Chapter 5 Externalities After learning this chapter you will understand : Externality Meaning. Consumption Externality. Social Optimum in case of a Negative Externality. Coase Theorem. Production Externality. Solutions to Externalities. Market Signals. The Tragedy of Commons. VVVVVVVV For Full Course Video Lectures of All Subjects of Economics (Hons), B Com (H), BBE, MA Economics, NTA UGC NET Economics, Indian Economic Service (IES) Register yourself at www.primeacademy.in Dheeraj Suri Classes Prime Academy 9899192027Prime Academy, www.primeacademy.in Bas. Concepts 1. Externality : An externality occurs whenever the activities of one economic actor affect the activities of another in ways that are not reflected in market transactions. The crucial feature of externalities is that there are goods people care about that are not sold on markets. It is this lack of markets for externalities that causes problems. When producers fail to take into account the social costs and benefits the amount of output produced will either be overproduced or underproduced. Likewise, when consumers fail to take into account the costs and benefits of their actions too much or too little output will be consumed vs. what is socially optimal. As societies get more urbanized, the presence of externalities becomes more commonplace. With more people, the likelihood that actions be decision makers will have a greater chance of affecting others increases. Externalities are fairly common in our society. Externalities can be negative and they can be positive. Negative externality — \t’s the production or consumption activity that creates an external cost. Positive externality — It’s the production or consumption activity that creates an external benefit. We can classify externalities in two forms : @ — Consumption Externality : An economic situation involves a consumption externality if one consumer cares directly about another agents production or consumption. Consumption externality occurs when consumption of a good by one person increases or decreases the welfare of other person. Let us consider an example in which there are two roommates A and B. They have preferences over money and smoke. A likes to smoke but B likes clean air. So, if A smokes then it reduces clean air for B and it represents negative consumption externality. Gi) Production Externality : A production externality arises when the production possibilities of one firm are influenced by the choices of another firm or consumer. A classic example is that of an apple orchard located next to a beekeeper, where there are mutual positive production externalities— each firms production positively affects the production possibilities of the other firm. Similarly, a fishery cares about the amount of pollutants dumped into its fishing area, since this will negatively influence its catch Here are some examples of externalities : + a firm’s pollution of a river that is being used by fishing farms downstream (negative production externality) + a driver entering a highway at peak hours, which increases the driving time for all drivers (negative consumption externality) + Air pollution (negative production externality) + Second-Hand Smoking (negative consumption externality) + Bee Keepers and Pollination (positive production externality) * Vaccinations (positive consumption externality) Micro Economics 2 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in Note: The decrease in market prices that occurs after one firm brings more units for sale cannot be interpreted as an externality. Instead, it's typically considered a standard market outcome resulting from changes in supply and demand dynamics. An externality refers to a situation where the actions of one party directly affect the well-being of another party, without compensation or consideration. In the context of market prices, if the actions of a firm directly affect another firm or individual without their consent or compensation, that would be an externality. However, the decrease in market prices resulting from increased supply is a fundamental aspect of market dynamics and is not typically categorized as an externality. Negative Externality : In the case of a negative externality, such as pollution, an unregulated equilibrium typically results in a market outcome where the quantity produced and consumed is higher than the socially optimal level, and the market price does not reflect the full social costs of production. Here's how it works: ¢ Market Equilibrium without Regulation: In an unregulated market, firms only consider their private costs when determining production levels. For example, a factory may produce goods without considering the environmental costs of pollution it generates. ¢ Negative Externalities: The production process results in negative externalities, such as pollution, which imposes costs on third parties (society) not directly involved in the transaction. These costs are not reflected in the market price. © Market Overproduction: Due to the absence of regulations or incentives to internalize the external costs, firms continue to produce at a level where their private marginal cost equals the market price. However, the social marginal cost (private cost plus external cost) is higher. © Overconsumption: Consumers, seeing lower prices due to the uninternalized costs, consume more than the socially optimal level of the product. © Welfare Loss: The result is a market equilibrium where resources are allocated inefficiently. There is a welfare loss because the total social surplus (consumer surplus plus producer surplus) is lower than it would be at the socially optimal level of production. In summary, an unregulated equilibrium in the presence of negative externalities Ieads to overproduction and overconsumption, resulting in welfare loss and inefficiency in resource allocation. 