76 ❖ Chapter 10/Externalities
27. The Coase theorem states that
a.
under certain circumstances government intervention is not needed to reach efficient outcomes
when an externality is present.
b.
government intervention is always required to reach an efficient outcome when an externality is
present.
c.
government intervention cannot lead to an efficient outcome when an externality is present.
d.
only negative externalities can be resolved using government intervention.
28. Which of the following is not a necessary condition for the Coase theorem?
a.
Property rights are clearly defined.
b.
There are no bargaining costs.
c.
The government intervenes to internalize the externality.
d.
There are only a few parties involved.
29. In many cases the Coase theorem does not work well because
a.
there are too few parties at the negotiation table.
b.
the government does not know about the Coase theorem.
c.
transaction costs are too high.
d.
transaction costs are too low.
30. Why can’t private individuals always internalize an externality without the help of government?
a.
Legal restrictions prevent side payments between individuals.
b.
Transactions costs may be too high.
c.
Side payments between individuals are inefficient.
d.
Side payments between individuals are insufficient.
31. What economic argument suggests that if transactions costs are sufficiently low, the equilibrium is economi-
cally efficient regardless of how property rights are distributed?
a.
the Coase theorem
b.
the laws of supply and demand
c.
the law of comparative advantage
d.
the law of externalities
32. The Coase theorem states that
a.
taxes are an efficient way for governments to remedy negative externalities.
b.
subsidies are an efficient way for governments to remedy positive externalities.
c.
industrial policies encourage technology spillovers.
d.
in the absence of transaction costs, private parties can solve the problem of externalities on their
own.
Chapter 10/Externalities ❖ 77
33. Mary and Cathy are roommates. Mary assigns a $30 value to smoking cigarettes. Cathy values smoke-free air
at $15. Which of the following scenarios is a successful example of the Coase theorem?
a.
Cathy offers Mary $20 not to smoke. Mary accepts and does not smoke.
b.
Mary pays Cathy $16 so that Mary can smoke.
c.
Mary pays Cathy $14 so that Mary can smoke.
d.
Cathy offers Mary $15 not to smoke. Mary accepts and does not smoke.
34. A dentist shares an office building with a radio station. The electrical current from the dentist’s drill causes
static in the radio broadcast, causing the radio station to lose $10,000 in profits. The radio station could put up
a shield at a cost of $30,000; the dentist could buy a new drill that causes less interference for $6,000. Either
would restore the radio station’s lost profits. What is the economically efficient outcome?
a.
The radio station puts up a shield, which it pays for.
b.
The radio station puts up a shield, which the dentist pays for.
c.
Neither the radio station nor the dentist purchase additional equipment.
d.
The dentist gets a new drill; it does not matter who pays for it.
35. Monte owns a dog; the dog’s barking annoys Monte’s neighbor, Teresa. Suppose that the benefit of owning
the dog is worth $200 to Monte and that Teresa bears a cost of $400 from the barking. Assuming Monte has
the legal right to keep the dog, a possible private solution to this problem is that
a.
Teresa pays Monte $150 to give the dog to his parents who live on an isolated farm.
b.
Monte pays Teresa $350 for her inconvenience.
c.
Teresa pays Monte $300 to give the dog to his parents who live on an isolated farm.
d.
There is no private transaction that would improve this situation.
36. Dick owns a dog whose barking annoys Dick’s neighbor Jane. Suppose that the benefit of owning the dog is
worth $700 to Dick and that Jane bears a cost of $500 from the barking. Assuming Dick has the legal right to
keep the dog, a possible private solution to this problem is that
a.
Dick pays Jane $600 for her inconvenience.
b.
Jane pays Dick $400 to give the dog to his parents who live on an isolated farm.
c.
Jane pays Dick $550 to give the dog to his parents who live on an isolated farm.
d.
The current situation is efficient.
37. Dick owns a dog whose barking annoys Dick’s neighbor Jane. Dick receives personal benefit from owning the
dog, and Jane bears a cost of Dick’s ownership of the dog. Assuming Jane has the legal right to peace and
quiet, which of the following statements is correct?
a.
If Dick’s benefit exceeds Jane’s cost, government intervention is necessary.
b.
Dick will pay to keep his dog if his benefit exceeds Jane’s cost.
c.
If Jane’s cost exceeds Dick‘s benefit, Dick will pay Jane to keep his dog.
d.
If Jane has the legal right to peace and quiet, no further transactions will be mutually beneficial.
78 ❖ Chapter 10/Externalities
38. Sally’s cat causes Mike to sneeze. Sally values her cat’s companionship at $300 per year. The cost to Mike of
tissues and her allergy medication is $350 per year. Based on the Coase theorem,
a.
Sally should pay Mike $400 so that she may keep her cat.
b.
Sally should pay Mike $350 for tissues and allergy medication.
c.
Mike should pay Sally $325 to give away her cat.
d.
Mike should move.
39. According to the Coase theorem, in the presence of externalities
a.
private parties can bargain to reach an efficient outcome.
b.
government assistance is necessary to reach an efficient outcome.
c.
the assignment of legal rights can prevent externalities.
d.
the initial distribution of property rights will determine the efficient outcome.
