1. The Sit ‘N Sip Tearoom has an outdoor deck where customers can sit outside on
ID: 1204792 • Letter: 1
Question
1. The Sit ‘N Sip Tearoom has an outdoor deck where customers can sit outside on nice days and sip their tea. Next door to the tearoom is the Flowerchild Nursery, which grows flowers for sale to florists. Using the ideas of social and private benefits, which company seems more likely to provide positive externalities for the other? Briefly explain.
2. The Gizmo Company is looking at plans for developing many new household gadgets. The table below shows the company’s demand for financial capital for research and development of these gadgets, based on its expected rates of return from selling them. However, say that every investment would have an additional 5% social return: that is, an investment that pays at least a 6% return to the Gizmo Company will pay at least an 11% return for society as a whole, an investment that pays at least 7% for the Gizmo Company will pay at least 12% for society as a whole, and so on.
Value of R&D Projects That Provide at Least This High a Private Rate of Return
Estimated Rate to the Gizmo Company
of Return (measured in millions of dollars)
10% $100
9% $102
8% $108
7% $118
6% $133
5% $153
4% $183
3% $223
a. If the opportunity cost of financial capital for the Gizmo Company is 9%, how much will it invest in R&D if it receives only the private benefits of this investment?
b. In the table, the numbers in the second column are rising as the numbers in the first column are falling. What’s the economic reasoning behind this pattern?
c. How much will the firm invest if it also receives the social benefits of its investment?
d. Sketch two demand curves of the Gizmo Company for financial capital to finance R&D, one demand curve based on private benefits to the company and one based on social benefits. Add the supply curve for financial capital faced by the firm and identify the equilibria
Explanation / Answer
(1) Flowerchild provides positive externality to Sit N Sip. This is because, customers of Sit N Sip can enjoy the visual beauty and fragrance of flowers from Flowerchild while having tea, not requiring to pay anything extra for enjoying the sensory pleasure obtained.
(2)
(a) If opportunity cost is 9%, investment = $102 million
(b) The reason behind this inverse relationship is that, as rate of return falls (rises), it requires a higher (lower) value that the project must generate to earn this return.
(c) If he also receives social benefits, social opportunity cost falls from 9% to (9 - 5)% = 4%. At 4% rate, required value is $183 million.
NOTE: First question is answered & first 3-sub-parts of 2nd question are answered.
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