3. Unregulated Equilibrium in case of Negative Externality : In the case of a negative externality, like a factory polluting a river, the polluter ignores the effect that its actions have on other individuals, such as poor air quality for citizens in the near by area and larger costs for filtering water by a fishing farm Micro Economics By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in downstream. If left unregulated, this polluting firm would produce a large amount of pollution, which is not necessarily optimal. Consider a monopolist facing inverse demand + function p(q) = a — bq, and total cost TC(q) = cg. Where q is the quantity produced by the monopolist. In unregulated market, this monopolist will produce at such level where its profit is maximum. Max 2 = (a—bq).q- cq Differentiating with respect to q and equating the differential with zero yields a—2bq—c=0 ¢ 4 a Pao Where q’ denotes unregulated equilibrium. The adjoining figure graphically represents the firm’s problem, which increases output g until marginal profits are zero. 4. Social Optimum in case of Negative Externality : We have to examine how much pollution would be generated by a social planner who considers both the firm’s profits and the externality that pollution imposes on other individuals and firms. In the presence of a negative externality, the social optimum involves producing and consuming a quantity of goods or services where the social marginal cost (private cost plus external cost) equals the social marginal benefit. This optimal level of production and consumption maximizes social welfare by taking into account the external costs imposed on society. Consider again a monopolist facing inverse demand function p(q) = a - bg, and total cost TC(q) = eq. Where q is the quantity produced by the monopolist. Assuming that each unit of output emmits a 2 0 units of pollution, the total amount of pollution that this firm generates when left unregulated is ag”. Assume that every unit of emissions e > 0 generates an external cost of EC = B(e)?, which is increasing and convex in emissions. This implies that emissions are damaging for individuals in the vicinity of the polluting factory, and at an increasing rate; that is, the first ton of carbon dioxide (CO2) might just create fog in the area, while the 10,000th ton creates serious health problems. Because emissions are defined as e = aq, the external cost can be rewritten as EC = B(ag). The social planner cares about society as a whole, thus considering the sum of firm profits and external costs by solving the following problem: max [(a—bq).q — eq]— B(aq)? profits External Cost This, essentially, adds the external cost of pollution, EC = (aq)? to the firm’s profit-maximization problem. Differentiating with respect to q and equating the differential with zero yields Micro Economics 5.4 By Dheeraj Suri, 9899-192027> which is decreasing in the rate of emissions per unit of output, a. The adjoining figure depicts the social planner’s problem. For comparison purposes, it splits this problem into two parts: marginal profit Gx / dq = a — 2bq — c and marginal damage GEC / éq = 2Bag. Whereas, marginal profit is a downward sloping straight line, marginal damage is upward sloping straight line. The point where marginal profit equals marginal damage gives the optimum output q5°. 3. Prohibiting Pollution : If per unit pollution generated is large enough such that the socially optimum output is zero, then the best policy is to ban the pollution generating activity. Exercise 1 QI. Consider a monopolist facing inverse demand function p(q) = 10 ~ g, and total cost TC(q) = 2g. If each unit of output generates 4 units of pollution, find the total pollution generated at monopoly equilibrium. Ans. q* =4, pollution = 16 units Q2. Consider a monopolist facing inverse demand function p(q) = 24 — 2g, and total cost TC(q) = q?. If each unit of output generates 4 units of pollution, find the total pollution generated at monopoly equilibrium. Ans. q* =4, pollution = 16 units Q3. Consider a monopolist facing inverse demand function p(q) = 10 =, and total cost TC(q) = 2g. Each unit of output generates 0 units of pollution such that pollution emitted is e = cig. Assume that every unit of emissions ¢ 2 0 generates an external cost of EC = 3(e)*, (i) _ Find the unregulated optimum output. (ii) Find the socially optimum output. (iii) Show that social optimum is decreasing in the rate of emissions per unit of output, a. Ans. (i) q’=4, ii) °° =8(2 + 602) Q4. Consider a monopolist facing inverse demand function p(q) = 10 ~ q, and total cost TC(q) = 2g. Each unit of output generates o units of pollution such that pollution emitted is e = ag. Assume that every unit of emissions e > 0 generates an external cost of EC = 3(e)? + Te, @)__ Find the unregulated optimum output. Gi) Find the socially optimum output Micro Economics 55 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in (iii) Show that social optimum is decreasing in the rate of emissions per unit of output, a. (iv) Find under which values of parameter a the pollution-generating activity should be banned. Ans. (i) q’=4, (ii) g® =(8-7a)(2+ 607) (iv) a> 8/7 Q5. Consider a monopolist facing inverse demand function p(q) = 10 — g, and total cost TC(q) = 2g. Each unit of output generates units of positive externality such that external benefit function is EB = 5(ag)? + 3, where a € [0, 1/5). (Find the unregulated optimum output. (i) Find the socially optimum output. Ans. (i) g/=4, (ii), g®? = 8/2 — 100°) Basic Concepts 1. Production Externality : Production externality is the cost of production that must ultimately be paid by someone other than the producer of a good or service. Production externalities are