Question

Fort Collins daily demand for gasoline in gallons is given by the equation Q = 200,000 – 10,000P or equivalently P = 20 – Q/10,000. The marginal private cost of producing a gallon of gasoline is $2. Meanwhile, the marginal external cost of consuming a gallon of gasoline is also $2, because combusting gasoline increases traffic congestion, wears down public roads, and contributes to climate change.

a. Draw a figure of Fort Collins’ consumers daily demand for gasoline, the marginal private cost of gasoline, and the marginal social cost of gasoline. Label all curves and axes.

b. What is the equilibrium price and quantity of gasoline?

c. Is the equilibrium in (b) efficient? Why or why not?

d. Describe three possible solutions to addressing this social dilemma?

e. Suppose that the government decides to internalize the externality created by gasoline by imposing a Pigovian tax on it. What tax should it impose on gasoline, how much revenue will it raise, and how will that impact the equilibrium price and quantity of gasoline?

f. Is the economic surplus larger with or without the gasoline tax? Why?

Answer 1