Externalities 2683
43. Suppose that Company A’s railroad cars pass through Farmer B’s corn fields. The railroad causes
an externality to the farmer because the railroad cars emit sparks that cause $1,500 in damage to
the farmer’s crops. There is a special soy-based grease that the railroad could purchase that
would eliminate the damaging sparks. The grease costs $1,200. Suppose that the railroad is not
liable for any damage caused to the crops. Assume that there are no transaction costs. Which of
the following characterizes the efficient outcome?
a. The railroad will continue to operate but will pay the farmer $1,500 in damages.
b. The railroad will purchase the grease for $1,200 and pay the farmer nothing because no crop
damage will occur.
c. The farmer will incur $1,500 in damages to his crops.
d. The farmer will pay the railroad $1,200 to purchase the grease so that no crop damage will
occur.
44. Suppose that Charles wants to dine at a fancy restaurant, but the only available table is
in the smoking section. Charles dislikes the smell of cigarette smoke. He notices that only one
person, Sam, is smoking in the smoking section. Charles values the absence of smoke at $40.
Sam values the ability to smoke in the restaurant at $15. Which of the following represents an
efficient solution in the absence of transaction costs?
a. Sam continues to smoke because he has a right to smoke in the smoking section.
b. Charles offers Sam between $15 and $40 not to smoke. Sam accepts, and both parties are
better off.
c. Charles offers Sam between $15 and $40 not to smoke. Sam declines because he has a right to
smoke in the smoking section.
d. Only a government policy banning smoking in restaurants will solve this problem.
2684 Externalities
45. Suppose that Bill wants to dine at a fancy restaurant, but the only available table is in the smoking
section. Bill dislikes the smell of cigarette smoke. He notices that only one person, Peter, is
smoking in the smoking section. Bill values the absence of smoke at $15. Peter values the ability
to smoke in the restaurant at $10. In order for Bill to pay Peter not to smoke, he will need to tip
the waiter $10 to facilitate the transaction. Which of the following represents an efficient solution?
a. Peter continues to smoke because the cost to Bill to pay him not to smoke is between $20 and
$25, which exceeds the benefit to him of no smoking ($15).
b. Bill offers Peter between $10 and $15 not to smoke, and he pays the waiter $10. Peter accepts,
and both parties are better off.
c. Bill offers Peter between $10 and $15 not to smoke, and he pays the waiter $10. Peter declines
because he has a right to smoke in the smoking section.
d. Bill offers Peter $5 not to smoke, and he pays the waiter $10. Peter accepts, and both parties
are better off.
46. Cameron lives in an apartment building and gets a $700 benefit from playing his stereo. Renee,
who lives next door to Cameron and often loses sleep due to the music coming from Cameron’s
stereo, bears a $1,000 cost from the noise. At which of the following offers from Renee could
both Renee and Cameron benefit from the silencing of Cameron’s stereo?
a. $250
b. $550
c. $750
d. $1,020
Externalities 2685
47. Alexander lives in an apartment building and gets a $250 benefit from playing his stereo. Mary,
who lives next door to Alexander and often loses sleep due to the loud music coming from
Alexander’s stereo, bears a $350 cost from the noise. Mary would like to offer Alexander some
money to turn down the volume on his stereo. If Mary had to hire a lawyer to draw up the
contract, what is the maximum amount she could pay to the lawyer to ensure that both Alexander
and Mary would benefit from the agreement?
a. an amount less than $100
b. an amount between $100 and $250
c. an amount between $250 and $350
d. Any amount could result in both parties benefiting from the agreement.
48. Ty lives in an apartment building and gets a benefit from playing his stereo. Olivia, who lives next
door to Ty and often loses sleep due to the loud music coming from Ty’s stereo, bears a cost from
the noise. Olivia is threatening to call the police to force Ty to turn down his stereo. Under which
of the following conditions would Ty be able to offer Olivia some amount of money to keep her
from calling the police and to allow him to continue to play his stereo loudly?
a. The cost of the noise to Olivia must exceed the benefit of the music to Ty.
b. The benefit of the music to Ty must exceed the cost of the noise to Olivia.
c. The Coase Theorem guarantees that Olivia and Ty will always be able to come to an
agreement that keeps Olivia from calling the police regardless of the individual benefits and
costs.
d. The cost of the noise to Olivia must exceed the benefit of the music to Ty by an amount
greater than the transaction costs associated with the agreement.
2686 Externalities
49. Thurman is a writer who works from his home. Thurman lives next door to Phil, the drummer for
a local band. Phil needs a lot of practice to earn $250, which is his share of the band’s profit.
