A. Suppose the demand for electricity in some large community is given by the following demand function P = 1200 – 0.4Q. If the supply function is given by P = 400 + 0.6Q. These are both private market valuations. Electricity generation is given for both functions in thousands of kilowatts, and involves the emission of sulfur dioxide into the atmosphere which has been linked to the prevalence of acid rain in the area. The marginal external damage associated with the harmful effects to the community from acid rain is $50 per thousand kilowatts generated.

1. What is the market determined quantity of electricity that will be generated in this community? What is the market price?

2. What is an externality? How does the association of sulfur dioxide emission with electricity generation affect the efficiency of the market generated allocation?

3. Provide a graph model of the market allocation and the externality described in this market clearly demonstrating the correct outcomes from part (1) and part (2).

4. Explain why the private solution provided by the Coase Theorem may not be applicable for resolving this problem.

5. Suppose the government imposes a Pigovian tax on electricity generators equal to $800 per thousand kilowatts generated. Discuss first what such a policy means intuitively, and second, why that is not an efficient solution to the problem.

6. Assuming that tradable permits are not feasible as a policy instrument in this economy, describe a market based policy instrument that might be successfully implemented in this community by the government that would address efficiently the externality. (Provide the exact policy recommendation and explain why it maximizes society’s net benefit)

7. Demonstrate using the analytics of consumer, producer and total surplus, why the market allocation is inefficient and how the correct policy implemented achieves efficiency (i.e. provide a welfare economics numerical explanation for the correct answer to part (6)