UMUC - Hohenfels
Spring (ii) 2017 Economics 203
Exercise 7 Exercise Set 7 (25 points; 12 5 points individual/group; 12.5 points class)
Please note that you must complete your answers on this sheet. And that your sheets must be stapled or clipped.
1. (Dominant Strategy Equilibrium)
Telesource and Belair are two of the largest firms in the wireless carrier market in Mobileland. Both firms account
for more than 80% of the market. Suppose they decide to collude and set the same price. Their payoffs from
cheating and colluding are given in the matrix below. Explain why both firms have an incentive to cheat. Does this
help explain why a cartel is unstable? Telesource Collude Collude Cheat Belair earns $12 million Belair earns $2 million Telesource earns $12 million Telesource earns $15 million Belair earns $15 million
Telesource earns $2 million Belair earns $10 million
Telesource earns $10 million Belair
Cheat 2. (Coase Theorem)
Johann and Alice live in the same apartment building. Johann loves to play his opera recordings so loudly that
Alice can hear them. Alice is not a fan of opera, i.e., she detests it. Further, Johann receives $100 worth of
benefits from his music; and Alice suffers $60 worth of damage. (a) From an efficiency perspective, should Johann be allowed to play his opera music? (b) Suppose the apartment building does not have any rules about noise. Johann and Alice can bargain at
zero cost. Will they reach an agreement in which Johann gives up his beloved opera? (c) Now suppose the apartment building passes a rule that residents are not allowed to play music their
neighbors can hear if any of the neighbors object. As before, Johann and Alice can bargain at zero cost.
Will Johann be allowed to play his music? 3. (Externalities)
Suppose we assume that the monthly fumes from a small local paper mill contribute to air pollution. And that the
diagram below adequately illustrates what’s going on. Marginal Social Cost (MSC) P ($/block of paper) D = MB (private)
S = MC(private) $7.50 $7.25
$7.15 600000 750000 Q (blocks of paper) (a) Explain how the government could use a tax on paper production to bring about the efficient level of
production. (b) What should be the value of the tax? Why? (c) How large is the deadweight loss in dollars from excessive paper production, as per the figure. (Show your
work.) 4. (Exernalities – with another look at taxes (Week 3)) In class we focused on negative externalities in production. But they can also exist in consumption. Might sugarsweetened soft drinks be an example? For one, consuming soft drinks leads to medical treatments partially paid
for by taxpayers through Medicare and Medicaid programs. Not to mention the perjorative effects on school
performance and work productivity. P ($/case of soft drinks) S = MC(private) P* (pri) D = MB (private) Q*(social) Q* (private) Q (cases soft drinks) (a) Assuming the analysis above is correct, how might you show this negative consumption externality in the
graph above? Explain (and show!). (b) Now show (in the graph) and explain the Pigovian tax that might be levied on consumers (not producers) to
move the market equilibrium from Q* (private) to Q* (social). (c) As per your (correct?) answer in (b), suppose a municipal government decides to impose a per-unit (i.e.,
per-case of soft drinks) Pigovian tax on consumers to generate a lower socially optimal level of Q, shown as
Q*(social) in the diagram above. (Note: some U.S. cities have already done so; Mexico as a nation! has
already enacted such a tax.) -Identify in the diagram the amount of the total per-unit tax that consumers pay relative to what they paid
before the tax. Remember, you show this by taking the difference between the final (new) after-tax selling
price and the pre-tax selling price. -Now show in the diagram the total tax (not the per-unit tax) paid for by consumers. (Remember, all you do
is multiply this per-unit tax times the new Q*(social), which is the area of ___________.) (d) Now identify in the diagram the per-unit and total tax paid for by producers. (e) So, given your answers to (c) and (d), who pays the bulk of this tax? And why? (Check out your Week 3
notes about this topic.) 5. (Externalities – with a review of “normal goods”) As we discussed briefly in class, while a good number of developed nations enact regulations to enhance climate
change, developing countries (nations with low per-capital levels of income) are not as wont to do so, since they
place greater priority on growing their economies than on environmental protection. It turns out that you can use
your newly acquired knowledge over the past seven weeks to explain why! (a) First, what is a “normal good.” If necessary, refer back to our Week 2 discussion of markets. Or look at
Evaluation 1! (b) Would you consider environment protection to be a normal good? Why or why not? (c) If your answer to (b) is in the affirmative, how might this help explain the divergence of environmental
regulatory activity between developed and developing countries, as referenced above? (d) Finally, how might the marginal benefit curve and marginal social curves of “environmental protection”
(pollution reduction) change as nations grow, i.e., as their income per capita increases? Show and explain
using the diagram below. P ($/pollution reduction) S = MC (fixed input prices and technology) P* (pri) D = MB (low level of income per capita) Q* Q (pollution reduction = environmental protection)

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