When estimating the costs of the CAF standard, the NHTSA assumed that other vehicle features would remain constant. Some claim this assumption is false and

When estimating the costs of the CAFÉ standard, the NHTSA assumed that other vehicle features would remain constant. Some claim this assumption is false and NHTSA underestimated costs. Assume hypothetically that NHTSA estimated the marginal cost of abatement as:

MC(a) = a

Automakers claim their marginal cost is actually:

MC(a) = 2a

Further, households have a marginal benefit of abatement of:

MB(a) = 60-a.

Congress decides to intervene and set a tax or use an abatement credit (i.e. permit) system (instead of the CAFÉ performance standard). There is a 50 percent chance that either of the marginal cost curves is true.

a. What is the expected deadweight loss if Congress uses a tax and no other instrument to achieve the optimal level of abatement? Shade and label this area on the graph and give a value.

b. What is the expected deadweight loss if Congress chooses to issue abatement credits (i.e. permits) and no other instrument to reach the optimal level of abatement? Shade and label this area on the graph and give a value.

c. Suppose instead that marginal benefit is really inelastic (i.e. steep slope). On a new set of axes below, draw this scenario with the original marginal cost curves and new marginal benefits curve. You do not need to use a specific equation, just draw a really steep marginal benefit curve. In this scenario, is it better to use a Pigouvian tax or a cap and trade system? Explain.

d. Now suppose Congress is absolutely sure that MC(a)=a. But an environmental group argues that marginal benefit is much higher. There is a 50 percent chance that marginal benefit is either:

MB(a) = 60-a

MB(a) = 80-a

Is it better to use a Pigouvian tax or an abatement credit system in this scenario? Explain.