ECON 1001 AB
Introduction to Economics I
Dr. Ka-fu WONG
Last week of tutorial sessions
KKL 925, KKL 1010, K812, KKL 106
Clifford CHAN
KKL 1109
givencana@yahoo.ca
Covered and to be covered
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Covered last week
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Dr. Wong finished up to slides of 51 of kf013.ppt
You should have at least read up to Chapter 12 Externalities and
Property Rights
If not, please press hard on it. For your interest, you can also read
Chapter 13 Economies of Information (not examinable)
The final exam covers everything up to chapter 12, except for
chapter 9. Format is similar to the first and second midterm
To be covered in the tutorial sessions this week
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Problems in chapter 12: #1, #3, #4, #5, #8 and #9
You are advised to work on the even ones as well
Problem #1, Chapter 12
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Determine whether the following statements are true or
false, and briefly explain why
A) A given total emission reduction in a polluting industry
will be achieved at the lowest possible total cost when
the cost of the last unit of pollution curbed is equal for
each firm in the industry
B) In an attempt to lower their costs of production, firms
sometimes succeed merely in shifting costs to outsiders
Solution to Problem #1 (1)
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A) True
Application of Equal Marginal Principle
For optimal allocation of production, marginal cost
should be the same across all the firms
If one firm’s marginal cost is higher than the other’s, it is
cost-minimizing to divert the production from the firm
with a higher marginal cost to the firm with a lower
marginal cost
Solution to Problem #1 (2)
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B) True
Notion of Negative Externality
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It refers to situation where producers do not bear the complete
production cost and the leakage is borne by a three-party outside
the market
Consider an example of production that generates
sewage
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The sewage is supposed to be collected by a municipal
government at a per unit charge
However, the manufacturer escapes from the discharge fee by
pumping the sewage into a river
The river gets polluted and the society then bears an extra
pollution cost
Problem #3, Chapter 12
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Suppose the supply curve of boom box rentals in Golden
Gate Park is given by P = 5 + 0.1Q, where P is the daily
rent per unit in dollars and Q is the volume of units
rented in hundreds per day. The demand curve for boom
boxes is 20 – 0.2Q. If each boom box imposes $3 per
day in noise costs on others, by how much will the
equilibrium number of boom boxes rented exceed the
socially optimal number?
Solution to Problem #3 (1)
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Equilibrium rental of boom boxes (Q*)
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Intersection of demand curve and supply curve
5 + 0.1Q* = 20 – 0.2Q*
0.3Q* = 15
Q* = 50
However, there is an (external) noise cost of $3 per box
Supply curve = marginal cost curve (the portion above AVC)
Social supply curve = original supply curve + 3
Social supply curve = 8 + 0.1Q
Solution to Problem #3 (2)
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Socially optimal rental of boom boxes (Q**)
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Intersection of demand curve and social supply curve
8 + 0.1Q** = 20 – 0.2Q**
0.3Q** = 12
Q** = 40
If the negative externality (noise) is internalized into the
rental, the equilibrium rental is greater than the social
equilibrium rental by 10 (50 – 40)
Problem #4, Chapter 12
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Refer to problem 3. How would the imposition of a tax of
$3 per unit on each daily boom box rental affect
efficiency in this market
Solution to Problem #4
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The imposition of a $3 per unit tax is efficiencyenhancing
Why?
It actually internalizes the noise cost into the private
supply curve
After the imposition of tax, the supply curve becomes the
social supply curve
It helps bring the inefficient rental of boom boxes to the
(socially) efficient rental of boom boxes
Problem #5, Chapter 12
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Suppose the law says that
Jones may not emit smoke
from his factory unless he gets
permission from Smith, who
lives downward. If the relevant
costs and benefits of filtering
the smoke from Jones'
production process are as
shown in the following table,
and if Jones and Smith can
negotiate with one another at
no cost, will Jones emit smoke?
Jones
emits
smoke
Jones
does not
emit
smoke
Surplus
for Jones
$200
$160
Surplus
for Smith
$400
$420
Solution to Problem #5 (1)
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The efficient outcome is for Jones to emit smoke
Why?
The total surplus for Jones to emit smoke ($600) is
greater than the total surplus for Jones not to emit
smoke ($580)
Jones gains more surplus by emitting smoke ($200 $160 = $40)
Smith gains less surplus by authorizing Jones emit
smoke ($420 - $400 = -$20)
Note that Smith has the right to authorize Jones emit or
not emit smoke
Solution to Problem #5 (2)
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Since both Jones and Smith can negotiate with one
another at no cost, they can actually come up with a plan
that is mutually beneficial
In order to induce Smith authorize Jones to emit smoke,
Jones can offer Smith a side payment $30 to Smith, so
that Smith’s lost in surplus (-$20) can be fully covered
plus some extra gain ($10)
Even if Jones has to pay Smith $30, Jones still gains $10
from the deal
Problem #8, Chapter 12 (1)
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Barton and Statler are neighours in an apartment
complex in downtown Manhattan. Barton is a concert
pianist, and Statler is a poet working on an epic poem.
Barton rehearses his concert pieces on the baby grand
piano in his front room, which is directly above Statler’s
study. The following matrix shows the monthly payoffs to
Barton and Statler when Barton’s front room is and is not
soundproofed. The soundproofing will be effective only if
it is installed in Barton’s apartment.
Problem #8, Chapter 12 (2)
Soundproofed
Not
soundproofed
Gain to Barton
$100/month
$150/month
Gain to Statler
$120month
$80/month
Solution to Problem #8 (1)
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A) If Barton has the legal right to make any amount of
noise he wants and he and Statler can negotiate with
one another at no cost, will Barton install and maintain
soundproofing? Explain. Is his choice socially efficient?
