Homework 7: Policy Tools; Financial Covering Part 7 Let's return to homework's 4 and 6. If you still have them, you can save time by starting with your answers from there. We will start with the same supply and demand functions for the U.S. wheat market: Demand: P=7-2Q Supply: P=4+Q Where P is output price in $/bushel and Q is billions (1,000,000,000s) of bushels. 1. Suppose there is a negative externality associated with wheat production. The costs that it imposes on society from water quality and soil erosion issues are estimated to be $1.50 higher per bushel than the private costs reflected in our supply function. a. How much is the total estimated externality cost being borne by society? (hint: the per bushel externality cost time the total bushels produced at market equilibrium) b. What do we call a tax that is designed with a goal of correcting for a negative externality? . How much would such a tax have to be to achieve this goal in this market? 2. Using a unit excise tax of $1.50, a. Determine what the new market-clearing price, Pjx, and quantity, Ques, would be. (Please show your work both graphically and algebraically.) b. Show the impact of this tax policy on social welfare using your graph and the following table. Using letters to denote areas on the graph like we did in class, calculate the changes in consumer surplus, producer surplus, government costs/revenues, and deadweight loss: o How much is the deadweight loss? d. Comparing this deadweight loss to the total externality cost that we found, is this policy justifiable from the point of view of the social contract approach? Which welfare criterion are you using? e. Who really bears the burden of this tax? i. Consumers, or producers, or both? ii. Show how much of the tax burden each bears. (It is sufficient to indicate the areas on the graph. You do not have to compute the actual values). iii. Who bears more? Why? What causes them to bear more of the tax burden? 3. Suppose that instead of a unit excise tax we opted instead for a carefully calibrated ad valorem excise tax that would achieve the same after-tax market equilibrium. Using a dashed line on the graph, show what an ad valorem excise tax on wheat would shift, and how. 4. We could use price supports (a type of subsidy) to get the price up to the same level as we did in question 2 above (i.e., up to Puy). Consider how the tax is different from the price support subsidy in terms of social welfare impacts: a. Who wins, who loses under the tax versus the subsidy? b. How does the deadweight loss of the tax compare to the deadweight loss of a price support subsidy? (hint: look at the graph and table for Price Supports in the Course Notes and compare with the graph and table in question 2 above) Why, in social welfare terms, is a tax a better than a subsidy? d. To what extent does a price support help achieve our goal of fixing the negative externality? e. There may be other reasons, in general, for preferring a tax rather than a subsidy. For instance, what are some general problems we might encounter with a wheat subsidy that we wouldn't get with a wheat tax? o 6. Compare and contrast a price support with a deficiency payment. a. Which has the great dead weight loss, why? b. Which is more preferable to e Consumers o Taxpayers e Producers