Question

Oil is an important source of energy. Extracting and burning oil also causes ecological damage. Let Q be the quantity of oil.

The demand for oil is given by: P = 80 - Q.

The aggregate marginal cost of producing oil is: MCpriv = Q.

The monetized marginal environmental damage caused by oil is: MCext = 40.

1. [5 points] Explain intuitively (but briefly!) how this will cause the quantity of oil (Qm) transacted in the free market to differ from the socially efficient amount of oil to have produced (Q*).

2. [5 points] Identify and label the axes, private MC, social MC, Qm and Q* on the following graph of demand.  

3. [5 points] Calculate the quantity of oil (Qm) that will be transacted in this market if no policy is put in place.

Qm = ____________

4. [5 points] Calculate the socially efficient amount of oil (Q*).

Q* = ____________

5. [5 points] Suppose the government imposes a tax on oil producers of 20 dollars per unit, so that the marginal private cost of producing oil (including the tax) is now MCtax = 20 + Q. What would be the quantity (Qtax) transacted in a market with this tax?

Qtax = ____________

6. [4 points] Is society better off with or without the tax? Write an intuitive one-sentence explanation for your answer.

Answer 1