ECON 431 Midterm: ECON 431 Cal Poly SLO 2004 MidtermSolutions
Document Summary
In a production externality situation, an unregulated competitive market will always produce a larger quantity than the socially optimal (welfare maximizing) level. Competitive markets will under-produce quantity in a positive externality situation. If a regulator does not know a firm"s demand for pollution, but believes it to be elastic, then the regulator should favor a standard over a tax as a method to reduce pollution. With elastic demand conditions, a 1% increase in price leads to greater than 1% reduction in quantity. So a mistake in the pollution price under a tax leads to a larger than proportional mistake in quantity and a standard is always better. A local waste-hauling company collects trash and dumps it in the municipal. A bad odor rises from the landfill and crosses into a neighboring subdivision where it decreases the value of people"s homes. Because this value is reflected in the housing market, this is an example of a pecuniary externality.
