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Spring 2013

Tutorial 4 Solutions

1. Textbook Q12

a. The total cost of emissions reduction is minimized only when the

marginal costs are equal across all polluters, therefore a cost-effective

solution requires that MC

1

=MC

2

or that 300e

1

=100e

2

. Substituting

3e

1

for e

2

in the formula e

1

+e

2

=40 (since the policy goal is to reduce

emissions by 40 units) yields the solution. It is cost-effective for Firm

1 to reduce emissions by 10 units and for Firm 2 to reduce emissions

by 30 units.

b. In order to achieve cost-effective emission reductions, the emissions

fee should beset equal to $3,000. With this emissions fee, Firm 1

reduces 10 units and Firm 2 reduces 30 units, but Firm 1 has to pay

$3,000 for each unit of pollution they continue to produce, which gives

them a tax burden of $3,000 x 90 (Firm 1 generated 100 units in the

absence of government intervention) or $270,000. Firm 2 has a lower

tax burden because it is reducing emissions from 80 units to 50units.

Firm 2 pays $3,000 x 50 =$150,000. As the text concludes, the firm

that cuts back pollution less isnt really getting away with anything

because it has a larger tax liability than if it were to cut back more.

c. From an efficiency standpoint, the initial allocation of permits does not

matter. If the two firms could not trade permits, then Firm 2 would

have to undertake all of the emissions reduction. Initially, Firm 1s

MC is zero, while Firm 2s MC is $4,000, so there is a strong incentive

for Firm 2 to purchase permits from Firm 1. Trading should continue

until MC

1

=MC

2

, which is the cost-effective solution. This means that

the market price for permits will equal $3,000, the same as the

emissions fee. At this price, Firm 2 will purchase 10 permits from

Firm 2, allowing Firm 2 to reduce emissions by 30 rather than 40 and

requiring Firm 1 to reduce emissions by 10. This solution is the same

as the solution achieved with the emissions fee. However, Firm 1 is

better off because instead of having to pay taxes, it will receive a

payment of $30,000 for its permits. Firm 2 must pay $30,000 for the

extra permits, but it also avoids the payment of taxes. The government

lost $420,000 in tax revenue. The firms must still pay the cost of

emissions reduction, plus Firm 2 must pay for the permits purchased

from Firm 1.

2. On Pogue and Sgontz (1989).

a. Alcohol consumption generates positive surplus for consumers but excessive

consumption also generates negative externalities. So the objective of the

study is to determine the social welfare maximising alcohol tax rate for the US

market using basic micro tools of analysis.

b. Taxes are indiscriminate; they hurt i.e. reduce alcohol consumption of

alcohol abusers who generate negative externalities but also of non-abusers

who generate no external damage.

c. P is constant average and marginal private cost curve for alcohol supply.

E is marginal external cost or damage curve from alcohol supply

So P+E captures marginal social (private +social) costs of alcohol supply.

This curve is increasing at an increasing rate because external damages are

assumed to accelerate with increasing consumption. So for a mild abuser, an

additional drink is assumed to cause less additional harm than one additional

drink for a heavy abuser.

d. Equation (1) states that the welfare gain from any alcohol tax will be equal to

the reduced external damage less the reduced consumer surplus of alcohol

abusers less the reduced consumer surplus of non-abusers. Equations (2) and

(3) propose that the change in consumption by both groups can be calculated

using the percentage change in the alcohol price due to the tax (T/P)

multiplied by the own price elasticity of demand for alcohol (s). This is so

far for just one individual so these two quantities are multiplied by the

population in each group (xs). Equation (4) is a re-expression of (1) using (2)

instead of x

A

and (3) instead of x

B

. Equation (4) is now quadratic in T i.e. it

contains some T squared terms, hence it will look something like an upside

down U, with a local maximum. This can be calculated by differentiating (4)

with respect to T and then setting this equal to 0: this is what is done in (5).

Solving (5) for T gives us (6), the welfare maximising alcohol tax rate as a

function of external damage E, alcohol price P, elasticitys and the population

in each group.

e. As usual in applied studies, there is a deal of uncertainty over the data: In

column (1) the authors set out their best guesses re the values of the variables

needed to estimate the alcohol tax (case 1) but test the sensitivity of their

results by making other assumptions about elasticitys, populations in each

group, marginal damages, etc.

f. The authors conclusions are as follows: the 1983 optimal tax rate,

conservatively estimated, appears to be about double the actual rate in the

standard welfare model.. That is, in 1983 the alcohol tax rate was too low

hence the price of alcohol was too low relative to the welfare maximising

price. Too much alcohol consumption generating more than optimal levels of

external damage.

g. Do you get it? Do you now have a better understanding of how economic

theory can be used to provide policy advice? Do you think the assumptions of

the model are reasonable? Can you think of any criticisms of the model and/or

assumptions? Could this framework be applied to Australian data?

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