Question

1. Suppose the Marginal Private Cost of baking bread = $2000 + 3.5Q and the Marginal Benefit of baking bread = $5500-2Q. Bread production is also accompanied by a constant $500 per loaf External Cost due to allergic downwind residents who are harmed by the smell of baking bread.
   1. What is the market quantity of the unregulated market for bread?

2. What is the socially optimal quantity?

3. The pollution victims form an advocacy group, which argues that enacting and enforcing a command and control policy that costs the government $30,000 to install pollution-abating equipment on the bakery (reducing the external cost to zero and eliminating the DWL) would be worth it from a social perspective. Are they right?

4. If you wanted to encourage socially efficient production using a Pigouvian Tax, how large would the tax need to be? Explain briefly why you chose your answer.
5. Would a Pigouvian tax on bread be Pareto Efficient or Kaldor-Hicks Efficient (or both or neither)? [Your answer should include an brief explanation of these terms]

6. How would your answers change to part b change if the production of bread was also accompanied by a $1000 per loaf external benefit from other downwind residents who like the smell of baking bread?

Answer 1

Marginal Private Cost of baking bread = $2000 + 3.5Q

Marginal Benefit of baking bread = $5500-2Q

Marginal External Cost = $500 per loaf

a. Market quantity of unregulated market

Marginal cost = Marginal benefit

2000+3.5Q = 5500-2Q

The unregulated market quantity is 636.36

b. Socially optimal quantity.

Include the external cost in marginal cost and equate MC = MR

5500-2Q = 2500+3.5Q

The Socially optimal quantity is 545.45

c. If the Govt.'s abatement strategy has eliminated the deadweight loss then, Yes it is worth for the social perspective.  

d. The pigouvian tax will be equal to the marginal external cost at the socially optimal quantity. Therefore Pigouvian tax = $500 per loaf.

e. Pareto efficient is when No one is made better off without making others worse off.

Kaldor-Hicks efficiency is that as long as there is a net societal benefit, the loss of local people could be compensated by the profit made by the bread makers.

By implementing Pigovian tax on bread makers, thier quantity of bread produced is reduced but allergic locals are compensated. Thus Pigouvian tax is pareto efficient .

The marginal benefit of baking bread at socially optimal quantity is $4409. Which is greater than the Marginal external cost creating a net gain in society. Thus Pigouvian tax is also Kaldor Hicks Efficient.

f. When there is also a Marginal external benefit = $1000

Net external gain = 1000-500 =>$500

Thus as there is a net external gain the the society. Now it is turn for those non-allergic people to compensate the allergic locals. This move is also Kaldor-Hicks efficient.