usually unintended and can have economic, social and environmental side effects. Production externalities can be measured in terms of the difference between the actual cost of production and real cost of production to society at large. Let us now consider a situation involving production externalities. Suppose there are two firms, firm S and firm F. Firm S produces some amount of steel, q. and also produces a certain amount of pollution, x, which it dumps into a river. Firm F, a fishery, is located downstream and is adversely affected by S’s pollution. Suppose that firm S’s cost function is given by c,(g, x), where q is the amount of steel produced and x is the amount of pollution produced. Firm F's cost function is given by cr (f, x), where f indicates the production of fish and x is the amount of pollution. Note that F’s costs of producing a given amount of fish depend on the amount of pollution produced by the steel firm. We will suppose that pollution increases the cost of providing fish Acr /Ax > 0, and that pollution decreases the cost of steel production, Ac,/Ax < 0. This last assumption says that increasing the amount of pollution will decrease the cost of producing steel-that reducing pollution will increase the cost of steel production, at least over some range. Profit Maximization for Steel firm and Fishery : The profit function for steel firm can be represented as MAX. Ts = Ds. — Cs(GX) xa And, the profit function for fishery can be represented as : max. 2, = p,.f ~¢,(f,x) f Note that the steel mill gets to choose the amount of pollution that it generates, but the fishery must take the level of pollution as outside of its control. The first order condition for maximum profit is Micro Economics 5.6 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in For steel firm Rs — 9 and 2 = Fe = O and $2 = 0 = Ps eset) fui! estan) =0 For fishery any 7 =o — Of Fax) > Ppa These conditions say that at the profit-maximizing point, the price of each good-steel and pollution-should equal its marginal cost. In the case of the steel firm, one of its produets is pollution, which, by assumption, has a zero price. So the condition determining the profit maximizing supply of pollution says to produce pollution until the cost of an extra unit is zero. Externality in Steel Production : \t is not hard to see the externality here, the fishery cares about the production of pollution but has no control over it. The steel firm looks only at the cost of producing steel when it makes its profit-maximizing calculation; it doesn’t consider the cost it imposes on the fishery. The increase in the cost of fishing associated with an increase in pollution is part of the social cost of steel production, and it is being ignored by the steel firm. In general, we expect that the steel firm will produce too much pollution from a social point of view since it ignores the impact of that pollution on the fishery. 2. Coase Theorem : According to Ronald Coase, “in the absence of transaction costs, if property rights are well defined and tradable, volunteer negotiations will lead to efficiency”. It doesn’t matter how rights are allocated initially because if they are allocated inefficiently, they can be sold traded until they are allocated efficiently. The following are the conditions for Coase theorem to hold : (i) Perfect Information : All parties are perfectly informed about each other’s benefits and costs; (ii) Zero Negotiation Costs : The negotiation and transaction costs are zero. Negotiation costs tend to increase as more agents generate the externality and more agents are affected by it. We can then expect negotiation costs to be low when only a few agents are involved (e.g., a single polluting firm and a single firm being affected by the externality, as in the fishing farm example), but otherwise, these costs can be large. (iii) Observable pollution and enforceable contracts : The amount of the externality is observable by a third party; and (iv) Well-defined property rights : This result holds both when the property rights of the resource are assigned to the agent generating the externality (the polluter) and when they are assigned to the agent affected by the externality (the victim). Micro Economics 57 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in Restoring the Social Optimum : Coase theorem identifies scenarios where bargaining can be an effective tool to address externality problems. Let us consider our example of steel firm and fishery. We first analyze the case in which the property rights over the river are assigned to the fishery and then the case where property rights are assigned to steel firm. (i) Providing Fishery the Right to Clean Water : The externality problem arises because the polluter faces a zero price for an output good that it produces, even though people would be willing to pay money to have that output level reduced. From a social point of view, the output of pollution should have a negative price. We could imagine a situation where the fishery had the right to clean water, but could sell the right to allow pollution. Let q be the quantity of steel produced and p, be the price of steel, p, be the price per unit of pollution, and let x be the amount of pollution that the steel mill produces. Then the steel mills profit- maximization problem is mand eg = Ps-4 — C5(4,X) = Py-X ‘And, thesfishery firms profit-maximization problem is max. m= Dp T+ Pe x- Gf (Fx) The ret maximization conditions for steel firm will be oe =0 and os =0 And, the profit-maximization conditions for fishery will be 2g ang ML =0 ax ar soge 2 ) and Dy = — 26508) fx) acr(F-x) Also, Dp = ae and py = On comparing values of p, we obtain — deslax) _ 9epF-X) ax ax This condition says that the marginal cost to the steel firm of reducing pollution