40. Assume that your roommate is very messy. Suppose she gets a $25 benefit from being messy but imposes a
$50 cost on you. The Coase theorem would suggest that an efficient solution would be for you to
a.
pay your roommate at least $25 but no more than $50 to clean up after herself.
b.
pay your roommate at least $51 to clean up after herself.
c.
charge your roommate at least $25 to have you clean up after her.
d.
charge your roommate at least $50 but no more than $100 to keep you from complaining about the
mess.
41. Assume that your roommate is very messy. According to campus policy, you have a right to live in an unclut-
tered apartment. Suppose she gets a $200 benefit from being messy but imposes a $100 cost on you. The
Coase theorem would suggest that an efficient solution would be for your roommate to
a.
stop her messy habits or else move out.
b.
pay you at least $100 but less than $200 to live with the clutter.
c.
continue to be messy and force you to move out.
d.
demand payment of at least $100 but no more than $200 to clean up after herself.
42. Suppose that Company A’s railroad cars pass through Farmer B’s corn fields. The railroad causes an external-
ity 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 farmer has the right to compensation for any damage that his crops suf-
fer. 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.
Chapter 10/Externalities ❖ 79
43. Suppose that Company A’s railroad cars pass through Farmer B’s corn fields. The railroad causes an external-
ity 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.
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 sec-
tion. Bill values the absence of smoke at $15. Peter values the ability to smoke in the restaurant at $10. In or-
der 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. John lives in an apartment building and gets a $700 benefit from playing his stereo. Mary, who lives next
door to John and often loses sleep due to the music coming from John’s stereo, bears a $1,000 cost from the
noise. At which of the following offers from Mary could both Mary and John benefit from the silencing of
John’s stereo?
a.
$200
b.
$600
c.
$900
d.
$1,100
80 ❖ Chapter 10/Externalities
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. Max lives in an apartment building and gets a benefit from playing his stereo. Lily, who lives next door to
Max and often loses sleep due to the loud music coming from Max’s stereo, bears a cost from the noise. Lily
is threatening to call the police to force Max to turn down his stereo. Under which of the following conditions
would Max be able to offer Lily 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 Lily must exceed the benefit of the music to Max.
b.
The benefit of the music to Max must exceed the cost of the noise to Lily.
c.
The Coase Theorem guarantees that Lily and Max will always be able to come to an agreement that
keeps Lily from calling the police regardless of the individual benefits and costs.
d.
The cost of the noise to Lily must exceed the benefit of the music to Max by an amount greater than
the transaction costs associated with the agreement.
49. Ed is a writer who works from his home. Ed lives next door to Ricky, the drummer for a local band. Ricky
needs lots of practice to earn his share of the bands profits, $250. Ed gets distracted by Ricky’s drumming but
needs to get his writing done to earn $500 for his current article. Which of the following is an efficient solu-
tion?
a.
Ricky offers Ed $499 to allow Ricky to continue drumming. Ed accepts and both are better off.
b.
Ricky offers Ed $249 to allow Ricky to continue drumming. Ed accepts and both are better off.
c.
Ed offers Ricky $251 to stop practicing his drumming. Ricky agrees and both are better off.
d.
Ed offers Ricky $501 to stop practicing his drumming. Ricky agrees and both are better off.
50. Emma is a writer who works from her home. Emma lives next door to Clay, the drummer for a local band.
Clay needs lots of practice to earn his share of the band’s profit, which will amount to $250. Emma gets dis-
tracted by Clay’s drumming but needs to get her writing done to earn $500 for her current article. If Emma
needs to hire a lawyer to help her reach an agreement with Clay, then what price is Emma willing to pay the
lawyer?
a.
less than $250
b.
less than $450
c.
less than $500
d.
less than $750
Chapter 10/Externalities ❖ 81
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.
53. When the government reduces my income tax by $0.30 for every $1.00 that I contribute to a charity, the gov-
ernment 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.
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.
82 ❖ Chapter 10/Externalities
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.
CONCLUSION
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.
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
1. Markets sometimes fail to allocate resources efficiently.
2. When a transaction between a buyer and seller directly affects a third party, the effect is called an externality.
3. Buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply.
4. In a market characterized by externalities, the market equilibrium fails to maximize the total benefit to society
as a whole.
Chapter 10/Externalities ❖ 83
5. In a market with positive externalities, the market equilibrium quantity maximizes the welfare of society as a
whole.
6. Barking dogs cannot be considered an externality because externalities must be associated with some form of
market exchange.
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.
8. Research into new technologies conveys neither negative externalities nor positive externalities.
9. The social cost of pollution includes the private costs of the producers plus the costs to those bystanders ad-
versely affected by the pollution.
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 ven-
ture.
11. When firms internalize a negative externality, the market supply curve shifts to the left.
12. Government subsidized scholarships are an example of a government policy aimed at correcting negative ex-
ternalities associated with education.
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.
