Economics 180, Spring 2002

TA: Ekaterina Chernobai

HOMEWORK 5

DUE MONDAY, JUNE 3RD

(Chapter 9)

The graph below depicts equilibrium in an unregulated, closed economy for some good Q. For future reference, call the country in question “Home”. Assume Home is a “small” country.

1.) Suppose the domestic production of the good generates pollution that harms the health of Home citizens. On the graph above draw and label curves associated with the marginal social cost (MSC) of producing the good and the marginal social benefit (MSB) of consuming the good. (Note that one of these curves will be redundant!)

2.) Suppose that Home would face a fixed world price P1 for the good if Home were open to free trade. Using the graph above, show the effect (label the relevant areas on the graph!) on Home’s welfare of opening to trade. I.e. measure Home’s welfare as the sum of consumers’ surplus, producers’ surplus and government tax revenue, less the health costs from local pollution. Assume for this question that Home is unregulated both in autarky and when open to trade.

3.) What does your answer to part 2 on the previous page suggest to you about the validity of the usual “gains from trade” argument when an economy is distorted?

4.) Use the graph below to repeat parts 2 and 3 using world price P2 instead. Explain briefly why the effects on welfare and gains from trade are different in these 2 cases.

5.) Now consider the effect of regulations. Assume Home is open to trade at the fixed world price P1 from the beginning.

(i) Suppose Home imposes a tax on domestic production of the good, with the tax equal to the health

costs associated with an additional unit of production. Use the graph below to show the change in

Home’s welfare (again, label all relevant areas and show all changes in welfare as explained in

part 2), if any, arising from the imposition of the production tax.

(ii) Suppose that instead of imposing a production tax, Home imposed a tax on exports of good Q, and the size of the export tax was the same as the production tax described in part (i). Show (again, label the relevant areas, etc. You can use the graph in part (i) with already labeled areas or you can redraw the graph below, if you want.) whether Home would be better off using a production or an export tax. Explain your answer.

6.) Suppose the Home government is “captured” by interests from the production sector, and so puts a larger weight on producers’ surplus than on other components of Home’s welfare. If the world price were P1, would the Home government have an incentive to exaggerate or downplay the magnitude of the local production externality? Explain. (You don’t need to draw a graph for this.)