Exercise 5

Due Monday 2/28

Imagine that you work for an economic consulting company and have been asked evaluate a proposed bus system for a small city. You are given the following pieces of information:

• There are 10,000 people who would use the bus system;
• Each person has an identical willingness to pay for bus trips given by the following equation: P=A - B*Qi , where Qi is the number of trips taken by individual i and A and B are constants that are the same across all individuals;
• The marginal cost of a bus trip is $1 (per person);
• An experimental study of bus ridership by three randomly-chosen individuals has been conducted. Each individual was charged a different price and the number of times he or she rode the bus was observed. The results were as follows: person 1 was charged $1 per ride and took 18 trips, person 2 was charged $0.50 per ride and took 19 trips, and person 3 was charged $1.50 and took 17 trips.

Using the information above, please answer the following questions:

1. Construct the market demand equation for bus trips.
2. Now find the market equilibrium price and quantity. Explain in non-technical language why this quantity is efficient. How much consumer surplus is produced (total, not per person)? How much producer surplus?
3. Now suppose that riding the bus creates a positive externality of $0.50 per trip. Explain in detail why the outcome from (2) is no longer efficient.
4. Given the externality from part (3), suggest a specific subsidy policy that could move the equilibrium to efficiency. Be sure to calculate the numerical value of the subsidy. Explain briefly why your policy would work and use a graph to illustrate your explanation.
5. Finally, thoroughly evaluate the distributional effects of the policy from part (4). Calculate the total amount of the subsidy and explain as specifically as you can where it goes. Use a graph if that would help. What are the pros and cons of the policy?

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