Question 1

The consumption of alcohol creates a negative extemality because of car accidents caused by drunks. This clearly has a negative effect on the victims of the drunk driver and on society in general through hospital and emergency service costs. a) Could placing a tax on alcohol be a socially optimal response to this action? Using an appropriate diagram, show how a (per-unit) tax might help to 'internalise' the externality. (4 marks) b) Would the Coase theorem provide a good solution to the externality in this situation? Why or why not? Explain. (2 marks) c) Ambrose is a responsible drinker. He likes an occasional glass of wine but never drives if he has had any alcohol to drink. He claims that using a tax to prevent drink-driving is both unfair and inefcient. Show that taxing all alcohol cannot eliminate all dead weight loss if there are both irresponsible people who drink and drive and responsible people like Ambrose. (4 marks) Suppose Pening Island is sewed by many independent coffee-shops that sell generic (or, standard) cups of coffee only, with identical and rising marginal cost. a) Use a diagram of the market for coffee (drink) to show the consumer surplus, producer surplus and social (or, total) surplus. (2 marks) b) What would happen to consumer surplus if there were an influx of avid coffee-drinking tourists into Pening Island? Illustrate using a new diagram. (3 marks) c) Now, suppose that a very wealthy entrepreneur (Mr. Ronald K. Frump, who always seeks to maximise prots) acquired all the independent coffee-shops in Pening Island, and combined them into one chain that sells generic cups of coffee at only one price. Use a new diagram to explain the following: i. What is the relationship between the price and marginal revenue? Briey explain. (1 mark) ii. Analyse the welfare implications (i.e. the impact on consumers, producers, and the coffee-drink market as a whole) of this merger, and compare those with the initial situation in part (a). (4 marks)