Chap 5

EC 238
Environmental Economics
Instructor: Sharif F. Khan
Department of Economics
Wilfrid Laurier University
Intersession 2009
Suggested Solutions to Assignment 2 (Optional)

Part A
True/ False/ Uncertain Questions
[10 Marks]
Explain why the following statement is True, False, or Uncertain according to economic
principles. Use diagrams and / or numerical examples where appropriate. Unsupported
answers will receive no marks. It is the explanation that is important.
A1. [10 Marks]
A Pigouvian tax achieves efficiency in the market for some externality-creating
product. [Diagrams Required]
Uncertain
It depends on the type of externality. A Pigouvian tax achieves efficiency in the market
for some negative externality-creating product. On the other hand, a Pigouvian subsidy
achieves efficiency in the market for some positive externality-creating product.
See Page 88 and Figure 5.1 of the textbook (4th ed.) for an explanation of how a
Pigouvian tax achieves efficiency in the market for some negative externality-creating
(pollution-generating) product.
See Pages 93-95 and Figure 5.5 of the textbook (4th ed.) for an explanation of how a
Pigouvian subsidy achieves efficiency in the market for some positive externalitycreating product.
Page 1 of 5 Pages
Part B
Problem Solving Questions
[30 Marks]
Read each part of the question very carefully. Show all the steps of your calculations to
get full marks.
B1. [10 Marks]
Suppose that a chemical manufacturing plant is releasing nitrogen oxides into the
air, and these emissions are associated with health and ecological damages.
Economists have estimated the following marginal costs and benefits for the
chemical market, where Q is monthly output in thousands of pounds and P is price
per pound.
MSB = 50 0.4Q
MSC = 2 + 0.4Q
MEB = 0
MEC = 0.2Q
a) Find the competitive equilibrium, QC and PC , and the efficient equilibrium,

QE and PE . Illustrate your results on a diagram. [6 marks]
Competitive equilibrium arises where MPB = MPC. In this case, MPB = MSB,
because MEB = 0. To find MPC, subtract the MEC from the MSC.
MPC = MSC MEC = 2 + 0.2Q.
Setting MPC equal to MPB and solving yields the following:
2 + 0.2Q = 50 0.4Q, so 0.6Q = 48, or QC = 80 thousand pounds.
Substituting into either the MPC or the MPB to find PC:
PC = 2 + 0.2(80) or 50 0.4(80) = $18
The efficient equilibrium is found by setting MSC = MSB and solving for QE, as
follows:
2 + 0.4Q = 50 0.4Q, so 0.8Q = 48, or QE = 60 thousand pounds.
Substituting into either the MSC or the MSB to find PE:
PE = 2 + 0.4(60) or 50 0.4(60) = $26
Figure B1 illustrates the results.
Page 2 of 5 Pages
b) Find the dollar value of a product charge that would achieve an efficient
solution. Illustrate the effects of this product charge on the diagram you
drew for part (a). [4 marks]
A product charge that achieves efficiency would be modeled as a Pigouvian tax.
This is the dollar value of the MEC at QE.
At QE, MEC in this case equals 0.2 (60) = $12, which would be the value of a
product charge that generates an efficient equilibrium. Figure B1 illustrates the effects of
this product charge. By setting a Pigouvian tax equal to $12, shown as the distance ab,
the MPC curve shifts up to MPCt. The competitive equilibrium output is then determined
by the intersection of MPCt and MSB, which is the efficient production level, QE.
B2. [20 marks]

In 1996, Michigan launched a voluntary emissions trading program, which allows
polluters to achieve cost-effective solutions when meeting requirements of the U.S.
Clean Air Act. Suppose that Michigans objective for two major firms in an urban
area is a 16 percent reduction in carbon monoxide (CO) emissions and that each
firm faces the following costs:
Firm 1: TAC1 = 1000 + 2.5(A1)2
Firm 2: TAC2 = 500 + 1.5(A2)2
where A1 and A2 represent the percentages of CO emission abatement achieved by
firm 1 and 2, respectively, and TAC1 and TAC2 represent total abatement costs for
firm 1 and 2, respectively. TAC1 and TAC2 are measured in thousands of dollars.
a) Derive the marginal abatement cost (MAC) functions for each firm. Calculate
the TAC and MAC for each firm if a uniform abatement standard were used.
[7 marks]
MAC1
TAC1
2 1
= 2.5 * 2( A1 ) = 5 A1
A1
MAC 2
TAC 2
2 1
= 1.5 * 2( A2 ) = 3 A2
A2
Page 3 of 5 Pages
Based on a uniform standard, A1 = A2 = 8 percent. Therefore,

MAC1 = 5(8) = $40 thousand,
TAC1 = 1000+ 2.5(8)2 = $1160 thousand,
MAC2 = 3(8) = $24 thousand,
and TAC2 = 500+ 1.5(8)2 = $596 thousand.
b) Based on your answer to part (a), is there an economic incentive for the
polluters to participate in the trading program? Explain. [3 marks]
With a uniform abatement standard, the MACs are unequal, which means that the
abatement allocation is not cost-effective. This in turn means that each firm could realize
cost savings by changing this allocation through participation in the trading program.
Based on the relative dollar values of the MACs, Firm 1 should abate less, and Firm 2
should abate more, since Firm 2 is capable of abating more cheaply than Firm 1 at the
margin.
c) Calculate the cost-effective abatement allocation that could be achieved

through trading. Quantify the cost savings associated this allocation by
comparing it with the allocation achieved under a uniform abatement
standard. [8 marks]
First, find the cost-effective solution as follows:
Cost-effectiveness requires:
5A1 = 3A2
(1)
Abatement standard requires:
A1 + A2 = 16
(2)
Solving equations (1) and (2) simultaneously:

Therefore:
5(16 A2) = 3A2

80 5A2 = 3A2, so A2 = 10, and
A1 = 15 A2 = 6
To check your solution, make sure that the MACs for each firm are equal:
MAC1 = 5 (6) = $30
MAC2 = 3 (10) = $30
Second, calculate each firms total abatement costs based on the cost-effective allocation:
TAC1 = 1000 + 2.5 (6)2 = $1,090 thousand
TAC2 = 500 + 1.5(10)2 = $650 thousand
Page 4 of 5 Pages
Finally, determine the cost savings by comparing the sum of these TAC values to the sum
under a uniform standard.
Combined TACs under a uniform standard = $1,160 + $596 =
Combined TACs under the cost-effective solution = $1,090 + $650 = $1,740 thousand
Cost savings = $1,756 $1,740 thousand = $16 thousand
d) At what price must each tradable permit be set to achieve the cost-effective
solution? [2 marks]
Based on the cost-effective solution, each tradable permit must be priced equal to the
MAC values, which in this case is $30 per ton, as shown in the solution to part (c).
Page 5 of 5 Pages

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EC 238

Suggested Solutions to Assignment 2 (Optional)

True/ False/ Uncertain Questions

Problem Solving Questions

a) Find the competitive equilibrium, QC and PC , and the efficient equilibrium,

B2. [20 marks]

Based on a uniform standard, A1 = A2 = 8 percent. Therefore,

c) Calculate the cost-effective abatement allocation that could be achieved

Abatement standard requires:

Solving equations (1) and (2) simultaneously:

5(16 A2) = 3A2

MAC2 = 3 (10) = $30

TAC2 = 500 + 1.5(10)2 = $650 thousand

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