Problem Set 6

Hard copies of your answers are due at the beginning of your section, either on
Thursday, November 3, or Friday, November 4. For example, if your section
starts at 10:00am on Friday, you should submit your answers to your TA in your
section classroom at 10:00am on Friday, November 4. Late problems earn zero
points.

Note: you can work on these problems or your own, or in a small group with
other current Econ 1 students. If you choose to work in a group, each student
needs to hand in a separate, individual copy to his/her TA.

1. According to economists Becker and Grossman, each pack of cigarettes

smoked creates about 68 cents of externalities borne by other members of
society. The externalities include the costs of cigarette smokers’ excess use of
health services, costs of fetal death, secondhand smoke, etc.
a. Explain how a tax could be used to correct the externality. Show it
graphically.
b. Mention another way that the government may try to use to correct the
overproduction of cigarettes due to the negative externality.

2. Suppose that it costs $25,000 per day to build and maintain a bridge
potentially serving 20,000 people. 10,000 of these people are willing to pay $2
per day to cross the bridge, while the other 10,000 value the bridge at $1 per
day.
a. Assuming that there is no congestion, is it efficient to build the bridge?
b. Can you find a toll that will raise revenues sufficient to cover the costs of
building and operating the bridge?
c. Is the bridge a public good? What does your answer to parts (a) and (b)
indicate about a possible role for government intervention?

3. A dentist and a writer live next door to each other, and each has her office
at home. Screams of pain from the patients in the dentist’s office interfere
with the writer’s creativity, causing her to write inferior novels and lose $800
per year in income. The dentist would have to spend $600 to install sound-
absorbing material on her office walls, and this material would have to be
replaced each year. The writer sues the dentist. The court can rule in favor of
the author and require the dentist to soundproof her walls, or it can rule in
favor of the dentist and dismiss the case. Explain what would happen under
each ruling if:
a. The dentist and the writer are on speaking terms (small transaction costs,
ignoring court fees).
b. They are not speaking to each other under any circumstances (large
transaction costs).
Make sure that your answer for parts (a) and (b) contains some comparison
between the socially optimal outcome and the outcome actually achieved in
each circumstance.

4. The Farm Bill passed in May 2002 promises billions of dollars in additional
subsidies for agricultural producers, with support programs for wheat, corn,
dairy, and peanut production among others. Use economic analysis to describe
and explain the effects of these subsidies. Why do you think the Farm Bill was
passed?

5. Cardassia and the Dominion produce only two goods: phasers and
transporters. Cardassia can produce either 200 phasers or 100 transporters in
one day, while the Dominion can produce 500 phasers or 1000 transporters (all
of them with constant opportunity costs).
(a) What are the opportunity costs of producing phasers for Cardassia and the
Dominion?
(b) If trade were to occur between Cardassia and the Dominion, who would
specialize in the production of phasers and who would produce starships.
(c) What would be the range of prices that would allow trade to occur?
(d) If Cardassia discovered a new technology that allowed it to produce 500
transporters per day with its existing resources, how would your answers to (a),
(b) and (c) change?

6. The nation of Acirema is “small,” unable to affect world prices. The demand
curve is QD=400-10P. The supply curve is QS=100+5P.
(a) Fill the following table. What is the equilibrium price and quantity of
peanuts without trade with other nations? Explain verbally and graphically.
Price Demand Supply
0
5
10
15
20
30
40
(b) Suppose the world price of peanuts is $10 per bag. If trade with other
nations is unrestricted, will Acirema import or export peanuts? How many bags
of peanuts will be imported or exported? Explain verbally and graphically.
(c) If there is an import quota of 75 bags, what will be the resulting domestic
price and production? Explain verbally and graphically.
Extra practice problems (completely optional; no points awarded)

A. Many agricultural crops are harmed by beetles and other insects. These
harmful insects are prey for the praying mantis, a large insect. The praying
mantis is not an endangered species, but several agricultural states still impose
a fine on anyone caught killing a praying mantis. Is there a good economic
reason for such a fine? Explain.

B. Imagine that wine makers in the state of Washington petitioned the state
government to tax wines imported from California. They argue that this tax
would both raise tax revenue for the state government and raise employment
in the Washington state wine industry. Do you agree or disagree with this
claim? Is it a good policy? Explain.

