978-1285165905 Chapter 10 Part 2

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190 ❖ Chapter 10/Externalities

pollution, issue permits for that amount, and allow the firms to trade the permits. This

reduces pollution while allowing economic efficiency.

3. Examples of private solutions to externalities include moral codes and social sanctions,

charities, and relying on the interested parties entering into contracts with one other.

The Coase theorem is the proposition that if private parties can bargain without cost over the

allocation of resources, they can solve the problem of externalities on their own.

Private economic participants are sometimes unable to solve the problems caused by an

externality because of transaction costs or because bargaining breaks down. This is most

likely when the number of interested parties is large.

Questions for Review

1. Examples of negative externalities include pollution, barking dogs, and consumption of

and positive externalities are possible.)

2. Figure 1 illustrates the effect of a negative externality. The equilibrium quantity provided by

quantity for society is

optimum. The private market produces too much of the good because

market is greater than

optimum.

Figure 1

3. The patent system helps society solve the externality problem from technology spillovers. By

effects.

Chapter 10/Externalities ❖ 191

4. Corrective taxes are taxes enacted to correct the effects of a negative externality. Economists

determine the least expensive way to reduce pollution. The tax gives firms incentives to

5. Externalities can be solved without government intervention through moral codes and social

6. According to the Coase theorem, you and your roommate will bargain over whether your

your roommate smoking. The outcome is efficient as long as transaction costs do not prevent

Quick Check Multiple Choice

1. c

2. b

3. a

4. c

5. b

6. c

Problems and Applications

1. The Club conveys a negative externality on other car owners because car thieves will not

implications include a subsidy for car owners that use the Lojack technology or a tax on

those who use The Club.

2. a. Fire extinguishers exhibit positive externalities because even though people buy them for

their own use, they may prevent fire from damaging the property of others.

192 ❖ Chapter 10/Externalities

Figure 2

supply curve.

c. The market equilibrium level of output is denoted

market and the efficient level of output

d. A government policy that would result in the efficient outcome would be to subsidize

people $10 for every fire extinguisher they buy. This would shift the demand curve up to

3. a. The extra traffic is a negative externality because the social cost is greater than the

private cost..

b. Figure 3 shows the market for theater tickets. Because there is no external benefit, the

intersect..

Figure 3

Demand

(social value)

Supply

social cost

optimum

market

Quantity of Tickets

Price of Tickets

Chapter 10/Externalities ❖ 193

c. This is a positive externality because the social value of theater tickets is greater than the

private value in this case.

d. Figure 4 shows both the positive and the negative externalities.

Figure 4

4. a. The market for alcohol is shown in Figure 5. The social-value curve is the same as the

demand curve in this case. The social-cost curve is above the supply curve because of

output is

optimum.

Figure 5

194 ❖ Chapter 10/Externalities

5. a. It is efficient to have different amounts of pollution reduction at different firms because

the costs of reducing pollution differ across firms. If all firms were made to reduce

b. Command-and-control approaches that rely on uniform pollution reduction among firms

give the firms no incentive to reduce pollution beyond the mandated amount. Instead,

c. Corrective taxes or tradable pollution rights give firms greater incentives to reduce

pollution. Firms are rewarded by paying lower taxes or spending less on permits if they

own.

6. a. At a price of $1.50, each Whovillian will consume 4 bottles of Zlurp. Each consumer’s

total willingness to pay is $14 (= $5 + $4 + $3 + $2). The total spent by each Whovillian

(=$14 − $6).

b. Total surplus would fall by $4 to $4.

d. The $1 tax raises the price of a bottle of Zlurp to $2.50. (The entire tax will be borne by

($12-$7.50) in consumer surplus.

Because each bottle has an external cost of $1, the per-resident external cost is $3 ($1

e. Yes, because total surplus is now higher than before the tax.

7. a. The externality is noise pollution. Ringo’s consumption of rock and roll music affects

Luciano, but Ringo does not consider that in deciding how loudly he plays his music.

c. Ringo and Luciano could negotiate an agreement that might, for example, allow Ringo to

play his music loudly at certain times of the day. They might not be able to reach an

for a better deal.

Chapter 10/Externalities ❖ 195

8. a. An improvement in the technology for controlling pollution would reduce the demand for

pollution rights, shifting the demand curve to the left. Figure 6 illustrates what would

demand for pollution rights and the curve labeled

2 is the new demand for pollution

rights after the improvement in technology.

Figure 6

Figure 7

9. a. In terms of economic efficiency in the market for pollution, it does not matter if the

government distributes the permits or auctions them off, as long as firms can sell the

permits to each other. The only difference would be that the government could make

money if it auctioned the permits off, thus allowing it to reduce taxes, which would help

196 ❖ Chapter 10/Externalities

reduce the deadweight loss from taxation. There could also be some deadweight loss

occurring if firms use resources to lobby for additional permits.

b. If the government allocated the permits to firms who did not value them as highly as

other firms, the firms could sell the permits to each other so they would end up in the

hands of the firms who value them most highly. Thus, the allocation of permits among

firms would not matter for efficiency. But it would affect the distribution of wealth,

10. a. The firms with the highest cost of reducing pollution will buy permits rather than reduce

their pollution. Firms that can sell their permits for more than it costs them to reduce

their pollution will sell.

Of the two remaining firms, firm A has the higher cost of reducing pollution so it will

keep its own 40 permits and reduce its pollution by 30 units at a cost of $20 x 30 units =

$600.

b. If the permits could not be traded, then firm A would have to reduce its pollution by 30

units at a cost of $20 × 30 = $600, firm B would have to reduce its pollution by 40 units

at a cost of $25 × 40 = $1,000, and firm C would have to reduce its pollution by 10 units

at a cost of $10 × 10 = $100. The total cost of pollution reduction would be $1,700,