In August 2014, Tesla announced a new "Infinite Mile Warranty". A Forbes article reported: "Tesla

announced that it would extend the warranty on the drive unit of its Model S cars to match the battery

pack's 8 years and unlimited miles with no limit on the number of owners. This will apply to new Model

S models and all ever produced." (Chuck Jones, Forbes, Aug 18, 2014)

(a) Suppose that without the new warranty, demand for Tesla's model S car is given by:

P = 200 2Q, where P is in thousands of dollars per car, and Q is in thousands of cars. Suppose

that prior to the new warranty, marginal cost of production was constant at 32 thousand dollars

per car.

Based on these assumptions, what is profit maximizing price per car for Tesla without the new

warranty? What quantity is sold? What is the producer surplus from sale of the model S? Fill in

your answers in the box below and explain using a clearly labelled illustration.

Price (in thousands of $ per car) =

Quantity (in thousand) =

Surplus (in $ millions) =

(b) Suppose that offering the eight year, unlimited mileage warranty increases willingness

to pay for each potential customer by 10 thousand dollars, so that the inverse demand curve shifts

up vertically by 10 thousand dollars.

Assume also that the cost of offering the warranty varies with mileage accrued by customers, at a

rate of $1 thousand per ten thousand miles. Tesla's estimates show that the average customer of

their Model S would drive about 60 thousand miles in eight years. So all-in-all the expected cost

to Tesla of the extended warranty is $6 thousand per car.

Assume there are no other additional costs involved with offering the extended warranty, and that

Tesla is risk neutral.

Would Tesla's surplus increase, decrease, or remain the same if they offered the warranty? What

would be the amount of the change in surplus? Explain.

Surplus would: Increase, Decrease, Remain the same?

Change in surplus (in $ millions) =

(c) Recent articles suggest that Tesla's extended warranty may be costing the company

more than anticipated. An article in October 2017 on Seeking Alpha noted that in particular,

taxi and ride sharing service drivers are buying the model S, attracted by the unlimited mileage

warranty.

Suppose that, due to larger than expected purchases by higher mileage owners, Tesla revises its

estimate of the mileage usually driven during the eight year warranty period to 120,000 miles (up

from 60,000 miles). Suppose that demand, the cost of the warranty per thousand miles, and all

other costs stay the same as in part (b) above.

Under the revised cost assumptions would Tesla's surplus increase or decrease or remain the same

if they offered the warranty compared to if they didn't? Explain.

Surplus would: Increase, Decrease, Remain the same?

(d) An estimate by the American Lung Association suggests that the health costs associated

with burning a gallon of gasoline in cars is $1.30. Suppose that the gas mileage of the average car

replaced by the Tesla S is 30 miles per gallon, and suppose that the Tesla S (which uses no gas

at all) is driven an average of 150,000 miles over its lifetime.

It's not all good news: producing the electricity to charge Teslas produces pollution. Suppose that

producing the necessary electricity to charge a Tesla imposes a cost on society equal to $0.01 per

mile driven by the Tesla.

Given these estimates, does the sale and use of each Tesla overall produce a positive or negative

externality? What is the amount of the externality? (Hint: There's a trade-off here; Teslas don't

use gas, but they the charging stations do create pollution. You can also ignore discounting. Do

not make any other assumptions than what is given here.) As a result, relative to the social

optimum, what can we say about the quantity of Tesla S's sold in the market?

Overall externality is: Negative, Positive,Zero?

Overall amount of externality per Tesla =

Relative to the