PROBLEM CHAPTER 5

1. A market survey for consumption of a commodity X in a locality shows

that demand for good X can be presented by two groups of consumers.
Demand of Group A is presented by a function of P = 100 - 4Q, while that
of Group B by a function of P = 40 – Q, in which P is measured as VND
million and Q as unit. MC for producing an additional unit of X is MC =
20.

(a) What is the market demand for good X if - X is private good - X is

public good.

(b) What is the efficient level of good X to be produced if - X is private

good - X is public good.

(c) Assume that good X is a private good but very important for
community health. The government decides to provide good X for free
without quantity limit. How many units of good X will be provided,
and what is the deadweight loss of this government decision?

SOLUTION:
- We have:
+ PA = 100-4Q => QA = 25-1/4P
+ PB =40 - Q => QB = 40-P
+ MC = 20
a. The Demand for X if:

- X is a private good: Quantity demanded on the market is determined by

horizontal summation of QA and QB

=> QAB = QA + QB = 25 - 1/4P + 40 – P = 65 – 5/4P

If: P<=40: QAB = 65 – 5/4P
If: P>40: QAB = 25-1/4P
 PA

PB

QA QB QAB = QA + QB

- X is a public good: Quantity demanded on the market is determined by

vertical summation of PA and PB.
=> PD = PA + PB = 100 - 4Q + 40 – Q = 140 – 5Q
PD = 140 – 5Q (Q<=25)
PD = 40 – Q (Q>25)

PAB = PA + PB

PA

PB

QA QB

b. If X is a private good, the efficient level of good X is to be produced when:

P = MC = 20 < 40
=> Q = 65 - 5/4x20 = 40 (units)
 If X is a public good, the efficient level of good X to be produced when:
P = MC =20
=> 20 = 140 – 5Q (Q<=25)
20 = 40 – Q (Q>25)
=> 120 = 5Q (Q<=25) => Q = 24 (units)
20 = Q (Q>25) (rejected, because: 20 < 25)

c. Since the government provides private good X for free (or P = 0) without
quatity limit, quantity demanded will reach to the maximal consumption.

We have: P = 0 <40 => QAB = 65 – 5/4x0 = 65 (units)

=> DAB cut MC = {A}
=> PD = 20 < 40 => QAB = Q0 = 65 – 5/4x20 = 40 => A is the economic
equilibrium point.
When the government decided to provide good X for free without a quantity
limit, and the units of good X will be provided at Qm=65 > Qo => appear
DWL.
=> SABC is the DWL of the government decision:
SABC = 1/2 x (65-40) x 20 = 250 (VND million)

2. A product of milk powder is consumed by two persons X and Y. Since X

has now children, her demand for milk powder is as low as QX = 12 -
0,6P. Y has many kids, so her demand for milk powder is as high as QY =
18 - 0,4P, in which P is price of milk powder measured by USD, and QX
and QY are personal demand for milk powder, measured by box.

(a) What is market demand for milk powder?

(b) If milk powder is privately provided in a perfect competition market

and marginal cost of producing additional box of milk powder is USD
10, what is price of milk powder? How many boxes will be consumed
efficiently by X and Y?

(c) Since milk is a necessity, the government concerns that the poor may
not afford to buy milk for their children. Thus, the government
decides to provide milk powder for free without quantity limit. In this
case, how many boxes of milk powder is demanded by X and Y? How
much is deadweight loss of this policy?

(d) Being aware of over consumption of milk powder once it is provided

freely, the government decides to limit the milk powder quota of 10
boxes per household. How much is deadweight loss now?

SOLUTION:
a. We have milk powder is a Private good
=> PX=PY=PXY and QXY=QX+QY
- Market demand for milk powder:
We have: QX= 12-0.6P; QY= 18 – 0.4P
QXY = 12 - 0.6P + 18 - 0.4P = 30 - P (P<=20)
QXY = 18 – 0.4P (45>P>20)
 Qx Qy Qxy

b. - If milk powder is privately provided in a perfect competition market

and MC = 10 (USD):
=> The price of milk powder: P = MC = 10 (USD)
The number of boxes will be consumed efficiently by X and Y:
We have: P = MC = 10 → QX = 12 – 0,6 x 10 = 6
➔ QY = 18 – 0,4 x 10 = 14
➔ Qxy = QX + QY = 6+ 14 = 20 (boxes)

c. - The government decides to provide milk powder for free without

quantity limit. In this case, The number of boxes of milk powder is
demanded by X and Y:
P=0 => Q=Qm=30 (boxes)

- DWL of this policy: DWL= SABC

= ½ x(30 – 20)x10 = 50.