C. Assume that American rice sells for $100 per bushel, Japanese rice sells for
16,000 yen per bushel, and the nominal exchange rate is 80 yen per dollar.
(a) Explain how you could make a profit from this situation. What would be
your profit per bushel of rice? If other people exploit the same opportunity,
what would happen to the price of rice in Japan and the price of rice in the
United States.
(b) Suppose rice is the only commodity in the world. What would happen to
the real exchange rate between the United States and Japan? Explain.

D. Capitol has 1200 workers, and it can produce two goods, apples and
bananas. Three workers can produce a ton of apples, while just two are
necessary to produce one ton of bananas. Worthing has a labor force of 800
workers. The production of apples and bananas require 5 and 1 workers,
respectively.
(a) Graph the production possibility frontiers for the two countries.
(b) What are the opportunity costs of apples in terms of bananas in Capitol and
Worthing?
(c) In the absence of trade between Capitol and Worthing, what would the
prices of apples in terms of bananas be in each country?
(d) Describe the pattern of trade.
(e) Show graphically that both Capitol and Worthing gain from trade.
 Problem Set 6 Solutions

Question 1.

(a) In the case of a negative externality, the marginal social costs exceed the marginal private costs and
the quantity produced (q) exceed socially optimal quantity q*. A tax on cigarettes could be imposed.
A tax equal to the difference between the marginal private cost and the marginal social cost (in this
case a tax of 68 cents/pack) would shift the supply curve up such that the marginal private cost with
tax would be equal to the marginal social cost. This would reduce the equilibrium quantity produced to
the efficient level. Thus, the quantity of cigarettes produced would decrease from q to q*.

Marginal Social Cost

P
Marginal Private Cost
tax

D
Q
q* q

b. Other possible means that the government could use to correct the overproduction of cigarettes
include:
• Government Quota: Assuming the government could know the efficient level, it could impose a
quota, limiting production of cigarettes to q*. The challenge for the government is estimating
the q* perfectly. Additionally, if supply and demand change, the government would need to
adjust the quota.
• Government regulation of cigarette quality: The government could impose “quality standards”
and allow production only of cigarettes that meet minimum health standards. This would
decrease the negative externality and also increase the marginal private cost, both of which
would bring the MPC closer to the MSC.

Question 2.

(a) Assuming there is no congestion, it is efficient to build the bridge. The total willingness to pay of
all 20,000 people is $2*10,000 + $1*10,000 = $30,000 per day, while the bridge only costs $25,000
per day. So, building the bridge would provide a net social surplus of $5,000 per day.
(b) It is not possible to find a single toll that will raise revenues sufficient to cover the costs of building
the bridge. To see this, think about whether the government could raise the necessary $25,000 per day
to finance the bridge. It could charge a $2 toll, in which case, 10,000 people would use the bridge,
bringing in $2*10,000 = $20,000 per day in revenue. Alternatively, the government could charge a $1
toll, in which case, all 20,000 people would use the bridge, bringing in $1*20,000 = $20,000 per day in
revenue. Any other toll would bring in less revenue.
Thus, assuming a single toll, only $20,000 per day could be raised, falling $5,000 short of the $25,000
per day necessary to finance the bridge. If the government was able to price discriminate, such that it
could discern the 10,000 who were willing to pay $2 per day to cross the bridge from those who were
only willing to pay $1 per day, then it could charge those willing to pay $2 more. This would allow it
to bring in enough revenue to cover the costs of building and operating the bridge. An example of this
may be if those willing to pay $2 per day all commuted across the bridge in the morning and returned
in the evening. In that case, a toll that varied by the time of day could be implemented.
(c) Assuming that there is no congestion, this bridge is non-rival (one person’s use of the bridge does
not infringe on anyone else’s use of the bridge) and non-excludable (no one can be excluded from the
bridge), and hence it is a public good. The answers to parts (a) and (b) indicate that it would be
socially optimal for the bridge to be in place, but the bridge could not be financed by the private
market or a single toll. Government intervention would have to find a way to charge a higher toll to
those with a higher willingness to pay.
The government could also finance the construction of the bridge by imposing some other sort of tax,
such as a property tax, on the 20,000 people who use the bridge (e.g., if everyone in the town uses the
bridge). If the costs were distributed equally, the cost per person per day would be $1.25. The socially
optimal outcome could be achieved in this manner, but note that there would be distributional
consequences. More specifically, the 10,000 people who were only willing to pay $1 would actually
face a net loss of $0.25, while the 10,000 people who were willing to pay $2 would have a net gain of
$0.75.

