Question

Manufacturing processes that rely on fossil fuels create carbon dioxide and other greenhouse gases that may contribute to global warming. Suppose you are in charge of designing an economic policy to reduce carbon dioxide emissions:

The inverse demand function for fuel is:
P = 18 − Q

The private cost of producing the fuels that emit carbon dioxide is:CP (Q) = 10 + Q^2

Atmospheric scientists have computed that the external cost of fuels (due to greenhouse gas emissions) is:

CE(Q) = 3/2 Q^2

The market for fuels is perfectly competitive.

1

1. What is the market clearing price and quantity if only the private cost is considered?

2. What is the efficient price and quantity if firms consider both the private costs and the external costs (on the environment)?

3. What is the deadweight loss if firms do not take into account the externality? (Note: it helps to draw a diagram and label it, then get the number!)

4. How much should the government tax this good to arrive at the efficient quantity of fuel production? [Hint: the government needs to know the MEC when setting a tax]

Answer 1