should equal the marginal benefit to the fishery of that pollution reduction. This condition gives the social optimum level of steel (q°9). If this condition were not satisfied, we couldn’t have the optimal level of pollution. ii) Providing Steel Firm the Right to Pollute : We now suppose that the steel mill has the right to pollute up to some amount ~T, say, but the fishery is willing to pay it to reduce its pollution. Then the profit-maximization problem for the steel mill is max. ms = Psd + Px (&— x) — 6504, %) ‘And, the fishery firms profit-maximization problem is max. Ty = Dy. f — Px. (% — x) — of (FX) af Micro Economics 58 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in The ee -maximization conditions for steel firm will be - Ons _ i 0 and F=0 And, the profit-maximization conditions for fishery will be t=0 md St=0 oF $0,D5 = seen and pe= — desis) o 2) der(F2) Also, Pp = are and Py = 5 On comparing vases of py we obtain _ des(ax) _ def.) ox ox These conditions are same as what we obtained in case of right of clean water for fishery firm. This condition gives the social optimum level of steel (q°°). Hence, socially optimal output °° emerges as the outcome of the bargaining process between the agents, both when the polluting firm and when the fishing farm owns the river. Thus, in the case of production externalities, the optimal pattern of production is independent of the assignment of property rights. Of course, the distribution of profits will generally depend on the assignment of property rights. Even though the social outcome will be independent of the distribution of property rights, the owners of the firms in question may have strong views about what is an appropriate distribution. 4. Government Intervention : Public policy seeking to correct externalities often takes two forms: a quota, which sets an upper limit on the amount of the externality that agents can generate (e.g., maximum tons of CO; that firms can emit per year, or maximum amount of fish that a fishing company can appropriate); or emission fees, which increases the cost that the firm faces per unit of the output generating externalities. (i) Emission Quotas : If the regulator seeks to induce a socially optimal output °° from the polluting firm, she can simply set an emission quota of exactly @°. When the firm emits less than q°°, no fines are imposed, whereas when the firm emits more, a hefty fir levied. (ii) Emission Fees : In this scenario, if the regulator seeks to induce a socially optimal output q°°, she only needs to set an emission fee t that induces the firm to produce exactly g°’. By anticipating the firm’s production behavior, the regulator knows how the firm reacts to the emission fee. s Solutions to Externalities : The presence of externality is the reason that the outcome is not Pareto efficient. There are several ways by which we can achieve an efficient level of production in the presence of externalities. Micro Economics 5.9 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in (i) Internalization : Suppose that the fishery and the steel firm merged and formed one firm that produced both fish and steel (and possibly pollution). Then there is no externality! because a production externality only arises when one firm’s actions affect another firm’s production possibilities. If there is only one firm, then it will take the interactions between its different divisions into account when it chooses the profit-maximizing production plan. We say that the externality has been internalized by this reassignment of property rights. Before the merger, each firm had the right to produce whatever amount of steel or fish or pollution that it wanted, regardless of what the other firm did. After the merger, the combined firm has the right to control the production of both the steel mill and the fishery. The merged firms profit-maximization problem is max. 1 = Psd + Pp-f— C542) — (FX) The first order condition for maximum profit is an on on a 0. == 0 and 7 0 Seslarare) 4 Acylqrxe) _ > Ds sete 4 See = 0 And p, = C) In the merged firm, the amount of pollution is determined by the condition gener) des(araxr) _ ax ta 9 ‘Thatiis, the merged firm produces pollution until the sum of the marginal cost to the steel mill and the marginal cost to the fishery is zero. This condition can also be written as —MC5(q,x) = MC/(f,x) In this latter expression MC; (f, x) is positive, since more pollution increases the cost of producing a given amount of fish. Hence the merged firm will want to produce where -MCs(q, x) is positive; that is, it will want to produce less pollution than the independent steel firm. When the steel firm considers mcr minimizing its _ private costs of. producing steel, it produces where the marginal cost of extra pollution equals zero; but the Pareto efficient level of pollution requires minimizing the social costs of the pollution. At the Pareto efficient level of pollution, the sum of the two firm’s marginal costs of _yc,-y¢, pollution must be equal to zero. As shown in the adjoining figure, MCs measures the marginal cost to the steel firm from producing more pollution. The curve labeled MC; Micro Economics 5.10 By Dheeraj Suri, 9899-192027 as eePrime Academy, www.primeacademy.in measures the marginal cost to the fishery of more pollution. The profit-maximizing steel firm produces pollution up to the point where its marginal cost from generating more pollution equals zero. But at the Pareto efficient level of pollution, the steel firm pollutes up to the point where the effect of a marginal increase in pollution is equal to the marginal social cost, which counts the impact of pollution on the costs of both firms. Gi) Pigouvian Tax : As far as the steel firm is concerned, its production of pollution costs it nothing. But that