question archive The production of batteries for eBikes is polluting and causes a negative externality whose marginal costs are estimated at 2q
Subject:EconomicsPrice:2.84 Bought5
The production of batteries for eBikes is polluting and causes a negative externality
whose marginal costs are estimated at 2q. The inverse demand function and the
supply function for the monopolist who produces these batteries is, respectively, p = 3 - q
and p = 2q
By imposing a tax on the production of batteries, the government wants to ensure that
the social optimum is reached. The government defines it
social optimum as that equilibrium outcome in which, given the market structure,
the externality is completely internalized. However, she has doubts between a specific
tax and an ad valorem tax.
Calculate both (the specific tax and the ad valorem tax) where
the monopolist produces a quantity corresponding to it
social optimum as defined by the government. Submit your
answers clearly.
Socially optimum price = $2.40 and quantity = 0.60
To generate this combination of price and quantity, either of the following will do the job:
Specific tax of 2Q
OR
Ad Valorem tax of $1.20
Step-by-step explanation
Without government intervention and recognition of the negative externality, the
market equilibrium occurs when demand = supply.
Demand: P = 3-Q, Supply: P=2Q
P =3-Q = 2Q or
3Q = 3,
Q = 1,
P = 3-1 = 2
Market price will be $2 and quantity will be 1.
With the externality, if the firms had recognized and internalized it,
their supply would have been P = 2Q +2Q = 4Q
In that case, equilibrium would have been where 3-Q = 4Q or
5Q = 3
Q = 0.60
P = 3-0.60 = $2.40
Thus, the government could put a specific tax of 2Q which would have brought about
the socially optimum quantity of 0.60 and a price of $2.40
Instead of the specific tax, the government could place an ad valorem tax of X.
Thus the firms' supply curve would be P = X +2Q
We know that the socially optimum Q =0.60 and P = $2.40.
Therefore $2.40 = X + 2(Q) = X + 2(0.60) = X + $1.20
Thus X = $2.40 -$1.20 =
$1.20
Consequently, if a flat tax of $1.20 is imposed,
the supply would be P= 1.20+2Q
Equilibrium would occur when demand equals supply or when
3-Q = 1.20 +2Q or
3Q = 1.80
Q = 0.60 and
P = 3-Q = $2.40.
Thus the socially optimum price of $2.40 and quantity of 0.60 would be realized.
Conclusion:
Specific tax of 2Q would generate the socially optimum price pf $2.40 and quantity of 0.60.
Ad valorem tax of $1.20 will also produce the same results and achieve the socially optimum P and Q.