Question

Suppose that the (external) damage done by pollution is known to be MD = 300 + 5Q, and the (private) cost and benet are given by MC = 100 + 2Q and MB = D − 2Q, where D is not precisely known.

(a) If D = 1, 000, what would be the optimal quantity? [1 mark]

(b) What tax would be necessary in order for the equilibrium quantity to be the optimal quantity? [1 mark]

(c) Suppose that, based on the result from part (a), a cap-and-trade system is imposed to allow the optimal quantity of pollution to be produced. If D = 900, what would be the deadweight loss associated with having the wrong quantity? [1 mark]

(d) Supposed that, based on the result from part (b), a tax is imposed to allow the optimal quantity of pollution to be produced. If D = 900, what would be the deadweight loss associated with having the wrong tax level? [1 mark]

(e) If D is not exactly known, which is likely to give better results, a cap-and-trade system or a tax? [1 mark]

Answer 1