neglects the costs that the pollution imposes on the fishery. According to this view, the situation can be rectified by making sure that the polluter faces the correct social cost of its actions. Suppose that we put a tax of ‘f dollars per unit of pollution generated by the steel firm. Then the profit- maximization problem of the steel firm becomes max. 1; = ps.S — C5(S,x) —t.x The profit-maximization conditions for this problem will be ns Ons a ad 0 = 964-2) _ Bes(qexe) =0 > Ds and a ax — 96) . ax Therefore, ¢ = SL ax This kind of a tax is known as a Pigouvian tax. The problem with Pigouvian taxes is that we need to know the optimal level of pollution in order to impose the tax. But if we knew the optimal level of pollution we could just tell the steel firm to produce exactly that much and not have to mess with this taxation scheme at all. (iii) Providing Fishery the Right to Clean Water : Another interpretation of the problem is that there is a missing market — the market for the pollutant. The externality problem arises because the polluter faces a zero price for an output good that it produces, even though people would be willing to pay money to have that output level reduced. From a social point of view, the output of pollution should have a negative price. As discussed above here fishery will sell the pollution rights and eventually the steel firm will produce socially optimum level. (iv) Providing Steel Firm the Right to Pollute : When steel firm is given the right to pollute, the fishery will pay the steel firm to reduce the level of pollution. The equilibrium will be such that the steel firm will produce socially optimum level of output. Micro Economics 51 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in 6. The Tragedy of Commons : If the property rights are well defined then the problem of externalities could be resolved by the market itself. But if property rights are not well defined, the outcome of the economic interactions will undoubtedly involve inefficiencies. Let us consider an agricultural village in which the villagers graze their cows on a common field. And let us compare two allocation mechanisms : (i) __ the private ownership solution where someone owns the field and decides how many cows should graze there; or (ii) _ the solution where the field is owned in common by the villagers and access to it is free and unrestricted. Suppose that it costs ‘a’ dollars to buy a cow. The amount of milk the cow produces will depend on how many other cows are grazed on the common land. We'll assume f(c) be the value of the milk produced if there are “c’ cows grazed on the common. Thus the value of the milk per cow is just the average product, fic)/c. In order to maximize the total amount of wealth, we set up the following problem : max. w= f(c)-ac z The first order condition for maximum wealth is cw Fe Oe tes MP(c*)=a If the marginal product of a cow were greater than ‘a’, it would pay to put another cow on the commons; and if it were less than ‘a’, it would pay to take one off. Now, in case of first solution, ie., if the common grazing ground were owned by someone who could restrict access to it, this is indeed the solution that would result. For in this case, the owner of the grazing grounds would purchase just the right amount of cows to maximize his profits. And in second solution where the field is owned in common by the villagers LO then, the total number of cows grazed will be ¢, where 4 =4 This is because each villager will compare the additional benefit he obtains from a cow with its cost and will stop only when additional benefits gets equal to the cost. Micro Economics 5.12 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in Exercise 1 Theory Questions QI. Suppose a firm “C” produces a positive amount of ‘good A’ and some pollution level ‘p’ which adversely affect production of another commodity “F”. What is the: (i) Privately optimal level of pollution? (ii) Socially optimal level of pollution? Give the equilibrium conditions in each case. [Eco. (H) 2007] Q2. “With well-defined property rights, a Pareto efficient allocation can be achieved even in the good that involves consumption externality? Illustrate with suitable iagram. Q3. Distinguish between the externalities in utility and inter-firm externalities. Give an example of each. [Eco. (H) IV Sem. 2014] Q4. Explain the Coase Theorem relating to the pollution rights equilibrium. [Eco. (H) IV Sem. 2014] Q5. A multinational company wishes to start mining the forests of Jharkhand, the habitat of the Munda tribe. In order to avoid any conflict between the two parties, the government is considering bestowing the property rights to the MNC so that a private Pareto Optimal equilibrium may be attained. But the environmentalists are pushing the government for bestowing the property rights to the tribals. Assuming both parties have convex preferences between land and all other goods, do you think it makes a difference? Explain in light of Coase theorem. [Eco. (H) 2011] Numerical Problems QI. Consider a monopolist facing inverse demand function p(q) = 10 ~ q, and total cost TC(q) = 2q. Each unit of output generates 4 units of pollution such that pollution emitted is e = 4g. Assume that every unit of emissions e > 0 generates an external cost of EC =e. (Find the private optimum output level. (ii) Find the socially optimum output level, q°°. (iii) If the regulator sets a fee ‘? on every unit of output, find the value of emission fee ‘1° which induces the firm to produce socially optimum level of output. Ans. (i) g=4,.