Thurman gets distracted by Phil’s drumming but he needs to get his writing done to earn $500 for
his current article. Which of the following is an efficient solution?
a. Phil offers Thurman $499 to allow Phil to continue drumming. Thurman accepts and both are
better off.
b. Phil offers Thurman $249 to allow Phil to continue drumming. Thurman accepts and both are
better off.
c. Thurman offers Phil $251 to stop practicing his drumming. Phil agrees and both are better off.
d. Thurman offers Phil $501 to stop practicing his drumming. Phil agrees and both are better off.
50. Gretchen is a writer who works from her home. Gretchen lives next door to Randall, the trumpet
player for a local band. Randall needs lots of practice to earn his share of the band’s profit, which
will amount to $350. Gretchen gets distracted by Randall’s trumpet playing but she needs to get
her writing done to earn $570 for her current article. If Gretchen needs to hire a lawyer to help her
reach an agreement with Randall, then what price is Gretchen willing to pay the lawyer?
a. less than $350
b. less than $450
c. less than $570
d. less than $920
Externalities 2687
51. That some firms are engaged in more than one type of business is explained, in some cases, by
a. moral injunctions such as the Golden Rule.
b. the existence of charitable organizations.
c. government regulations that discourage the internalization of externalities.
d. the fact that the internalization of externalities sometimes coincides with the self-interest of the
relevant parties.
52. The Coase theorem asserts that, in the presence of externalities,
a. private economic actors sometimes can reach a bargain that produces an efficient outcome.
b. private economic actors always can reach a bargain that makes everyone better off.
c. private solutions cannot be very effective.
d. corrective taxes cannot be very effective.
2688 Externalities
53. When the government reduces my income tax by $0.30 for every $1.00 that I contribute to a
charity, the government is effectively
a. alleviating the negative externalities that are associated with charitable giving.
b. imposing a negative externality on those who do not pay income taxes.
c. encouraging a private solution to a positive–externality problem.
d. encouraging a private solution to a negative-externality problem.
54. When a particular negative externality affects a very large number of people, it is likely that
a. government will not find it worthwhile to impose a corrective tax.
b. private solutions to the problem will dominate any attempt by government to alleviate the
problem.
c. the solution to externalities suggested by the Coase theorem will work very well.
d. the solution to externalities suggested by the Coase theorem will not work.
Externalities 2689
55. The Coase theorem asserts that, if externalities are present and if private parties can bargain over
the allocation of resources at no cost, then
a. the private market will reach an equilibrium in which resources are allocated inefficiently.
b. the private market will reach an equilibrium in which resources are allocated efficiently.
c. the private market cannot reach an equilibrium.
d. a mixture of corrective taxes and subsidies is necessary for a socially optimal equilibrium.
56. Which of the following statements about the Coase theorem is true?
a. Underlying the results of the Coase theorem is the idea that private parties can bargain without
cost over the allocation of resources.
b. The Coase theorem asserts that private solutions to externalities invariably lead to inefficient
allocations of resources.
c. The Coase theorem applies to negative externalities, but not to positive externalities.
d. All of the above are correct.
2690 Externalities
57. The Coase theorem asserts that the private market will always solve the problem of externalities
and allocate resources efficiently
a. even if private parties experience substantial costs of bargaining.
b. even if the initial distribution of legal rights is skewed in favor of some private parties over
others.
c. only when there is a large number of private parties that engage in bargaining.
d. All of the above are correct.
58. By allowing an income-tax deduction for charitable contributions, the government
a. encourages a private solution to a particular positive-externality problem.
b. discourages a private solution to a particular positive-externality problem.
c. encourages a private solution to a particular negative-externality problem.
d. discourages a private solution to a particular negative-externality problem.
Externalities 2691
59. When the government uses a command–and-control policy to solve an externality, it
a. is usually the most effective policy option available.
b. creates policies that directly regulate behavior.
c. usually involves taxing the consumption of a commodity.
d. typically refers to the Coase theorem to structure the policy.
60. A local manufacturing plant that emitted sulfur dioxide was forced to stop production because it
did not comply with local clean air standards. This decision provides an example of
a. a direct regulation of an externality.
b. corrective taxes.
c. a Coase theorem solution to an externality.
d. the misuse of a subsidy.
2692 Externalities
61. If the government were to impose a fine of $4,000 for each unit of air-pollution released by a
fertilizer plant, the policy would be considered
a. a subsidy.
b. a regulation.
c. a corrective tax.
d. an application of the Coase theorem.
62. In Singapore, littering fines are strictly enforced. This is an example of a policy that
a. relies on moral codes to reduce the pollution externality.
b. relies on the Coase Theorem.
c. discriminates against foreigners.
d. relies on incentives to reduce the pollution externality.