84 ❖ Chapter 10/Externalities
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.
15. The government can internalize externalities by taxing goods that have negative externalities and subsidizing
goods that have positive externalities.
16. If the social value of producing robots is greater than the private value of producing robots, the private market
produces too few robots.
17. The patent system gives firms greater incentive to engage in research and other activities that advance technol-
ogy.
18. Government intervention in the economy with the goal of promoting technology-producing industries is
known as patent policy.
19. A technology spillover is a type of negative externality.
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 con-
sumer surplus is maximized.
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 maxim–
ized.
22. The concept of external cost is associated with a negative externality, but not with a positive externality.
Chapter 10/Externalities ❖ 85
23. When market activity generates a negative externality, the level of output in the market equilibrium is lower
than the socially optimal level.
24. To determine the optimal level of output in a market with negative externalities, a benevolent social planner
would look for the level of output at which private cost equals private value.
25. The concept of external benefit is associated with a negative externality, but not with a positive externality.
26. Patent protection is one way to deal with technology spillovers.
27. Laws that are passed that either require or forbid certain behaviors are examples of command-and-control poli-
cies.
28. The tax on gasoline causes deadweight losses, as is the case with all taxes.
29. Even if possible, it would be inefficient to prohibit all polluting activity.
30. When correcting for an externality, command–and-control policies are always preferable to market-based poli-
cies.
31. Corrective taxes enhance efficiency, but the cost to administer them exceeds the revenue they raise for the
government.
32. Corrective taxes cause deadweight losses, reducing economic efficiency.
86 ❖ Chapter 10/Externalities
33. Most economists prefer regulation to taxation because regulation corrects market inefficiencies at a lower cost
than taxation does.
34. A corrective tax places a price on the right to pollute.
35. According to recent research, the gas tax in the United States is lower than the optimal level.
36. The least expensive way to clean up the environment is for all firms to reduce pollution by an equal percent-
age.
37. Corrective taxes are more efficient than regulations for keeping the environment clean.
38. A market for pollution permits can efficiently allocate the right to pollute by using the forces of supply and
demand.
39. Economists believe that the optimal level of pollution is zero.
40. The Environmental Protection Agency (EPA) cannot reach a target level of pollution through the use of pollu-
tion permits.
41. Social welfare can be enhanced by allowing firms to trade their rights to pollute.
42. Firms that can reduce pollution easily would be willing to sell their pollution permits.
Chapter 10/Externalities ❖ 87
43. When he was a candidate for president, Barack Obama proposed a cap-and-trade system for carbon.
44. In some circumstances, selling pollution permits may be better than levying a corrective tax.
45. Although regulation and corrective taxes are both capable of reducing pollution, regulation accomplishes this
goal more efficiently.
46. Government can be used to solve externality problems that are too costly for private parties to solve.
47. Government intervention is necessary to correct all externalities.
48. According to the Coase theorem, if private parties can bargain without cost, then the private market will solve
the problem of externalities.
49. According to the Coase theorem, the private market will need government intervention in order to reach an
efficient outcome.
50. Despite the appealing logic of the Coase theorem, private actors often fail to resolve on their own the problems
caused by externalities.
51. According to the Coase Theorem, individuals can always work out a mutually beneficial agreement to solve
the problems of externalities even when high transaction costs are involved.
52. According to the Coase theorem, whatever the initial distribution of rights, the interested parties can bargain to
an efficient outcome.
88 ❖ Chapter 10/Externalities
53. Private parties may choose not to solve an externality problem if the transaction costs are large enough.
54. Many charities like the Sierra Club are established to deal with externalities.
55. The Coase theorem asserts that private economic actors can solve the problem of externalities among them-
selves, without government intervention, regardless of whether those actors incur significant costs in reaching
and enforcing an agreement.
56. When externalities are present, reaching an efficient outcome is especially difficult when the number of inter-
ested parties is large.
57. The Coase theorem suggests that taxes should be enacted to alleviate the effects of negative externalities.
SHORT ANSWER
1. Using a supply and demand diagram, demonstrate how a negative externality leads to market inefficiency.
How might the government help to eliminate this inefficiency?
ANS:
Chapter 10/Externalities ❖ 89
2. Using a supply and demand diagram, demonstrate how a positive externality leads to market inefficiency.
How might the government help to eliminate this inefficiency?
3. Why are Pigovian taxes preferred to regulatory policies as methods to remedy negative externalities?
4. Use a graph to illustrate the quantity of pollution that would be emitted (a) after a corrective tax has been im-
posed and (b) after tradable pollution permits have been imposed. Could these two quantities ever be equiva-
lent?
90 ❖ Chapter 10/Externalities
5. To produce honey, beekeepers place hives of bees in the fields of farmers. As bees gather nectar, they polli-
nate the crops in the fields, which increases the yields of these fields at no additional cost to the farmer. What
might be a reasonable private solution to this externality, and how might the solution be reached?
6. The Coase theorem suggests that efficient solutions to externalities can be determined through bargaining. Un-
der what circumstances will private bargaining fail to produce a solution?