(i) @=2, iii) 1=4 Q2. Consider a monopolist facing inverse demand function p(q) = 20 ~ q, and total cost TC(q) = 2q. Each unit of output generates 2 units of pollution such that pollution emitted is e = 2g. Assume that every unit of emissions e > 0 generates an external cost of EC = 2e”. (i) Find the private optimum output level. (ii) Find the socially optimum output level, q°?. (iii) If the regulator sets a fee ‘i on every unit of output, find the value of emission fee “1° which induces the firm to produce socially optimum level of output, Ans. (i) g=9 (i) Micro Economics 5.13 By Dheeraj Suri, 9899-192027 lL, ii) 1=16Prime Academy, www.primeacademy.in Q3. Ina mall, a cloth store and jewellery store is located side by side. The customer buys goods according to the amount of money he has. Both store attract customers by advertising they shop in the store which has advertised and they shop in the neighbouring shop as well. Profits of clothing store = ,(x,,x,)=(60+x,)x,—2x? and profits of jewellery store = 77,(x,.x,)=(105+x,)x,-2x7, where xe and x, are advertising costs on clothing and jewellery. (a) Ifeach store is independent of other’s advertising costs, Find the equilibrium amount of advertising for each store. Find the profits. (b) How much extra profit would the jeweler get from an extra rupee advertising by the clothing store? How much extra profit would be jeweller’s advertising give the clothing store? (c) _ If owner of clothing store knows the profit function of both the stores, he decides how much advertising he must do before the other owner decides and when the other come to know then they both would behave accordingly. Find the reaction curve of jewellery store, the value of x, and x, which maximizes the profits and find the profits? (@)__ If they have same profit function but owned by a single firm then find the value of x, and x.. Find total profits? Would independent decision have more profits? [Ans.:(a) xc = 23, 4) = 32, me = 1058, mj = 2048, (b) and on, Ox; (d) xe =37.5,.x = 45, = He + m = 3487.5] Q4. A honey firm is located near an apple orchard and they both are competitive firms. Cost function of honey firm is Cy(H) = H°/100 and apple is Ca(A) = A2/100 ~ H. The prices of honey and apple are Rs. 2 and Rs. 3 respectively. (a) If both firms operate independently find the number of units of honey and apple produced? (b) If both the firms merge, find the profit maximizing output of honey and apples? (©) What is the social efficient output of honey? If firms are independent how much would apple firm subsidize to honey firm to induce efficient supply? a) H=100,A=150,(b) H=150,A=150,(c) He=150,s= 1] Q5. Steel firm A is situated along the banks of a river. Further downstream is fishery B. The cost function of A is given by ca (8, x) = 10s ~ 5s? + (1 — x)’, where s denotes the quantity of steel produced by A in a year and x denotes the quantity of pollutants that A dumps into the river in a given year. The cost function of fishery B is cg (f, x) = ff? — 2x, where f denotes the quantity of fish caught in a given year. Suppose that both firms behave competitively in the output market and take the price of their output as given. (Eco. (H) 2011] Micro Economics 5.14. By Dheeraj Suri, 9899-192027 =x,=238, (©) xe = 24.64, x5 = 32.41, 1, = 1062.72, mj = 2100.82,Prime Academy, www.primeacademy.in () Compute the profit maximizing quantity of steel and pollutant produced by A. Gi) Compute the profit maximizing quantity of fish caught by B. (ii) Suppose that the two firms A and B merge. Find the quantities of steel, Fish and pollutants that the new firm produces. [Ans.:(i) s=1,x=1, Gi) f=05, (iii) s=1,f=05,x=0) Q6. A firm, S, produces steel but also produces waste that contaminates a nearby river. Steel can be sold for Rs. 10 per ton. The cost function of the steel firm is given by Cs(s) where s is the output of steel in tons. The level of waste, x, is related to output by x = 0.1s. A fish farm, F, is located downstream and is negatively affected by the waste polluting the water. Every fish produced by the farm can be sold for Rs. 2. The cost of the fish farm is given by Cr(f, x) = f+ x2. The fish farm has a capacity constraint fs 10, (a) | Compute the optimal output of the steel firm if it makes its decision without any constraint. (b) Assume now that the steel firm must compensate the fish farm an amount Rs. q per unit of waste produced. Find the optimal output of steel firm. Q7. Graduate student A smokes, but his office mate B hates smoking. A and B have the following utility functions : U* = 100 + 10z — 0.1z* and U® = 100 — 10z, where z is the number of cigarettes smoked by A. Determine : (a) | The number of cigarettes smoked by A when the external effect on B is ignored. (b) The socially optimal level of cigarettes that should be smoked by A. (c) _ The optimal Pigouvian tax needed to decentralize the social optimum. (d) The outcome with Coasian bargaining when the property right is assigned to the smoker. (e) \ The outcome with Coasian bargaining when the property right is assigned to the non-smoker. Q8. A chemical factory produces a product that is sold at the price of Rs. 10 per ton. The cost of production is C¥(y) = 0.5y2, where y is the number of tons of production. For each ton of production, the factory produces 1 kg of pollutants that are either dispersed into the atmosphere at a cost of Rs. 0 to the factory or captured and stored at a cost of Rs. 2 for each kg of pollutant. The amount of dispersant pollutant is denoted e. The pollution causes a nearby textile firm to have to wash its products twice with an additional cost of C® = 0.5e?, which does not depend on the amount of output, m, produced. The unit price of the output of the textile firm is Rs. 5, and the cost of production CT = 0.02m?. (a) Determine the values of y, m and e in the competitive equilibrium. How much does the chemical factory spend on capturing the pollutant? What level of environmental cost does the factory inflict on the textile firm? (b) Why is the competitive