MM5006

Assignment 4B

1. The following table shows the marginal private cost (MPC) and the marginal social cost
(MSC) of a chemical factory.

Tons of Chemicals MPC MSC

1 100 120

2 110 130

3 120 140

4 130 150

5 140 160

Answer the following questions:

a. What is the marginal cost of the factory’s externality? Is it constant at all quantities?
b. If the factory is a perfectly competitive firm and is not required by the government
to internalize its external cost, how many tons should the factory produce, given that
the market price of a ton of chemicals is $130?
c. If the factory is a perfectly competitive firm and is required by the government to
internalize its external cost, how many tons should the factory produce, given that
the market price of a ton of chemicals is $130?
d. Draw a graph illustrating your answers.

2. Wearing a light long-sleeved sweater adds about 2 degrees of warmth to the wearer
and allows such individuals to keep their homes at 2 degrees lower temperature. Such
sweaters cost approximately $20, or three for $60. The 2 percentage point decrease in
heat can save, maybe, $200 a year in heating bills.
a. If the government is interested in saving electricity, should it require people to wear
such sweaters and keep their homes 2 degrees cooler?
b. What are two alternatives to this regulation?
c. If it is cheaper to keep warm with sweaters than with furnaces, why don’t people
voluntarily wear more sweaters?

3. A local energy provider offers a landowner $180,000 for the exploration rights to natural
gas on a certain site and the option for future development. This option, if exercised, is
worth an additional $1,800,000 to the landowner, but this will occur only if natural gas is
discovered during the exploration phase. The landowner, believing that the energy
 company’s interest in the site is a good indication that gas is present, is tempted to
develop the field herself. To do so, she must contract with local experts in natural gas
exploration and development. The initial cost for such a contract is $300,000, which is
lost forever if no gas is found on the site. If gas is discovered, however, the landowner
expects to earn a net profit of $6,000,000. Finally, the landowner estimates the
probability of finding gas on this site to be 60%. Create a payoff table that specifies the
landowner’s payoff (in dollars) associated with each possible decision and each outcome
with respect to finding natural gas on the site.

4. Pizza King (PK) and Noble Greek (NG) are competitive pizza chains. Pizza King believes
there is a 25% chance that NG will charge $6 per pizza, a 50% chance NG will charge
$8 per pizza, and a 25% chance that NG will charge $10 per pizza. If PK charges price
p1 and NG charges price p2, PK will sell 100 + 25(p2 – p1) pizzas. It costs PK $4 to make
a pizza. PK is considering charging $5, $6, $7, $8, or $9 per pizza. To maximize its
expected profit, what price should PK charge for a pizza?