ESSEC BUSINESS SCHOOL

Economics Department
Microeconomics
2019-2020
Solution to Problem Set 8
Externalities

Do not turn in. For Self-Study.

Exercise 1 (Final Exam 2016)

Consider a …rm producing a good that it can sell for 10 e in a competitive market. This …rm uses
energy (E) as its only input and this input causes pollution. The …rm’s production function is given as
p
F (E) = E. The market price of each unit of energy is equal to 1 e.

1. Find the optimal level of energy that the …rm should use in order to maximize its pro…t. What
are the resulting production and pro…t levels?

The …rm has only one input, energy E and it will choose its level to maximize its pro…t pF (E) 1E =
p
10 E E: To get the …rst-order condition for a maximum, we take the derivative of the pro…t with respect
to E and equate this derivative to zero:

1 1=2
10 E 1 = 0
2
1 1=2
10 E = 1
2
1=2 1
E =
5
E 1=2 = 5

E = 25
p p
Accordingly, the optimal production level is 25 = 5 and the maximized level of pro…t is 10 25 25 = 25:
Each unit of energy generates one unit of pollution and we estimate the cost of each unit of pollution as
C > 0.

2. If the government decides to tax each unit of pollution at the amount C, what would be the new
level of energy used by the …rm and its new pro…t level?

1
 We have to adjust the …rm’s pro…t function by changing the cost of energy to 1+C (instead of 1).
Now the …rst-order condition is

1 1=2
10 E = 1+C
2
1=2 1+C
E =
5
5
E 1=2 =
1+C
25
E = 2
(1 + C)
q
25 5 5
Accordingly, the optimal production level is (1+C)2
= 1+C and the maximized level of pro…t is 10 1+C
25 25
1+C = 1+C :

Instead of taxing pollution, the government decides to directly limit the use of energy. For this purpose,
it introduces a system of permits. Each permit authorizes the …rm to purchase a unit of energy at the
market price.

3. What is the maximum price that the …rm is willing to pay to acquire a single unit of permit? Find
the marginal bene…t of a permit for the …rm.
p
With one single unit of the permit, the …rm can get the pro…t 10 1 1 = 9 euros. More generally,
the marginal value of a permit is given by the derivative of the pro…t function with respect to the
@
energy level E, that is @E = 10 12 E 1=2
1= p5
E
1.

4. Assuming that the marginal cost of pollution is C, …nd the permit price that the government
should choose in order to maximize the total surplus (considering the pro…t of the …rm and the
environmental costs). What would be the number of permits (or the amount of energy) bought by
the …rm at this price?
p
The government wants to maximize the …rm’s pro…t net of the cost of pollution: 10 E (1 + C) E:
When the price of the permit set exactly equal to the unit cost of pollution C, the …rm’s objective
function becomes the same as the government’s. In this case, the optimal level of Energy that will
be chosen by the …rm is

1 1=2
10 E = 1+C
2
1=2 1+C
E =
5
5
E 1=2 =
1+C
25
E = 2
(1 + C)

2
Suppose that a second …rm has the same production function as the …rst one and it can sell its product
for 20 e. Suppose further that these two …rms initially have the same number of permits (denoted as
D).

5. What will be the …nal allocation of the permits between the two …rms if they can trade these
permits on a competitive market?

When there is a market for permits, the marginal value for the permit should be the same across all
…rms. We calculated above the marginal value of a permit for the …rst …rm is p5 1, if E is the amount
E
of permits used by this …rm. By following the same steps, we can calculate the marginal value of a permit
10
for the second …rm as p
E
1, if E is the amount of permits used by the second …rm. Suppose the …rst
…rm sells t units of permits to the second one. The resulting permit amounts for the two …rms would be
D-t and D+t. When we equate the marginal value of permits, we get

5 10
p 1 = p 1
D t D+t
p
D+t
p = 2
D t
D+t
= 4
D t
D+t = 4D 4t

5t = 3D

t = 3D=5

Therefore the …nal allocation of the permits would be D t = 2D=5 units for the …rst …rm and D + t =
8D=5 for the second.

6. If the unit cost of pollution C is equal to 1, which value of D should the government choose in
order to maximize the total surplus by balancing the interests of the …rms and the protection of
the environment?

For this, the marginal value of a permit for a …rm should be equal to the environmental cost of
pollution generated by using the permit. We calculated above that the marginal value of a permit for the
…rst …rm as p5 1. We also found out that the resulting energy level for this …rm is E = D t = 2D=5:
E
To …nd the e¢ cient level of D, we equate the marginal value of a permit for this …rm to the unit cost of

3
pollution:

5
p 1 = 1
2D=5
5
p = 2
2D=5
25
= 4
2D=5
125 = 8D

D = 125=8