1. The market for a particular agricultural product is competitive, with a demand curve that often shifts. Each unit of the output is produced with one unit of pollution. A government could reduce the output below the competitive equilibrium level by imposing a unit excise tax on sellers in the market. A regulator of a permit system could obtain the same reduced output level by giving sellers a certain number of tradable permits, making more permits available for purchase and requiring sellers to own a permit for each unit of the product that they sell. This makes it seem as if a permit system can achieve the same outcome as a tax.

a.[10] Show that if the quantity of available permits cannot be changed once it has been set, an excise tax might typically lead to a more socially efficient quantity of output in this market. What properties of the marginal damage from the output and the government's information make this more likely? Illustrate your answer with a graph of PMC, SMC and SMB curves and explain what it is about these curves that makes the tax typically more efficient than the permit system.

b.[10] One possible disadvantage of a tax compared to a permit system as a method of reducing the output is that the sellers' total tax payment and the reduction in their producer surplus could be bigger than the total damage they impose on others. Draw a graph showing how this is possible. Your graph should show PMC, SMC and SMB curves, the size of the tax per unit, the total tax paid by the sellers and the total damage they impose on others. Explain what it is about the marginal damage (MD) and the shapes of the demand and supply curves for the output that make this possible. Rephrase your explanation in every day English so that it could be understood by someone who has studied principles of microeconomics but no other economics (so has not taken this course). In the graphs of tax,MDand lost producer surplus, change shapes of the supply (PMC) curve andSMCcurve to get a smaller total damage that sellers impose and to get a bigger lost producer surplus from the tax.