Economic Analysis Of Externalities, Cost Structures, And Market Outcomes In Steel And Water Supply Industries

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1Economic Analysis of Externalities, Cost Structures, and MarketOutcomes in Steel and Water Supply Industries1. The production of gasoline causes air pollution but the damage from thispollution is not priced and is not factored into the price of gasoline. Markets areinterconnected, and the price of gasoline affects the cost of transportation; the costof transportation affects how easy it is to get people and goods, including food, fromone place to another and thus affects the value of land for housing and the cost offood; the cost of transportation also affects the market for cars and publictransportation; and all of these affect people’s budgets. Given this interconnectionof markets, what are the consequences of an unpriced (and unregulated) externalityin the market for gasoline? If there are competitive markets in all these othermarkets, are they likely to produce an efficient allocation of these other goods?Explain the reasons for your answer.Answer:-###The consequences of an unpriced and unregulated externality concerning the marketprice of gasoline has been existing long and in markets related to energy generation andconsumption, many more distortions tend to come into picture that has the potentiality tocreate opportunities for bettering the situation but that are not considered to beexternalities as these distortions falls outside the purview of the study and the committeethat keeps in touch with them only briefly. It would be a valid attempt if we can try toidentify and quantify at the same time those externalities and that would help inrecognizing the consequences concerning the externality in the market of gasoline.One form of marketdistortions thathas the capability of affecting energy markets is thepresence of market power.In the extreme cases there exista single supplier of energy(monopoly) or s single buyer (monopsony). In such cases a firm having the market powercan affect the price and also the quantity that is being traded to fulfill its own advantagesAnd imply costs on others that exceed its gains. Cartels, such as OPEC, or largepurchasers of oil, such as the United States, can exhibit market power.Another form of market distortion that can greatly impact the energy markets is theenforcement of taxes or subsidies that do not help at all in correcting externalities butrather are imposed to augment revenue and thereby aiding support to an industry or servesome otherpurpose. Theprimary concern of this is the subsidies for oil exploration haveencouraged the swift expansion of the petroleum basedindustry and hence raising thevolume of externalities generated by the production and consumption of petroleum andpetroleum basedresources.Information asymmetries and public goods are two additional cases of market failure thatcould affect energy markets. So, from thisstudy, we quantify to the extent possible thenointernalizedexternalities conditional on the existing set of market regulations, taxes,subsidies, and market distortions from all sources.

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2###Now, if thereare efficient allocations for all other services in the other markets then itis possible to generate an efficient allocation of gasoline. For example, increased cornprices owing to the production of bio-fuels do not gives a broad picture as they tend toresult from the proper functioning of the market. This is not to actualize and say thathigher corn prices are unimportant or it should npt be looked upon from the standpoint ofpublic concern and policy. But still there exist no market failure to correct nor is there anexternality to internalize. Another vital example can be put here regarding the distortionof social costs across space, time or varying population groups but the fact of the matteris that such distributional issues may become of great concern to policy markets but thesebarely represent externalities.2. [Based on BH pp 201-217] The Stalin Steel Company burns coal in its factory to producesteel. But, it is now required to abate the emissions from its use of coal.(a) Suppose this emissions reduction raises (i) only Stalin’s fixed costs of production, or (ii)only Stalin’s variable costs of production, or (iii) both Stalin’s fixed and variable costs ofproduction. In each case, using both words and the appropriate diagrams, explain howemission reduction affects Stalin’s supply curve of steel.(b) Stalin Steel is one of three firms that make up the Slovakian steel industry, and the othertwo firms already meet emission restrictions for the production of steel, and therefore faceno change in their cost of production. Using both words and the appropriate diagrams,explain how Stalin’s emission reduction affects Slovakia’s steel industry supply curve.(c) The Slovakian steel industry grows over time as the economy expands, the demand forsteel increases, and new firms enter the steel industry, new factories are built and oldfactories sometimes shut down. Pollution control regulations also change over time, andbecome more stringent. In its planning for a new round of tighter air pollution controlregulations on its steel industry, the Slovakian government is considering grandfatheringthe original three firms in the Slovakian steel industry. How would grandfathering affectthe steel industry (the original three firms, firms that entered the steel industry later, andfirms that are thinking of entering the steel industry). How would grandfathering affectconsumers of steel? How would it affect the rest of the Slovakian public?Answer:-(a)This can be illustrated on the basis of the following supply curve for steel productionthat shows the amount of revenue generated in the y axis and the no of unit sold in the xaxis. As can be seen if the fixed cost of production of the company is increased then theamount of revenue gained from the selling of steel is lessened as the volume ofsellingisnot mentioned to be getting altered here. So, if the fixed price is taking a upper turn thevolume of revenue would come down.

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3On the contrary if the fixed cost remains stagnant due to the changes and only changeoccurs in variable component then also the volume of revenue obtained from the sellingof steel declines but not to a great extent as variable cost generally is not going to surpassthe fixed cost and is quite less in comparison to the fixed cost and liabilities. So, theultimate effects of variation in the margin of operating gain from the selling of steelwould not get a huge downfall if only the variable cost rises keeping the Fixed costunchanged.Lastly, if in some circumstances both the costs rises it can then create problem as it mayso happen that total cost of production(that is combination of Fixed and variable costs)may well surpass the total profit earned from the sales and this is a crisis for the companysince it creates a no gain situation for it as there is no profit.(b)As per the information provided within the question, it is evident that barring the Stalinand Slovakian steel industries the other two steel industries are not coming into thepicture from the standpoint of comparison since the other two concerns has alreadyreduced down the effect of extra cost owing to the fact that they already abiding by theemission restrictions for a long period but for Stalin and Slovakian steel industries sincethey have recently put into the venture so the comparison would mainly revolve aroundthese two.

