Practice Questions Chapter 1 1. People respond to incentives ...

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2. Suppose citizens living around Metropolitan Airport value peace andquiet at a value of €3 billion.a. If it costs the airlines €4 billion to make their planes quieter (the airlinesvalue noise at €4 billion), is it efficient for the government to requirethat the planes be muffled? Why?b. If it costs the airlines €2 billion to make their planes quieter, is itefficient for the government to require that the planes be muffled?Why?c. Suppose there are no transaction costs and suppose that people havethe right to peace and quiet. If it costs the airlines €2 billion to maketheir planes quieter, what is the private solution to the problem?d. Suppose there are no transaction costs and suppose that airlines havethe right to make as much noise as they please. If it costs the airlines€2 billion to make their planes quieter, what is the private solution tothe problem?e. Compare your answers to (c) and (d) above. What are the similaritiesand what are the differences? What general rule can you make fromthe comparison?f. Suppose it costs the airlines €2 billion to make their planes quieter. If aprivate solution to the noise problem requires an additional €2 billion oftransaction costs (due to legal fees, the large number of affectedparties, and enforcement costs) can there be a private solution to theproblem? Why?3. Suppose there are four firms that each wish to dump one barrel ofwaste chemicals into the river. Firm 1 produces a product that is sovalued by society and sells for such a high price that it is willing to pay€8 million to dump a barrel. Firm 2 produces a somewhat less valuableproduct and is only willing to pay €6 million to dump a barrel. In similarfashion, suppose firm 3 is willing to pay €4 million to dump a barrel andfirm 4 will pay €2 million.Practice Questions to accompany Mankiw & Taylor: Economics 26
a. Draw the demand for the right to pollute in Exhibit 2.Exhibit 2b. Suppose the government’s environment protection directorateestimates that the safe level of pollutants in the river is 3 barrels. Atwhat value should they set a Pigovian tax?c. Suppose the government’s environment protection directorateestimates that the safe level of pollutants in the river is 3 barrels. Howmany tradable pollution permits should they allocate? At what price willthe permits trade?d. Compare part (b) and (c) above. How many barrels are dumped ineach case? What is the price paid to pollute in each case? Is there anadvantage to one method of internalizing the externality compared tothe other?Practice Questions to accompany Mankiw & Taylor: Economics 27
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