Question 3.
a.
The dentist and the writer are on speaking terms (small transaction costs, ignoring court fees)
Court rules in favor of dentist Court rules in favor of writer
If the court rules in favor of the dentist, the dentist would If the court rules in favor of the writer,
have no incentive to soundproof her walls. However, we the dentist would have to pay $600 to
know by the Coase theorem that if property rights are soundproof the walls. In this case, the
clearly defined and transaction costs are low, then the dentist would be forced to internalize
efficient resolution of externalities will be reached. In this the costs of the negative externality.
case, the writer would have the incentive to pay the dentist Since the costs of the negative
$600 to soundproof the walls. This is because the writer externality will be internalized, the
would be better off by paying the $600 and not losing any efficient outcome will be reached.
money from the screams of pain than by not paying the
$600 and losing $800. Thus, given the small transaction
costs, the efficient outcome would be reached because the
negative externality would be internalized by the writer.

b.
The dentist and the writer are NOT on speaking terms (large transaction costs)
Court rules in favor of dentist Court rules in favor of writer
If the court rules in favor of the dentist, the dentist would If the court rules in favor of the writer,
have no incentive to soundproof the walls. Since the the dentist would have to pay $600 to
dentist and the writer are not speaking to each other under soundproof the walls. In this case, the
any circumstances, the costs of negotiation (perhaps dentist would be forced to internalize
through a third party) would be high. Thus, in addition to the costs of the negative externality.
 paying the dentist the $600 to soundproof the walls, the Since the costs of the negative
writer would also incur the costs of negotiating the externality will be internalized, the
agreement. If these costs exceeded $200 (and assuming efficient outcome will be reached.
the negotiations would have to occur each year), then the
writer would not have the incentive to pursue negotiations
because the costs of getting the dentist to soundproof the
walls would exceed the benefits. Thus, with high
transaction costs, the efficient outcome would be less
likely. This situation illustrates the importance of low
transaction costs in the application of the Coase theorem.

Question 4.
There are two possible answers for this:

1. The subsidy is given per unit of quantity.

P S
With the subsidy, price decreases (P1 Æ P2) and
Ssubsidy
quantity increases (Q1 Æ Q2). Consumers of
agricultural goods benefit; CS increases (a Æ
a a+b+e+f). Agricultural producers also benefit; PS
P1 h increases (b+c Æ c+d+g). However, society as a
b e f i whole is worse off, because now there is a deviation
P2 g from the efficient quantity due to overproduction.
c
This is shown in the creation of DWL (h+i). Note
d that the government pays out the size of the subsidy
times the quantity produced with the subsidy, which
D can be seen on the graph as the area between the
Q1 Q2 Q
supply curve with the subsidy and the supply curve
without the subsidy (d+e+f+g+h+i). So, the DWL
can also been seen as the social surplus after the subsidy (PS_after+CS_after-govt cost) minus the
social surplus before the subsidy (PS_before+CS_before)

2. The subsidy is given in terms of a price floor when the government buys the extra unsold quantity of
agricultural products at a set price.

With the subsidy, the price increases to the

P minimum price floor level (P2), and the overall
quantity sold increases. However, quantity
demanded by consumers decreases (Q1 Æ Qd), but
S quantity supplied increases (Q1 Æ Qs) because the
a
P2 government buys Qsubsidy - Qd. Consumers of
f agricultural goods are worse off, as CS decreases
b d (a+b+d Æ a). However, agricultural producers
P1
g benefit, as PS increases (c+e Æ c+e+b+d+f).
c e Overall, society as a whole is worse off because
once again, the producers are producing more than
D the efficient market quantity (Q1). The subsidy
results in the creation of DWL (g).
Qd Q1 Qsubsidy Q
See the dairy example in Problem Set 3, Extra Practice D, for a more in-depth analysis of the welfare
effects of a price floor.

It is likely that the Farm Bill passed for food security and other political reasons (e.g., the political
clout of farmers, lobbying, etc). Consumers also tend to like low food prices.

Question 5.

