Reference no: EM131244281
Maggie likes her cigars. Her demand for cigars is MRSXC = 60−C, where X is the amount of money for all other goods she is willing to give up for an additional cigar. Rui only consumes X, but for each cigar Maggie smokes, Rui’s cost is MRSXC = −3C, i.e., the marginal external cost to Maggie’s cigar smoking is 3C to Rui.
(a) How many cigars would Maggie be allowed to smoke in the social optimum?
(b) If Maggie is allowed to smoke as many cigars as she wishes, how many cigars will she smoke? What is the total benefit Maggie obtains? What is the total cost Rui suffers? What is the dead-weight-loss relative to the social optimum?
(c) Suppose a law is passed which makes cigars illegal, so that C = 0. What is the total benefit Maggie obtains? What is the total cost Rui suffers? What is the dead-weight-loss relative to the social optimum?
(d) The law is now before a judge, whose only concern is to find the solution that maximizes the joint welfare of Maggie and Rui, but whose only recourse is to either declare the law legal or not. Explain how transactions costs should affect the Judge’s decision.
(e) Suppose that after the tax has been imposed, an itinerant economist is hired to study the situation and her report states that transactions costs are zero. Given this conclusion, what would be her recommendation as to the value of the tax on cigars? Explain.
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