5. Using a well-labeled diagram, show how inefficiency can be corrected in a perfectly competitive market via: i) a tax on a good that has a negative external cost; ii) a subsidy for a good with a positive external benefit. Price Quantity Price Quantity

1. Externalities - Definition and examples An externality arises when a firm or person engages in an activity that affects the wellbeing of a third party, yet neither pays nor receives any compensation for that effect. If the impact on the third party is adverse, it is called a externality. The following graph shows the demand and supply curves for a good with this type of externality. The dashed drop lines on the graph reflect the market equilibrium price and quantity for this good. Adjust one or both of the curves to reflect the presence of the externality. If the social cost of producing the good is not equal to the private cost, then you should drag the supply curve to reflect the social costs of producing the good; similarly, if the social value of producing the good is not equal to the private value, then you should drag the demand curve to reflect the social value of consuming the good. ? PRICE (Dollars per unit) QUANTITY (Units) Supply Demand Demand Supply With this type of…

1. Suppose market demand for gasoline is given by QD = 60-2P where QD is quantity demanded and P is the market price. Market supply is given by Qs = 4P where Qs is quantity supplied and P is the market price. (a) Find the equilibrium price and quantity in this market. (b) What is the consumer surplus and producer surplus? (c) Suppose that the government imposes a $3 tax on the good, to be included in the posted price (i.e. tax paid by suppliers). What is new equilibrium posted price? How much of that price do producers keep? What is the new market equilibrium quantity? What is the change in surplus for consumers? What is the change in surplus for producers?

B. Let’s consider the market for flour in a different town. Assume that it is efficient (i.e. that there are not external costs to producing flour, and no external benefits from consuming it). Price ($/lb) Quantity Supplied (thousands of lbs per day) Quantity Demanded (thousands of lbs per day) 1.5 8 14 2 9 13 2.5 10 12 3 11 11 3.5 12 10 4 13 9 What is the price and quantity of flour sold without government intervention. Graph this equilibrium. XXXX   2. Suppose that, alarmed by the inability of many poorer consumers to buy flour, the government institutes a $2/lb price ceiling. How much flour will suppliers wish to sell, and how much will buyers demand?  How much flour will actually be sold? Show this outcome on the same graph you drew for question 1. XXXX 3. Describe, in one sentence each, three problems that this policy might create? Please do not simply copy down phrases from the textbook, but instead describe ways that…