Question

Suppose the State of Oregon is successful in establishing a new tax on carbon emissions. Burning coal to generate electricity is known to generate substantial carbon emissions, and so the State’s new policy adds a tax on the market for coal-fired electricity.

a) Use a supply-and-demand diagram to show what happens to the quantity of coal-fired electricity and the price that consumers pay for coal-fired electricity.

b) Wind power is a substitute for coal-fired electricity. Suppose that wind power production generates no carbon emissions. Use the supply-and-demand model to show what happens to revenues in the wind power market in response to Oregon’s carbon price.

Answer 1

(a) When the State of Oregon establishes a new tax on carbon emissions, the supply curve of coal-fired electricity shifts leftward by the amount of the tax levied by the State. So, with the demand remaining constant, when the supply curve shifts towards the left from SS to S^'S^', the equilibrium price increases from P to P^' as shown in the diagram and the equilibrium quantity decreases from Q to Q^'. Hence, the quantity of coal-fired electricity decreases and the price that consumers pay for coal-fired electricity increases than before.

(b) Since wind power is a substitute for coal-fired electricity and wind power generates no carbon emissions, so the demand for wind power will increase than before since the substitute's price i.e coal-fired electricity has increased. With the supply of wind power being constant than before, the demand increase for wind power leads the demand curve to shift to the right from DD to D^'D^'. Hence, the equilibrium price would increase and the equilibrium quantity would also increase. Since the quantity generated increases along with the price, the revenue in the wind power market which is equal to Price * Quantity would naturally increase than before.