Consider two firms: a yoga studio and a bar. The bar produces noise which reduce
ID: 1192772 • Letter: C
Question
Consider two firms: a yoga studio and a bar. The bar produces noise which reduces the price that the yoga studio can charge from its customers.
(a) Assume that the bar can sell an unlimited amount of drinks at the market price p and its marginal cost increase in the quantity of drinks. Assume further that the marginal damage to the yoga studio is a constant amount x per drink. Draw the demand curve of the bar, the marginal cost per drink, the marginal external cost, and the marginal social cost. Indicate in the graphic the quantity of drinks in the competitive market equilibrium and the welfare-maximizing quantity of drinks.
(b) Explain why the welfare-maximizing quantity of drinks is welfare-maximizing.
Explanation / Answer
Bar's profit = Qd(p) - Cost(Qd)
Yoga studio's profit, = p(Qd)(no. of customers) - xQd
xQd is the social cost that yoga studio is bearing
Demand curve of the bar is perfectly inelastic as it can sell any amount as market price p.
Marginal cost per drink = dcost(Qd)/Qd
Marginal social cost = x
Marginal external cost = marginal cost + marginal social cost
b) Welfare maximizing quantity of drinks is when marginal external cost is minimized.