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4Two scenarios may arise here. If the cost ofemissionrestriction is large so that the totaloperating costis large for Slokian steel then the profit margin of it will be lower incomparision to Stalin industries and this fact is pictorially a shown in the upper leftcorner of the diagram.On the contrary if the reverse thing happens that is if the total operational costs of Stalinsteelindustriesbe greater than the Slovakian steel industries then the plot would look likewhat is shown above in the upper right corner of the plot. And as can be seen that thetotal cost curve of the Stalin steel industries is lying above that of the Slovakian steel.(c)Grandfathering greatly affects steel industries. Steel has superseded the entire markettoday. It is everywhere. It is present in the car that we drive. It is in the building where welive and work. It is present in the tools and equipment that we use in every day basis.Steel industry of today is really exciting and competitive globally and in this contextwhen there is emergence of new steel industries, it is inevitable that they would face steepchallenges from the other steel industries that are already present in the market. Forexample, here the Stalin and the Slovakian steel industries are quite new in the marketwhere as the other two steel industries have been doing their business for long and here ifthere is no grandfathermeaningany support or back up plan for the new ones then theywould at some point of time feel the peer pressure originating from maintaining the sameselling price keeping in with those of the other two steel industries and sometimes this isdone even though it may incur some losses for the company for a short while.On theother hand if grandfathering effect is present for the newly formed steel industries then itwould be really easy for it tospread itself effectively in themarketplace.Grandfathering may affect the consumer of steel in a variety of ways. It is not alwayspossible for an individual consumer to scan through the entire market to know in detailwhich retailer is selling steel in what price and as the steel prices varies to great dealdepending on basis of locality so the consumer located in some state may have to shellout some extra money where as the other consumer may have been expending less for the

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5same and all this originates from the grandfathering effect since it is the effect ofgrandfathering that hascreated the kind of anomaly of prices of steel in the market.This would not expected to affect the Slovakian people too much since the steel industrybased in Slovakia is quite oldand so it is expected that the steel prices there would bestandardized to a good extent so the consumer would be able to have access tosteel ataffordable prices.3. [See Lecture 2-21, Aggregate Welfare] The Bureau of Reclamation is an agency of theU.S. government that constructs and manages many dams in the western United States. Thewater from its dams is used for irrigating agriculture. Let’s assume that the Bureau isdeciding what size dam to build at a particular location in Wyoming. The water yield, whichwe will assume will sell at a fixed pricePper unit to the farmers, increases linearly with thesize of the dam. Let's assume as well that the costs, as a function of water yield, Q, are U-shaped.(a) Draw the graphs of the average and marginal cost curves as a function of the water yield(Q).(b) If the dam is built, an irrigation district in the area would contract with the Bureau tobuy the water from its dam. Now draw in the district’s demand curve for water, expressedas a function ofP(c) Given these demand and marginal costs curves, use the diagram to identify the amountof water the Bureau would plan to sell (the water yield that it would select for the dam) if itwanted to maximize its profit acting competitively (not as a monopolist). Explain youranswer.(d) Would that amount of water, determined in (c), maximize consumer’s plus producer’ssurplus and therefore be socially optimal? Explain your answer.(e) In fact, the Bureau has been required by Congress to recover its costs rather thanmaximize profits in its water pricing. Recovering its costs means that it must set its prices sothat its revenues exactly equal its costs. Using your diagram, identify the marketequilibrium if the Bureau follows this mandate and engages in average cost pricing.(f) Compare the solution in (e) to the solution in (c). Identify the economic loss–the loss ofconsumer’s plus producer’s surplus from the solution in (e) compared to that in (c)–bothverbally and in terms of an area in your diagram.Answer:-(a)The graphs showing the average and marginal costs as a function of wateryield (Q) is shownBelow.Here Mc stands for short-run marginal costs, ATC average total cost, AVC averagevariablecost;AFC stands for average fixed costs.

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6(b)The district’s demand curve for water, expressed as a function of P (price is depicted in thefollowing diagram.Where Q stands for the quantity of water being purchased and D1 is the demand curve.(c)The maximum optimal profit would be made possible if the company sells water at price P1 as isshown in the plot as it refers to that portion of the plot that demonstrates stability in the marketprices of water. As any price below the P1 say p3 would mean that now more volumes of watercan bepurchased at a lower affordable prices by the customers but that would also mean that forthe company it may not be so suitable as it is having to sell water at lower prices and it may notcreate asuitablesituation for theconcern.

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7Again, if we consider price P2 which is higher as compared to P1 then there would be lesserquantity of consumption of water as is depicted in the graph by the point Q2. This again not agood situation of both from the standpoint of customers and the company. As company notexpected to get now more customers for water and also consumers would find it difficult to shellout more money to get the requisite amount of water.So, the best optimal point is shown by thepoint (P1,Q1) meeting optimality.(d)The answer to this is yes it will create a situation that would enable maximize consumer’splus producer’s surplus and therefore be socially optimalsince the optimal price would see bothends both that of the customer and that of the producer and so on a large scale we can well tellthat is would socially optimal as well as a society formed of many people so when the budget ofevery people is optimized then the optimal cost of the society is also expected to be optimized.(e)In this case as it tries to recover itscost only and not optimize its profits so it would mean thatthe doubling of the cost price of the manufacturing of water would be set as the selling price inthis context. So, here the graph would be as following

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