d. Being aware of over consumption of milk powder once it is provided

freely, the government decides to limit the milk powder quota of 10
boxes per household.
 => DWL now is the total of DWL of overconsumption (SMNQ) + DWL of
underconsumption (SPQR)
MC = 10 → Q1 = QX = 6, Q2 = QY = 14, Q*/2 = 10
➔ QP = 10 – 6 = 4
QN = 14 – 10 = 4
Q*
/2 = 10 → For Person X at Q*/2, we have 10 = 12 – 0,6P → PXQ* = 10/3
➔ QR = 10 – 10/3 = 20/3
For Person Y at Q*/2, we have 10 = 18 – 0,4P → PYQ* = 20
➔ QM = 20 – 10 = 10
➔ DWL = SMNQ + SPRQ = 1/2 x QN x QM + 1/2 x QP x QR
= 1/2 x 4 x 10 + 1/2 x 4 x 20/3 = 100/3 (USD)

3. There are two families sharing a common yard. Marginal benefit (MB) of
clean yard for Family 1 is MBI = 11 - 2Z, while for Family 2 is MBII = 9
- Z, in which Z as number of cleaning service purchased. The cost for
cleaning service is 5 RM (RM is hypothetical currency unit).

(a) What is efficient level of cleaning services being purchased? In this

case, how much each family has to pay?
(b) If Family 2 plans to be the free rider, so that the Family demonstrates
its fake demand for cleaning as MBII’ = 6 – Z, how many cleaning services
will be purchased? What is ‘free riding” benefits enjoyed by Family 2?

SOLUTION:
We have:
+ MBI =11 – 2Z
+ MBII= 9 – Z
a) Since the cleaning service is public good for both families, the
aggregate demand for yard cleaning (or marginal social benefit) will be
vertical summation of individual families’ demand.
Marginal social benefit (MSB) of yard cleaning for both families is:
=> MBI+II = MBI + MBII = 20 – 3Z (Z <= 5.5)
MBI+II = MBI + MBII = 9 – Z ( Z > 5.5 )
The cost for cleaning service of 5 RM is also marginal cost of the service: MC
=5
The efficient level of cleaning services being purchased is achieved when
MSB = MC, or
MBI+II = MC =5 = 20 – 3Z (Z <= 5.5)
MBI+II = MC = 5 = 9 – Z ( Z > 5.5 )

=> Z = Zo = 5 (times)
Z = 4 (times) (does not satisfied Z > 5.5)

The money that each family has to pay:

The amount of money Family 1 has to pay is:
For each time of cleaning: MBI = 11 – 2 x 5 = 1 (RM)
Total payment: TPI = 1 x 5 = 5 (RM)
The amount of money Family 2 has to pay is:
For each time of cleaning: MBII = 9 – 5 = 4 (RM)
Total payment: TPII = 4 x 5 = 20 (RM)
 PII

PI

Z0

b. If Family 2 plans to be the free rider: MBII’ = 6 – Z

PII

PII’

Z0

The fake marginal social benefit of year cleaning for both families will be:
=> MBI+II’ = 11 – 2Z + 6 – Z = 17 – 3Z (Z <= 5.5)
MBI+II’ = 6 - Z ( Z > 5.5 )
The number of cleaning services will be purchased is:
MBI+II = MC = 5 = 17 – 3Z (Z <= 5.5)
 MBI+II = MC = 5 = 6 – Z ( Z > 5.5 )

=> Z = Zo = 4 (times)
Z = 1 (times) (does not satisfied Z > 5.5)

The amount of money family 2 has to pay this time for each time of cleaning
is: MBII’ = 6 – Z = 6 - 4 = 2 = PII’ (RM)

If family 2 do not lie, the amount of money family 2 has to pay for each time
(with Z = 4) is: MBII = 9-4=5 (RM)

The “free riding” benefits enjoyed by Family 2 for each time of cleaning is:
MBII – MBII’ = 3 (RM)
Total free riding benefit enjoyed by Family 2 is: 3x 4 = 12 (RM)
 PROBLEM CHAPTER 6
1. There are two plots of land: once for rice plantation (Plot A) and the other
for maize plantation (Plot B). If plot A is sprayed with pesticide, its annual
yield will increase according to the following function: Qrice = 10 –
2*Qpes. in which, Qrice is additional output gained (measured by ton) if
an additional unit of pesticide is used. Qpes is number of pesticide units
used. However, thank for adjacent location to plot A, the likelihood to be
damaged by pests in plot B has been reduced. Thus, its yield has also
increased by Qmaize = 5 – Qpes, in which Qmaize is additional maize
yield gained in plot B (measured by ton) if an additional pesticide unit is
sprayed in plot A. Price of rice is 5 RM per ton (RM is hypothetical
currency unit), while price of maize is 2 RM per ton and price of pesticide
is 6 RM per unit. Question:

(a) What is the efficient level of pesticide used by the landowner of plot A
if he concerns only his utility? How about if the utility of the
landowner of plot B is taken into account as well?