Externalities 2693
63. A corrective tax is also known as:
a. a command–and-control regulation.
b. a Coase tax.
c. a Pigovian tax.
d. a Smithian tax.
64. Which of the following statements is not correct?
a. Patents help internalize the externalities associated with technological advances.
b. Economists typically prefer regulations to corrective taxes because regulations provide more
incentives for firms to seek continued reductions in pollution.
c. Allowing firms to trade pollution permits will lower the total cost of reducing pollution.
d. A big impediment to implementing the Coase theorem in many cases is high transactions costs.
2694 Externalities
65. Once tradable pollution permits have been allocated to firms,
a. the government controls the price of permits.
b. firms that can reduce pollution only at high cost will be willing to pay the most for the pollution
permits.
c. the value of pollution-saving technology will be lower than the market value of a pollution
permit.
d. the Coase theorem is no longer applicable as a solution to reducing pollution.
Multiple Choice – Section 03: Private Solutions to Externalities
1. In markets, the invisible hand allocates resources efficiently
a. in all cases.
b. when the buyers and sellers are the only interested parties.
c. when there are positive externalities, but not when there are negative externalities.
d. when there are negative externalities, but not when there are positive externalities.
Externalities 2695
2. For the purpose of protecting the environment, upon which of the following approaches do we rely
more and more as time goes by?
a. adherence to the notion of the invisible hand
b. command-and–control policies
c. the development and enforcement of regulations
d. the requirement that decision makers bear the full costs of their actions
True/False and Short Answer
1. Markets sometimes fail to allocate resources efficiently.
a. True
b. False
2. When a transaction between a buyer and seller directly affects a third party, the effect is called an
externality.
a. True
b. False
2696 Externalities
3. Buyers and sellers neglect the external effects of their actions when deciding how much to demand
or supply.
a. True
b. False
4. In a market characterized by externalities, the market equilibrium fails to maximize the total benefit
to society as a whole.
a. True
b. False
5. In a market with positive externalities, the market equilibrium quantity maximizes the welfare of
society as a whole.
a. True
b. False
Externalities 2697
6. Barking dogs cannot be considered an externality because externalities must be associated with
some form of market exchange.
a. True
b. False
7. When a driver enters a crowded highway he increases the travel times of all other drivers on the
highway. This is an example of a negative externality.
a. True
b. False
8. Research into new technologies conveys neither negative externalities nor positive externalities.
a. True
b. False
2698 Externalities
9. The social cost of pollution includes the private costs of the producers plus the costs to those
bystanders adversely affected by the pollution.
a. True
b. False
10. Organizers of an outdoor concert in a park surrounded by residential neighborhoods are likely to
consider the noise and traffic cost to residential neighborhoods when they assess the financial
viability of the concert venture.
a. True
b. False
11. When firms internalize a negative externality, the market supply curve shifts to the left.
a. True
b. False
Externalities 2699
12. Government subsidized scholarships are an example of a government policy aimed at correcting
negative externalities associated with education.
a. True
b. False
13. A congestion toll imposed on a highway driver to force the driver to take into account the increase
in travel time she imposes on all other drivers is an example of internalizing the externality.
a. True
b. False
14. Negative externalities lead markets to produce a smaller quantity of a good than is socially
desirable, while positive externalities lead markets to produce a larger quantity of a good than is
socially desirable.
a. True
b. False
2700 Externalities
15. The government can internalize externalities by taxing goods that have negative externalities and
subsidizing goods that have positive externalities.
a. True
b. False
16. If the social value of producing robots is greater than the private value of producing robots, the
private market produces too few robots.
a. True
b. False
17. The patent system gives firms greater incentive to engage in research and other activities that
advance technology.
a. True
b. False
Externalities 2701
18. Government intervention in the economy with the goal of promoting technology–producing
industries is known as patent policy.
a. True
b. False
19. A technology spillover is a type of negative externality.
a. True
b. False
20. Suppose a certain good conveys either an external cost or an external benefit. If the private cost
of the last unit of the good that was produced is equal to the private value of that unit, then the
sum of producer and consumer surplus is maximized.
a. True
b. False
2702 Externalities
21. Suppose a certain good provides an external benefit. If the private cost of the last unit of the good
that was produced is equal to the social value of that unit, then the sum of producer and consumer
surplus is maximized.
a. True
b. False
22. The concept of external cost is associated with a negative externality, but not with a positive
externality.
a. True
b. False
23. When market activity generates a negative externality, the level of output in the market
equilibrium is lower than the socially optimal level.
a. True
b. False