(a) Cardassia’s tradeoff is 200 phasers for 100 transporters. Hence, the opportunity cost of one phaser
is 0.5 transporters in Cardassia. Dominion trades off 500 phasers for 1000 transporters, so one phaser
costs 2 transporters in Dominion.
(b) Because the opportunity cost of one phaser is lower is Cardassia (0.5 < 2), Cardassia would
specialize in phasers. Dominion would specialize in transporters.
(c) The range of prices lies between the respective countries’ opportunity costs of production. The
price would have to be between 0.5 and 2 transporters per phaser.
(d) Cardassia’s tradeoff changes to 200 phasers for 500 transporters. The opportunity cost of one
phaser rises to 5/2 = 2.5 transporters. Dominion’s opportunity cost remains unchanged at 2
transporters per phaser.
Dominion now has a lower opportunity cost of producing phasers, so Dominion would specialize in
phasers, and Cardassia in transporters (the specialization is reversed).
The trading price would be between 2 and 2.5 transporters per phaser.

Question 6.

(a)
Price Demand Supply
0 400 100
5 350 125
10 300 150
15 250 175
20 200 200
30 100 250
40 0 300

Without trade to other nations, the equilibrium price and quantity are when supply is equal to demand
in Acirema. This occurs at a price of $20, and a quantity of 200.

Graphically, the market for peanuts in Acirema can be seen as follows:

Peanut Supply
Price

40

30

20

10

Demand

100 200 300 400 Quantity of

Peanuts

(b) If the world price of peanuts was $10 per bag and trade with other nations was unrestricted, then
Acirema would import peanuts, because the cost of the imported peanuts would be below the market
price in Acirema prior to trade.
In this case, Acirema can be thought of as a price taker, because the nation is “small” and unable to
affect world prices. So, the equilibrium price when trade is unrestricted would be $10 per bag. At this
price, the demand for peanuts is 300 bags, and the supply of peanuts is 150 bags. The difference, or
shortage, will be made up for by importing 300-150 = 150 bags of peanuts. This can be seen
graphically:

Peanut Supply
Price

40

30

20

world price
10

Demand

100 150 200 300 400 Quantity of

Peanuts
imports
(c) If there is an import quota for 75 bags, then the “shortage” or difference between supply and
demand is limited to 75 bags. The resulting domestic price and quantity can be read off the graph
where demand exceeds
supply by 75. This price is a price of $15, since supply is 250 and demand is 175, giving a difference
of 250-175 = 75.
Alternatively, this difference can be solved for by using the equations for supply and demand in the
peanut market. Setting QD – QS = 75, allows us to solve for the price:
QD – QS = 75
[400-10P] – [100+5P] = 75
300-15P = 75
P = $15
As mentioned above, from reading off the table, at a price of $15, the resulting domestic production is
175, and the domestic consumption is 250. This can be seen graphically:
Peanut Supply
Price

40

30

20

15
Demand
10

100 175 200 250 300 400 Quantity of

Peanuts
Imports = 75
EXTRA PRACTICE PROBLEMS SOLUTIONS

A.
There is a reasonable economic reason for the fine imposed on anyone killing a praying mantis in
agricultural states. Because the preying mantis provides a valuable service to farmers by keeping
down the population of beetles and other insects that harm crops, killing a preying mantis can be
thought of as imposing a negative externality. That is, the killing a preying mantis has negative
spillover effects on farmers by allowing beetles and other insects to damage the crop more than they
would have had the preying mantis been around.
Thus, the agricultural states with fines on killing a preying mantis are attempting to “internalize the
externality” by forcing those who would kill a preying mantis to pay for the negative externality they
cause. This raises the effective price that people pay for killing a preying mantis—thus reducing the
number of people will kill a preying mantis (reducing the quantity). If the fine is fully enforced, and is
at the level of the externality, then only the socially optimal number of preying mantises will be killed.

B. We could approach this problem with two different sets of assumptions.

1. First, let’s begin by assuming that WA wine and CA wine are perfect substitutes. Assume also
that WA is a small state (WA is a price taker). In addition, assume WA is small enough that
the decreased demand for CA wine will not influence the price of CA wine. As can be seen in
the graph above, the tax (tariff) imposed on CA wine results in a decrease in CS, an increase in
PS, and DWL for the WA society. Increased production of WA wine would lead to increased
employment in the WA wine industry. And the WA government would receive a tax (tariff)
revenue of E. However, not only would consumers in WA be worse off but WA society as a
whole would suffer DWL.

Washington Wine Market Pre-Tariff Post-Tariff

Producer G G+C
P
Surplus

Consumer A+B+C A+B

S Surplus +D+E+
(Domestic F
Supply of
Wine) Revenue from - E
Tax
A
Deadweight - D+F
Loss
B
P0+tariff
C D E F
P0
G D
(Domestic
Demand
for Wine)

S1 S2 D2 D1 Q
Imports after tariff

Imports before tariff

2. Secondly, assume that CA wine and WA wine are not perfect substitutes. In this case, the price of
CA wine may be different than the price of WA wine. We now need to analyze the two markets
separately,

First, let’s consider the WA market for CA wine. As can be seen below, the tax (tariff) does produce
tax revenue but also results in DWL (in this case, borne by CA producers and WA consumers).

