue u,ith
# externzrlitles is tha1, blrere rnal'L,c considerable uncertaint,y about thc true costs-
(For exaimple, are defirritel.y experierrcing, nran-rlrade global warmirrg and, if so,
tld what will be i1;s consequences'1)

.$
t *'l Uxorr:isc 8.2(i \\"1rf i: noL gencrallr, cllicicrtL to sr:L zrn enti;^siitrts st,errtclarcl
a.llou,ir-rg zr:r'o pollutlonI

A;'
Solu{;ion B-26 This is similar to exercise B-14 par:t; (b). If some produr:i,ion
process geileratcs a nonzero lerrel ol pollution lrut tlte benefi.ts exceed the cost.
tl-ren l,hjs produr:tion is sociall1, optirna.l a.ncl slior,rld be allorved. ]Ience the ei"nis-
-'
sion sLalrdarcls rnay allorv lor a ccrlaili noltzcro itolluLion level.
;.- ''
 94
B L Is s?
| Hi ":J,Yr',J,]"=
"?

#i,lf;*;{"il}'''t'Ei; 181

Exercise B'27 Education is often

a. Explain hou, education migrrt'ierved
as a goocl ri,ith positi,e cxter..ziliLies. -t
procluce positi'e external cflecls.
b' Suggesl a possltrie acliort o[ t]ie governrrrcnt. Lo induce t]re rnarkct for
education to perfbrm more efJiciently. .l
Solrrtion 8.27 a ljrlucation increase.s labor prodrrci;ivity by raisilg the skill el
ol'thc labor forct:. Lr addit,iorr, cducaLion upholcls ti-.<:linical p.ug."sI. t,irrough
inventive act;ivity. I'lenr:e edircation leads to higher out.pul, a1d highcr
iricornc, frorn whi<:ir cveryone lrcnefits
national
b- 'Ilhe gover.ment may sirbsirlize eclrrcation fo. t;hc financialll, co,sfrzrirred
'j
farnilit:s, a^s rvell as subsidize local public litrrarics ancl acccss 1;r., e6rr<:^tional
l'esouroes irr l;lre lnterrret.
"i
er
*J 1

€J
1
j

e1
6:
s:
€:

si
el I

S:i
*;

C;";
l
I

g:. l
:

:
a J
i

,' .
:

:
:
t:

at,