Question

Suppose the demand for electricity in some large community is given by the following demand function P = 1200 – 0.4Q. If the supply function is given by P = 400 + 0.6Q. These are both private market valuations. Electricity generation is given for both functions in thousands of kilowatts, and involves the emission of sulfur dioxide into the atmosphere which has been linked to the prevalence of acid rain in the area. The marginal external damage associated with the harmful effects to the community from acid rain is $50 per thousand kilowatts generated.

What is the market determined quantity of electricity that will be generated in this community? What is the market price? (2 points)

What is an externality? How does the association of sulfur dioxide emission with electricity generation affect the efficiency of the market generated allocation? (2 points)

Provide a graph model of the market allocation and the externality described in this market clearly demonstrating the correct outcomes from part (a) and part (b). (4 points)

Answer 1

a)

Demand: P = 1200 - 0.4Q

Supply: P = 400 + 0.6Q

At equilibrium, demand will be equal to supply thus,

1200 - 0.4Q = 400 + 0.6Q

800 = Q

Thus P = 1200 - 0.4Q = 880

b)

An externality is an unintended cost or benefit associated with the production or consumption process which is not reflected by the market outcome.

The marginal external damage from the sulfur dioxide is not reflected in the market outcome. The firm does not takes into account the damage that the production process results in. Thus the private cost is lesser than the social cost. Hence the firm produces an output that is greater than what is socially optimum.

If the marginal external damage is taken into account the supply curve of the firm would be: P = 50 + 400 + 0.6Q = 450+0.6Q

Now the equilibrium will be,

1200 - 0.4Q = 450 + 0.6Q

750 = Q

P = 1200 - 0.4Q = 900

c)

With the addition the external marginal damage, the supply curve will shift up. Thus the socially optimum price would rise and quantity will fall.