Problem Set 5

Principles of Economics Problem Set 5 Fall Externalities and Efficiency Directions Seminar Group Watch the following advertisement by the Warby Parker Company:
Use the economic way of thinking to explain the role of middlemen in the market for eyeglasses. Why might looking at this video from an economic standpoint expose an irony in the advertisement?(Five sentences maximum).
The advertisement uses middlemen to convey the function of the eye glasses and their efficiencies. They are portrayed to use the real product like in the case a student who reads effectively using the glasses. It is quiet ironical that the glasses can provide a glance at opaque objects.
2. Do shortages caused by rent controls tend to be larger in the short run or the long run? Use a supply and demand diagram to illustrate your answer and provide no more than five sentences of explanation.
P3 D1 D2 S1
P1 Equilibrium

Q1 Q2
When prices are set below the equilibrium, i.e P2, there will be an increased demand in the houses by the population. Since supply remains constant as demand rises, there will be a shortage in the short run. However, in the long run, people will tend to build their own houses or property owners will develop more to avoid the shortages. This increases the supply of the houses and reducing shortages.
3. Use the following to answer questions 3a-3b:
Figure: Market with External Cost
(Figure: Market with External Cost) The figure displays a market with external costs. The efficient level of output of __Q1______ units would eliminate the deadweight loss area of __ce______.
Q1. ce
Q0. ce
Q0. gh
Q1. de
(Figure: Market with External Cost) Suppose that the figure displays the demand and supply curves for dry cleaning, a service that creates pollution. The external cost of dry cleaning is:
P1 – P0.
P2 – P0.
4. Use the following to answer questions 4a-4b:
Figure: Market for Vaccines
(Figure: Market for Vaccines) The figure represents the market for vaccines with external benefits. The external __benefit______ of vaccination is __$ 5______.
cost. $15
cost. $10
benefit. $20
benefit. $5
(Figure: Market for Vaccines) The figure represents the market for vaccines with external benefits. The efficient level of output is __1,800______ vaccines, which is ___greater_____ than the markets output.
1,200. greater
1,800. less
2,400. greater
1,800. greater
5. Suppose Tesco (A) and Sainsbury’s (B) both emit pollutants when producing their plastic bags used by customers to collect and carry their groceries home. The government enforces regulations saying that neither firm can release more than 10 units of pollutants. (Assume that pollutants can be measured in discrete and comparable units.) Currently Tesco releases 10 units and Sainsbury’s releases 11 units. The government requires Sainsbury’s to reduce its pollution by 1 unit – the company can do this, but at a cost of £1,000. Tesco, however, can reduce its pollution by 1 unit for a cost of £400. Sainsbury’s wants to save money by trading allowances with Tesco. After negotiations, Tesco agrees to see one unit of pollutant to Sainsbury’s for £650.
What is the total amount of pollutants emitted into the air after the firms have traded allowances?
The total pollutants into the air is 20 units

How do both firms profit from trading allowances? Give exact figures for both firms.

Trading allowances will sees both firms’ benefits. Tesco will make an extra profit while Sainsbury save on its production cost.
Tesco will get a profit of 650-400= 250
Sunbury will be able to save 1000- 650= 350
6. From Chapter 11: Graphically illustrate how a constant cost industry responds to an increase in demand in the short run and in the long run.
D1 D2 S1

P1 E S2 new equilibrium

Q1 Q2 Q3 quantity produced
From the diagram, P1 and Q1 are the equilibrium price and quantity respectively. In the short run the time is too short for firms to adjust production. However, in the long run, firms will increase output to Q2 and charge high price P2 due to an increase in shock demand. This leads to demand curve to shift from D1 to D2. This will make the firms to make abnormal profits. Since there is free entry, the excess profits will attract more firms into the market. This will increase supply from S1 to S2. Due to excess supply and constant demand, the firm will reduce its price from P2 to P3 making it to earn normal profits.
7. Firms in a perfectly competitive industry maximize profits by:
A) eliminating the competition.
B) producing a higher quality good and setting a price higher than the competition.
C) setting a price equal to the market price.
D) setting a price less than the market price and undercutting the competition.
8. True or False: Firms should exit the industry if average costs are greater than marginal costs.
True. Average cost greater than marginal cost implies prices are lower than the average cost. The firm is better off not producing since it incurs economic loss. The amount i produces cannot meet the cost of productions more so the fixed costs.
9. Explain why a profit-maximizing firm in a competitive market would increase output until price is equal to marginal cost? (Five sentences maximum)
A competitive firm maximizes profits where P=MC. When prices are less than marginal, the firm is under producing and cab continue produce more. If price is more than the marginal cost, the firm is over producing and would only make a loss (Tisdell, 2005). This makes the firm to operate at the breakeven point where the price equals marginal cost so that it maximizes on its profits.
10. What is the main insight from Ronald Coase on externalities? Give an example. (2 paragraphs maximum)
Ronald Coarse noted there were economic inefficiencies in the production of goods by firms. These inefficiencies are a result of the externalities to those who do not participate in the production process (Tisdell, 2005). The government however should intervene in the production to solve the situation. They can do so by taxing the producing unit or providing subsidies so that the firm can meet the social cost. But if the loss is more than the gain, the externality should not be removed.
Ronald also advocated for bargains in an attempt to solve externalities (Tisdell, 2005). For example operating firm in a society can decide to negotiate with society members to built hospitals so as to treat diseases that may results due to its operations. By doing so, the firm easily solves the problem of externalities and the state does not have to involve in their removal.
TISDELL, C. A. (2005). Economics of environmental conservation. Cheltenham, UK, E. Elgar Pub.