Question

10. (8 points) Consider the following graph depicting the competitive market for oil. Price of Oil ($) Demand - - Supply ***** Social Cost 0 1 10 11 2 3 4 5 6 7 8 9 Quantity Oil (millions of barrels) a. In a free market with no restrictions, what is the equilibrium quantity and price of oil? b. Why does the above graph indicate that there is an externality associated with producing oil? What is the value of the externality? c. What tax rate on oil could the government set that would generate the socially optimal (efficient) level of oil? Be specific. d. How much revenue does the government collect from the tax in part (c)?

Answer 1

(a) In a free market with no restrictions, the equilibrium occurs where demand equals supply. So, the equilibrium quantity = 5 million barrels of oil and equilibrium price = $5.

(b) Because social cost curve lies above the private cost curve (i.e supply curve) , this implies there is an existence of negative externality in producing oil. The value of the externality is equal to $(4-0)=$4 (i.e the difference between social cost and private cost ).

(c) The tax rate on oil should be equal to external cost i.e $4 that would generate the socially optimal level of oil.

(d) The revenue that the government from the tax =$(7-3) million (3)=$12 million.