Washington Market for CA wine

New Export Supply Curve
P
Export Supply Curve (Supply of exported wine from CA)
Shaded area = government revenue

Price paid by Wash

Consumers with tariff
DWL
Price without tariff
Price received by CA
producers (with tariff)

Import Demand Curve (WA’s demand for CA wine)

q1 q0 Q

Secondly, let’s consider the WA market for WA wine. The demand for WA wine will shift up
(depending on the degree to which the two wines are substitutes). This will increase the quantity
produced and the price of WA wine. The increase in quantity produced will lead to increased
employment.

The evaluation of the policy thus depends on the assumptions made. However, in both cases, WA risks
provoking retaliatory measures by CA and perhaps provoking a tariff war.

C.
(a) When American rice sells for $100 per bushel and Japanese rice sells for 16,000 yen per bushel and
the nominal exchange rate is 80 yen per dollar, you could make a profit on this situation by buying rice
in America, and selling it in Japan. Rice can be sold for 16,000 yen per bushel / 80 yen per dollar =
$200 per bushel in Japan. Assuming negligible transportation costs, buying rice in American and
selling rice in Japan yields a profit of $200 - $100 = $100 per bushel. With transportation costs of T,
the profit would be $200 - $100 – T = $100 – T per bushel. This difference in price across countries is
what is called an arbitrage opportunity.
If other people exploit the same opportunity, the demand for rice in the United States would rise (due
to people demanding rice to export to Japan), while the supply of rice in Japan would rise (due to
importers selling their imported rice). This would lead to the price in the United States rising and the
price in Japan falling. The arbitrage profit opportunity would continue until the price rises enough in
the United States and falls enough in Japan that no more additional profit can be made. Assuming
negligible transportation costs, this would imply that the price in Japan would be exactly equal to the
price in the United States. If there are transportation costs of T, the price in the United States would be
the price in Japan minus the transportation costs: PUS = PJap – T
(b) If rice is the only commodity in the world, then the real exchange rate between the United States
and Japan would fall. That is, the yen will appreciate in value relative to the dollar. This is because
the exchange rate is greatly affected by the price of goods and services in one country compared to
another. In this case, the price of rice is falling in Japan relative to the United States. So, since rice is
the only commodity, the average price of goods and services is decreasing in Japan relative to the
United States. This means that relative to before the trade, the demand for Japanese goods (in this case
rice) in the United States is greater than is was before. So, the yen will appreciate in value. (See
Taylor p. 421)

D.
a. To graph the production possibility frontiers, the following chart may be helpful:
If all resources devoted to If all resources devoted to
apples, none to bananas bananas, none to apples
Capitol 400 tons apples 600 tons bananas
Worthing 160 tons apples 800 tons bananas

(b) Opportunity cost of apples in terms of bananas:

Capitol: cost of an apple = 1.5 bananas
Worthing: cost of an apple = 5 bananas

(c) In the absence of trade between Capitol and Worthing:

Price of apples in Capitol in terms of bananas: apple = 1.5 bananas
Price of apples in Worthing in terms of bananas: apple = 5 bananas

(d) Pattern of trade: As can be seen from the calculations above, Capitol has the comparative
advantage (is relatively more efficient) in producing apples while Worthing has the comparative
advantage in producing bananas. We know that by exporting the goods it has a comparative advantage
in, a country can increase consumption of both goods. Thus, Capitol should export apples and
Worthing should export bananas. The relative price with trade would be somewhere between the range
of prices in the two countries before trade. That is, the price of apples in terms of bananas would be
somewhere between 1.5 and 5.

(e) Capitol and Worthing both gain from trade: Assume that with trade, the price of an apple = 2
bananas (the price determines the slope of the Consumption Possibility Curve for each country).
 apples
Capitol Before Trade apples Worthing Before Trade

400 400
Production Possibilities Curve
Production Possibilities Curve

bananas bananas
800 800
apples apples Worthing After Trade
Capitol After Trade

400 Consumption Possibilities Curve 400 Consumption Possibilities Curve

bananas bananas
800 800