1.
Depict a perfectly competitive market for cigarettes as a market with negative externalities in consumption. Demonstrate in your graph why the market allocation is inefficient and explain where the deadweight loss in your diagram and why and what it means. (3 points)
2. Discuss the following statements: “A pigovian tax on consumption would be preferred to a pigovian tax on the sellers because the latter is placing the tax on cigarette producers whereas the externality is coming from the consumption of cigarettes”. “An even better policy would be to set a price ceiling on cigarettes at the price that matches the efficient quantity” (4 points)
3. Distinguish between a PD-game and a coordination game. Further within the framework of externalities, explain why the presence of reciprocal benefit externalities is not depicted as a PD-game but as a coordination game. (3 points)
4. Discuss the advantages and disadvantages of the following policies for dealing with air pollution due to gas emission from cars
• Ban the internal combustion engine after the year 2020 (2 points)
• Impose a tax on each care that varies with the amount of noxious gas it emits (2 points)
• Subsidize research to develop better antipollution devices that can be used by cars (2 points)
5. Consider an aluminum producer who produces aluminum under competition the demand for whose product is given by P = 2250 – 0.0055Qd. The privately valued supply function is given by P = 900 + 0.0125Qs. This firm’s production includes the generation of red mud a hazardous by-product of its production process discharged as waste into a nearby lake which is used for recreational activities by the local community. As a result the lake is becoming dangerous to use, having a foul odor and the fish population have diminished significantly.
• Demonstrate graphically and with explanations, the producer’s optimal production choice. (2 points)
• Suppose this is a friendly community and everyone knows everyone and the producer is also a resident of the community. Discuss any private solutions that could be arrived at to address this externality problem. (2 points)
• Suppose the producer is from out of town and the community is fairly large and impersonal why might private solutions not be feasible in resolving this problem? (2 points)
• Suppose the community government decides that the externality has to be addressed by putting in place a pigovian tax. If the social marginal cost of producing with the externality taken into account is given by 1350 + 0.0125Qs. Explain clearly what the pigovian tax would be and what would be the resulting equilibrium price of the product and quantity that the producer will sell after the tax is put in place. Depict this graphically. (4 points)
• In practice the SMC would not be known by the government because the PMC is privately held information known to the firm. Explain how the government would proceed in the hopes of correcting the externality using a pigovian tax. (2 points)

 
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