(b) In the former, what is deadweight loss of social welfare?

(d) What is the compensation amount that Plot B landowner should pay
for Plot A landowner to encourage him spraying more so that Plot B
landowner can enjoy the spillover effect of spraying?

SOLUTION:
We have:
Plot A: Qrice = 10-2Qpes , Price = 5 (RM)
Plot B: Qmaize = 5 – Qpes , Pmaize = 2 (RM)
Ppes = MC = 6 (RM)

a. We have:
- Mariginal benefit of plot A when he used an additional pesticide:
MBA = MPB = Price x Qrice = 5x(10-2Qpes) = 50 – 10Qpes.
=> The efficient level of pesticide used by the landowner of plot A if he concerns
only his utility is: MPB = MC
Because only plot A uses pesticide so the marginal cost of plot A is MC = 6
=> 50 – 10Qpes = 6 => Qpes = 4.4 (units) = Q1.

When the utility of the landowner of plot B is taken into account, his marginal benefit
of Plot B will present MEB of the pesticide used in Plot A:
MBB = MEB = Pmaize x Qmaize = 2x(5-Qpes) = 10 – 2Qpes

Then, The marginal social benefit is:

MSB = MPB + MEB = 50 – 10Qpes + 10 – 2.Qpes = 60 – 12Qpes
The efficient level of pesticide used by social is:
MSB = MC => 60 – 12Qpes = 6 => Qpes = 4.5 (units)

b. The deadweight loss of social welfare:

SABC = ½ x (Q0 – Q1) x MEBQ1 = ½ x (4.5-4.4) x (10-2x4.4) = 0.06 (RM)

c. The amount of compensation that Plot B landowner should pay for Plot
A landowner:
The amount of compensation per unit of pesticide is MEBQ0 = 10-2x4.5 = 1
(RM)
∑ 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑐𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛 = SMNBE
=>∑ 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑐𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛 = BE. Q 0 = MEBQ0 . Q 0 = 1 x 4.5 =4.5(RM)
2. MC for producing an additional ton of chemicals follows the function of
MC = 100 + 5Q, while demand for such chemicals follow the function of
Q = 60 - 1/3 P (in which, P and MC are measured as USD million per
thousand tons, Q as thousand tons). However, the chemical firm has used
a common pond to dispose its production waste. A fishery cooperative
also uses the pond as its fishing source. It is estimated that the waste
disposed from production of an additional ton of chemicals can reduce
the fish catching volume by 4 tons. Fish price is USD 10,000 per ton. The
cooperative decides to sue the chemical firm for the damage it suffers
from chemical production.

(a) Before the sue, how much is optimal level of chemical production?

(b) If the court decides to limit chemical production at the socially

optimum level, how much will the chemical firm produce?

(c) What is the deadweight loss of chemical production if the court does
not interfere?

(d) If the court decides that the firm has to compensate to the cooperative,
what is efficient level of compensation per ton of chemicals produced?
 In this case, how much the chemical firm has to pay for the
cooperative?

SOLUTION:
We have:
MC = 100 + 5Q => MPC = 100 + 5Q
Q = 60 - 1/3P => MB = 180 - 3Q

The loss of fish catching output of 4 tons due to waste disposal is marginal damage
(or MEC) created by the chemical production, therefore:
MEC = Pfish x Qloss = 10,000 x 4 = $40,000 ( per ton ) = $40 (per thousand
tons).
We have, Qloss is the loss of fish catching output due to chemical production:
=> MPC = 100 + 5Q
=> MSC = MPC + MEC = (100 +5Q) + 40 = 140 + 5Q
Since QD = 60 – 1/3*P => P = 180-3Q = MB
a) Before the sue, the optimal level of chemical production is achieved
when:
MB = MPC => 180 – 3Q = 100 + 5Q => Q = Q1 = 10 (thousand tons)

b) If the court decides to limit chemical production at the socially optimum

level, the figure for chemical production is achieved when:
MSC = MB => 140 + 5Q = 180 – 3Q => Q = Q0 = 5 (thousand tons)

c) The deadweight loss of chemical production if the court does not

interfere is:
DWL = SABC = ½ x (Q1 – Q0) x 40 = ½ x (10-5) x 40 = 100 (million USD)

d) If the court decides that the firm has to compensate to the cooperative,
The efficient level of compensation per ton of chemicals produced should
be equal to MECQ0 or 40 million per thousand of tons of chemical
production.

The chemical firm has to pay for the cooperative is:

SADEF = MECQ0 x Q0 = 40 x 5 = 200 (million USD).