equilibrium inefficient from a social perspective? (©) Whatis the socially optimal level of y? (d) Assume that the externality is internalized. Determine the values of y, m and e. Micro Economics 5.15 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in Q9. In acity there are 1001 citizens, Everyone loves driving but they complaint about noise and pollution. Their utility function is u(n, d, h) =m + 16d — d° — 6h/1000 Where m, d and h are consumption of big mac cars, number of hours of drive per day and total hours of driving done by all citizens respectively. The price of big macs is Re.1 each and they have an income of Rs. 40 per day. (a) How many hours per day will a citizen drive if he doesn’t care about other factors? (b) If dis decided, find the total amount of h by other citizens? (c) _ Find the utility? (@)__ If everyone drives 6 hours a day. Find the utility level? (e) How much driving should everyone be allowed if the objective is to maximize the utility of a typical citizen if a law is passed restricting the total number of hours that anyone is allowed to drive? (f) | How much would the tax have to be per hour of driving? [Ans.:(a) d=8,(b) h=8000, () u=56, (d) u=64, (©) d=5,(f) t=Rs.6] QI0. There are 100 cottagers in a circle around the lake. There is only one commodity X. Each cottager cares about his consumption and the consumption by the left neighbor. Thus, utility function becomes u(c,)=¢—P where c is his consumption and 1 is his left neighbour’s consumption. (a) If each cottager consumes one unit of x then calculate his utility. (b) If each consumer 3/4th of a unit. Will individual be better off? (©) What is the best possible consumption if all are to consume the same amount? (@) If each cottager consumers 1 unit. Can any two make themselves better off either by redistributing or throwing something away? (e) — How about a group of three cottagers? [Ans.:(a) 0, (b) Yes, (c) /=%,(d) No, (€) No] QI. Ina village, there is a lake filled with lobsters. The council issues permit to the people to trap lobsters. They want to determine how does it work. The economic conditions are (People need to spend Rs. 2000 per month to operate the boat. Gi) The total revenue is f(x) = 1000(10x — x2) where x is the number of boats in the lake. (a) Draw the MR and AR curves and plot the line cost. (b) If there is not permit charge, how many boats will trap lobsters? (c) | What number of boats maximizes the total profit? (d) If the council wants to restrict the number of boats that maximizes total profit then now much it should charge per month for lobster permit? [Ans.:(b) x=8,(c) x=4,(d) License Fee = 4000] Micro Economics 5.16 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in QI2. Assume that villagers graze their goats on the common pasture land at Binsar. If “g’ is the total number of goats that graze on the common pasture land, the output of milk (as a function of g) is fig) = 48g — g* (assume that the output of milk is in litres). Let the price of milk be Re. 1 per litre and price of a goat be Rs. 4. (i) If the village panchayat owns the common pasture, what would be the profit maximizing number of goats grazed? (i) If all the villagers are permitted free access to the common pasture, what would be the total number of goats grazed? Draw a diagram to depict the equilibria in (i) and (ii). What is the generic term for, and the lesson learnt from, such phenomena in Economics? (iii) If the panchayat has the right to impose a Pigouvian tax on each goat that grazes on the common pasture, what should be the Pigouvian tax? [Eco. (H) IV Sem. 2015] [Ans.:() g=22, i) g=44, (ii) t= 22) Q13. A lake is open for all use to all fisherman. The cost of taking a fishing boat out to fish is constant and equal to C. If B boats are taken out, f(B) fish will be caught in all. f'(B)>0, f(B) <0 at all B > 0. Also C > 0, and the price of fish (Pr > 0) is unaffected by the fish catch of these fisherman. (i) | Write the condition for the equilibrium number of fishing boats taken out on lake. Is the condition for the efficient number of boats the same? Explain. (ii) If f(B) = 100B°%, C = 10 and Pr = 2, calculate the equilibrium number of boats, efficient number of boats and the amount of tax that needs to be imposed on each boat so that the efficient number of boats are taken out on the lake. [Eco. (H) IV Sem. 2016] Ql4. A farmer cultivates rice adjacent to a dairy farm. Each farmer behaves as a competitive firm. The farmer benefits from the free waste generated by cows of the dairy farm and the money value of the benefit to the rice farmers from the cow waste is 1000 from each cow. Dairy farm has a marginal cost MC = 1000 + 5Q, where Q is the number of cows. The dairy farmer can sell the milk yielded from each cow at 4000.The waste from each cow is being disposed- off freely by the dairy farmer. [Eco. (H) IV Sem. 2021] (i) ~ Find the privately optimal number of cows that the dairy farmer will maintain. (ii) Find the socially optimal number of cows that the dairy farmer should maintain. (ii) Suggest two ways in which the socially optimal number of cows can be maintained in this economy. QIS. The demand for energy efficient appliances is given as: [Eco. (H) IV Sem. 2017] p= @ The market for energy efficient appliances is perfectly competitive. The marginal (private) cost of production of energy efficient appliances is given 2 . By reducing demand on the electricity network, energy efficient appliances generate an external marginal benefit according to MEB = E.Q, where E is some constant. Micro Economics 5.17. By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in (i) What is the equilibrium amount of energy-efficient appliances traded in the private market ? Gi) If the socially optimum quantity of energy efficient appliances is 