His choice is socially efficient
Barton’s payoff without soundproofing is $50 greater
than his payoff with soundproofing
Barton has the legal right to make noise
He will of course not install the soundproof unless he
receives an additional income of at least $50
Solution to Problem #8 (2)
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Statler’s payoff without soundproofing is $40 less than
his payoff with soundproofing
Statler’s additional payoff from having a soundproof is
not sufficient to feed Barton’s additional payoff from not
having a soundproof
Both Barton and Statler will have no intention to
negotiate with one another
Since the total payoff from not having a soundproof
($230) is greater than the total payoff from having it
($220), it is socially efficient
Solution to Problem #8 (3)
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We can notice that an inequitable allocation of payoff
can be socially efficient!
B) If Statler has the legal right to peace and quiet and
can negotiate with Barton at no cost, will Barton install
and maintain soundproofing? Explain. Is his choice
socially efficient?
As Statler’s payoff with soundproofing is $40 greater
than his payoff without soundproofing, he will exercise
his right to require Barton to install and maintain a
soundproof
Solution to Problem #8 (4)
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The total payoff will then be $220, which is less than the
total payoff without soundproofing ($230)
Statler’s choice is thus not socially efficient
However, the negotiation cost is zero
Barton will have an intention to negotiate with Statler on
not installing the soundproof by providing Statler a
compensation of $40 (Statler’s additional payoff from
having a soundproof)
Barton is willing to make this compensation, as he can
gain an additional payoff from not having a soundproof
If such transaction occurs, the result will then be socially
efficient
Solution to Problem #8 (5)
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C) Does the attainment of an efficient outcome depend
on whether Barton has the legal right to make noise, or
Statler the legal right to peace and quiet?
No, it is actually independent of who has the legal right
on either issues.
Parts a and b arrive with the same result
However, it is only true because the negotiation cost is
zero in this case
If the negotiation cost is high enough to make transfer or
compensation infeasible, the attainment of an efficient
outcome will then become dependent on who has the
legal right on either issues
Problem #9, Chapter 12
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Refer to problem #8. Barton decides to buy a full-sized
grand piano. The new payoff matrix is shown in the
matrix below
Soundproofed
Not
soundproofed
Gain to Barton
$100/month
$150/month
Gain to Statler
$120month
$60/month
Solution to Problem #9 (1)
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A) If Statler has the legal right to peace and quiet, and
Barton and Statler can negotiate at no cost, will Barton
install and maintain soundproofing? Explain. Is this
outcome socially efficient?
Statler’s payoff with soundproofing is $60 greater than
his payoff without soundproofing
He has the legal to peace and quiet
Thus, Statler will exercise his right to require Barton to
install and maintain a soundproof
Solution to Problem #9 (2)
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Barton will not have an intention to negotiate with Statler,
as Barton’s additional payoff from not having a
soundproof ($50) is not enough to provide a
compensation for Statler’s additional payoff from having
a soundproof ($60)
Therefore, they will end up having a soundproof installed
and maintained
It is an efficient outcome
The total payoff from having a soundproof is $10 greater
than the total payoff from not having a soundproof
Solution to Problem #9 (3)
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B) Suppose that Barton has the legal right to make as
much noise as he likes and that negotiating an
agreement with Barton costs $15 per month. Will Barton
install and maintain soundproofing? Explain. Is this
outcome socially efficient?
Barton’s payoff without soundproofing is $50 greater
than his payoff with soundproofing
Barton has the legal right to make noise
He will of course not install the soundproof unless he
receives an additional income of at least $50
Solution to Problem #9 (4)
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On the other side, Statler’s payoff with soundproofing is
$60 greater than his payoff without soundproofing
However, Statler will have no intention to negotiate with
Barton, as there is a negotiation cost of $15
In order to reach an agreement with Barton to install a
soundproof, Statler will need to pay a total of $65 ($50 +
$15)- it is beyond his additional payoff with
soundproofing
As the total payoff without soundproofing is $10 less
than the total payoff with soundproofing, the outcome is
not socially efficient
Solution to Problem #9 (5)
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C) Suppose Statler has the legal right to peace and quiet,
and it costs $15 per month for Statler and Barton to
negotiate any agreement. (Compensation for noise
damage can be paid without incurring negotiation cost.)
Will Barton install and maintain soundproof? Is this
outcome socially efficient?
As Statler’s payoff with soundproofing is $60 greater
than his payoff without soundproofing, he will exercise
his right to require Barton to install and maintain a
soundproof
Solution to Problem #9 (6)
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The total payoff will then be $220, which is greater than
the total payoff without soundproofing ($210)
Statler’s choice is thus socially efficient
Barton will have no intention to negotiate with Statler on
not installing the soundproof by providing Statler a
compensation of $60 (Statler’s additional payoff from
having a soundproof)
Solution to Problem #9 (7)
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D) Why does the attainment of a socially efficient
outcome now depend on whether Barton has the legal
right to make noise?
It is attributed to the presence of negotiation cost
The $15 negotiation cost blocks the efficient outcome, as
total amount Statler has to pay to compensate for
Barton’s additional payoff with soundproofing ($65)
outweigh Statler’s payoff with soundproofing ($60)
However, if Statler has the legal right to peace and quiet
instead, no agreement is necessary to arrive at the
efficient outcome
The end
Thanks and Goodbye!
Good luck on
the final exam
@^.^@