Question

The supply curve in the market for vodka is Q = 0 if P < 4, Q = any value if P = 4, and

Q =

∞

if P > 4. The demand curve is Q = 12 - P if

P≤12

and 0 otherwise. Answer the following

questions, showing your work. Illustrate using diagrams.

(a) What are the equilibrium consumer surplus and producer surplus?

(b) Now change the situation by supposing that each unit of vodka sold inflicts an average

negative externality of 2 on people who have to deal with vodka drinkers. What is the total

social surplus? What is the surplus-maximizing quantity? What is the DWL at the equilibrium

quantity?

(c) Suppose next that there is an externality of 2, but the government also imposes a price floor

of 5. What is the total surplus? Is it higher than in (b)?

(d) Finally, suppose that there is an externality of 2, but the government can impose a tax on

sellers of vodka. What is the optimal amount of tax? What are the consumer surplus and

producer surplus? What is the total surplus? Is it higher than in (c)?

Answer 1