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Tutorial 2: Solutions
For discussion week 3, relevant for Quiz 2
Question 1: Pareto Improvements
This question is based on Kolstad, Chapter 4, Problem 1
Reproduce the diagram below, then find and label the following points:
1. a point D such that Z and Y are Pareto preferred to D, but S is not.
2. a point E such that BZ is the portion of the Pareto Frontier which are Pareto improvements on E.
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Question 2: Efficiency and Externalities
1. List examples of the private benefits and costs for cigarette consumers. What about producers?
Also list examples of the external benefits and costs of cigarette consumption.
2. It’s 1950’s Australia and society is unaware of the health costs associated with smoking. The
marginal private benefit of cigarette consumption is MPB(q) = 45? 4q, where q is the quantity of
cigarettes smoked. Competitive suppliers import cigarettes, and the import cost (marginal private
cost) is constant for all quantities q. Specifically, MPC(q) = 5.
(a) Sketch the market for cigarettes - including the private demand and supply curves, and the
consumer and producer surplus.
(b) Calculate the efficient level of cigarette consumption for this society, from this society’s per-
spective (i.e. ignoring any health costs). Give an intuitive explanation as to whether this
quantity would be supplied by a competitive market.
3. Health experts discover that the cigarettes cause health problems for smokers. Specifically, $12 of
damage is done to smokers for each unit of cigarettes consumed.
(a) What is the efficient level of smoking given new this knowledge? Calculate the quantity and
show it on your diagram.
(b) What is the level of smoking that would arise in a competitive market? Mark the deadweight
loss on your diagram (if any).
4. Health experts make an additional discovery - that smoking also causes health problems for non-
smokers who spend time around smokers. Specifically, they find that $8 of damage is done to
non-smokers per unit of cigarettes smoked by their peers.
(a) What is the efficient level of smoking? Calculate the quantity and show it on your diagram.
(b) What is the level of smoking that would arise in a competitive market? Mark the deadweight
loss from this level of smoking on your diagram (if any).
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Question 3: Externalities
Which of the following statements are true? Explain why it is true or false.
The external cost of the pollution created by a steel factory:
1. is larger if the wage paid to the factory workers is higher.
2. would shrink if the same factory moved from a populated area to a rural area.
3. is smaller if the exposed population have a large b1 based on the equation:
sickness = b0 + b1 × (pollutionexposure)
4. would shrink if the government introduces a pollution tax.
5. is likely to increase during economic booms and to shrink during recessions.