20, find the value of 'E'. . (iii) If the government subsidized production of energy efficient appliances by Rs. S per unit, what level of the subsidy would induce the socially efficient level of production ? QI6. A beekeeper chooses the number of hives 'H' to keep. Each hive produces one kilogram (kg) of honey which sells at a price of Rs. 60 per kg. The marginal cost of holding ‘H' hives is : MC = 20 + 8H. The hives are located next to an apple orchard. The orchard owner benefits (without paying) from the bees because bees pollinate the trees and bees from one hive pollinate one acre of apple trees. The cost of artificial pollination is Rs. 24 per acre of apple trees. (How many beehives 'H’ will the beekeeper maintain ? (ii) _ Is this the economically efficient number of beehives? Explain. Gii) What changes would lead to a socially efficient operation ? (iv) How much subsidy should be given to the beekeeper for inducing him to produce socially efficient number of beehives? [Eco. (H) IV Sem. 2018] QI7. Consider a plant that manufactures dynamite ‘d' and a nearby farm. producing tomatoes ‘t’, The cost of production of dynamite is : TC, (d, n)=3d? +(n-2)? where ‘d’ is the amount of dynamite produced and 'n' is the intensity of use of a nitrogen in the production process. The side product associated with use of the nitrogen is ammonia - a fertilizer that is released into the air. Such fertilizer promote growth of tomatoes making the production on the farm cheaper. In particular the higher the intensity ‘n’ the lower the farmers cost TC (d, nate? + 2t—nt. The prices of tomatoes and dynamite are Py = P;= Rs. | (Find the level of production of dynamite ‘d' and intensity ‘n! that maximizes the profit of the dynamite manufacturer. What is the maximal level of profit? Gi) Given the intensity 'n' from (i) find the optimal level of production of tomatoes ‘t’ and the profit of the farmer. Gi) _ Find the joint profit of the dynamite manufacturer and the farmer. (iv) Economists say that the positive externality is associated with too little activity, compared to the efficient outcome. Are your findings in this problem confirming this statement ? [Eco. (H) IV Sem. 2018] QI8. The production of good X confers external benefits on the producer of Y through a reduction in the latter's cost of production. Specifically C(x) = x?/4 and Cy) = 4 = 20x are the total coat functions of goods X and Y respectively. X and Y are sold in competitive markets at prices P, = 30 and P, = 90 respectively. Micro Economics 5.18 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in (i) Find the amounts of X and Y produced and their profits if each producer operates Independently. [Eco. (H) IV Sem. 2019] (ii) Find the socially optimum amounts of X and Y. (iii) Find the total profits at the socially optimum Amounts of X and Y. (iv) Find the amount of subsidy per unit that the producer of X must be given in order to induce him to produce the socially optimum amount Q19. A housing developer wants to build houses on a piece of land located next to an airport. However, the noise pollution from the planes that land at the airport reduces the value of houses and hence the profits of the developer. If X denotes the number of planes that fly per day and Y be the number of houses the developer builds. The profit functions of the airport and the developer are as follows : 1, = 56X — X? Mp = 70¥ ~ ¥2— XY () If no bargains can be struck between the airport and the developer and each can decide its own level of activity, how many planes (X*) will fly to maximize the profits of the airport? Find the maximum profits? (i) Given X* planes fly, how many houses will be built to maximize profits of the developer? Find the maximum profits of the house developer. (iii) Suppose that a local ordinance makes it illegal to land planes at the airport because they impose an externality on the developer. Find the optimum number of houses built and the profits made by the developer under such a rule. (iv) Suppose there is no ban on planes landing at the airport. If a single firm buys the developer’s land and the airport, how many planes will be flown and houses built to maximize joint profits? [Eco. (H) IV Sem. 2022] Q20. A perfectly competitive market exists for wheat. The inverse demand is P = 200 - Q where P is the price of wheat and Q is the total quantity of wheat. The private total cost for the unregulated market is C = 50 + 800 + 0.50”. The production of wheat creates an externality where the total external cost is EC = 0.507. () Solve for the unregulated competitive equilibrium of wheat and the socially optimal level of wheat. (i) Derive the Pigouvian tax (per unit of output of wheat) that results in the social optimum. [Eco. (H) IV Sem. 2022] Q21. A cinema hall is located next to a factory. The efficiency of workers is negatively affected by the loud music in the hall. The cost function of the hall (C,) and that of the factory (C)) are as follows [Eco. (H) IV Sem. 2023] Cy = 5x? and Cy= 2)? + 4xy x and y are the outputs of the hall and the factory. The output price of the hall and the factory are Rs. 150 and Rs. 90 respectively. (Suppose the hall decides its output independent of the factory’s and the factory decide its output based on the hall’s. What will be the output of both units? (ii) Suppose the factory and the hall decide to merge. What will be the output of the hall and the factory with internalized externality? Micro Economics 5.19 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in For Full Course Video Lectures of All Subjects of Economics (Hons), B Com (H), BBE, MA Economics, NTA UGC NET Economics, Indian Economic Service (IES) Register yourself at www.primeacademy.in Dheeraj Suri Classes Prime Academy 9899192027 icro Economics By : Dheeraj SUTi, 9899-192027