A large city currently provides free water service to residents. The marginal social cost of making a gallon of water available per month is estimated to be 5 cents no matter how much water is used. Currently, city residents consume 500,000 gallons of water per month. The costs of making the water available are financed by a local tax on city residents.
a. Draw a graph to show that the current monthly consumption of water is not efficient.
b. Show the net gains in well-being possible by applying a user charge of 5 cents per gallon to residential users.
Assume that monthly consumption declines to 400,000 gallons after the user charge is imposed. Calculate the tax revenues that can be freed for other uses each month (including a reduction in taxes to local residents) after the user charge is imposed.