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Chapter 16/Externalities, the Environment, and Natural Resources
PROBLEMS
1. Muddy Manufacturing finds it convenient to discharge some of its waste into nearby
Crystal River, upstream from the town of Midville. Authorities in Midville estimate that
each pound of waste costs the town $5.50 in terms of purification at the water plant,
damage to fisheries, pollution of beaches, etc. They have asked Muddy to reduce
emissions, but so far Muddy has not complied. Engineers at Muddy estimate that the
company’s profits are increased as more waste is dumped into the river, as follows:
Pounds of Total
Waste Emitted Cost Savings
per minute per minute
1 $10
2 19
3 27
4 34
5 40
6 45
7 49
8 52
9 54
10 55
11 55
a) Draw a diagram showing the marginal benefit and marginal cost of Muddy’s waste
emissions.
b) How much waste does Muddy dump into Crystal River each minute? Show on the
diagram.
c) From a social point of view, what is the optimal amount of waste emission? Show on
the diagram. Explain how the optimal amount of waste emission can be positive.
d) What tax on Muddy’s emissions would lead it to produce the optimal emissions?
Show on the diagram.
e) Is it possible to design a subsidy program that would achieve the same result as in d)?
Explain.
Solution:
a)
Chapter 16/Externalities, the Environment, and Natural Resources
b) Muddy will dump 11 pounds of waste into the Crystal River each minute.
c) Optimum amount of waste is five pounds per minute. At this level, marginal benefit
to the company is equal to the marginal cost to the society. It is positive because up to
Chapter 16/Externalities, the Environment, and Natural Resources
d) A tax of $5.50 on each pound of waste disposal will lead to optimum waste emission.
e) A subsidy equal to reduction in profit due to the drop in waste emission beyond the
2. Alpha Company and Beta Company are each emitting 10 pounds of waste matter into the
atmosphere each hour, for a total of 20 pounds. The regional air quality control board
wishes to cut the emissions in half. It is debating whether to issue a regulation requiring
the two companies to halve their emissions to five pounds an hour each, or to tax the
emissions. Because they manufacture different products, with different technologies,
Alpha and Beta estimate the total costs of reducing their emissions quite differently:
Emissions
Reduced (pounds Total Cost
per hour) Alpha Beta
1 $11 $1
2 23 3
3 36 6
4 50 10
Chapter 16/Externalities, the Environment, and Natural Resources
5 65 15
6 81 21
7 98 28
8 116 36
9 135 45
10 155 55
a) What tax rate on emissions would succeed in reducing them by half?
b) If the tax is imposed, what company will reduce its emissions, and how much money
will it spend doing so?
c) Explain why one of the companies will decline to reduce its emissions when the tax is
imposed. How much tax will it pay instead?
d) If the board decides to issue a regulation requiring each company to cut its emissions
in half, what will be the cost of the cleanup?
e) Which method of pollution control do you favor in this case, and why?
Solution:
3. The City Council of Smogville has decided to reduce air pollution by issuing licenses to
emit waste material into the atmosphere. Each license permits the holder to emit a certain
physical quantity. Each adult resident receives one license a month free from the city, and
the holders of the licenses are permitted to sell them.
a) Draw a diagram showing the supply and demand, and equilibrium price and quantity,
of the licenses.
b) Explain what determines the demand for the licenses. Why does the demand curve
have the slope you have shown?
c) How will the equilibrium change when:
i) the Council decides to reduce air pollution further.
ii) new technology is developed that allows cheaper reduction of emissions.
iii) new industries move into Smogville.
d) What are the advantages and disadvantages of this scheme as compared to regulation?
Solution:
a)
Chapter 16/Externalities, the Environment, and Natural Resources
b) The price will be high if the number of permits offered for sale is small and many
firms need permits to carry out their industrial activities. Similarly, the price of a
4. Market analysts confidently expect that the price of oil will be $100 a barrel one year
from today, and that no new oil reserves will be discovered over the next year.
a) If the prevailing rate of interest is 15 percent, what is the price of oil today?
b) If the prevailing rate of interest were to fall today to 5 percent, how would the price of
oil change?
c) Explain how and why the price change would occur.
d) If the rate of interest did not change, how would the price of oil change
i) if new reserves were discovered?
ii) if consumers and firms improved their fuel conservation?
Solution:
a) $86.96
Chapter 16/Externalities, the Environment, and Natural Resources
5. Using appropriate diagrams, explain the effect of rising oil prices upon:
a) Conservation
b) Discovery of new reserves
c) Development of alternative energy sources
d) Income distribution in the United States
Solution:
a) The ever-rising prices accompanying increasing scarcity of a depletable resource
b) The supply curve will shift to the right. Equilibrium price decreases and quantity
demanded increases.
c) Demand shifts downwards. Equilibrium price and quantity decreases.
Chapter 16/Externalities, the Environment, and Natural Resources
d) The area PES was the consumer surplus initially. Due to a rise in price, consumer
surplus is reduced to the area P1E1S. Area P1E1XP is transferred to suppliers.
DISCUSSION QUESTIONS
1. What do you think is the best sort of public policy to deal with the following pollution
problems?
a) Acid rain
b) Nuclear radiation
c) Garbage disposal in wilderness parks
d) Trash collection in cities
e) Highway litter
Suggested Answer: Students should come up with their own suggestions. As always,
there is no single best solution. They could also base their discussions on historic data.
Chapter 16/Externalities, the Environment, and Natural Resources
2. Economists make use of the concept of externalities in explaining excessive
environmental pollution in market economies. People and firms pollute because they are
not charged for the cost they impose upon the society. It appears, however, that
environmental pollution has been much greater in the formerly communist countries of
Eastern Europe. It is hard to put the blame on externalities in this case because the
government, which presumably represented all the people, owned the polluting factories.
Discuss this paradox. Does it imply that externalities are not a useful tool in
understanding pollution?
Suggested Answer: A major part of environmental pollution is the result of economic
activities. Any economic activity may have a negative impact on the natural environment.
3. “It is completely unfair for the government to allow firms to pollute providing they pay a
tax or buy a license. All that happens is that the rich continue to pollute, while the little
guy is squeezed. The only fair way to reduce pollution is to require each firm to reduce
emissions by an equal share.” Discuss.
Suggested Answer: The discussion should revolve around the pros and cons of direct
controls vis-à-vis emission taxes and permits. Under permits, firms will have the
4. How do you explain the fluctuations in the price of oil that are shown in Figure 17-4 in
the text?
Suggested Answer: Students will be able to identify many things that can interfere with
the price patterns that theory leads us to expect. Some include: discoveries of reserves
5. Environmental pollution appears to be a case of a market failure, that is to say, the
inability of the unregulated market to deal optimally with external costs. What about the
case of nonrenewable natural resources? Do you think the unregulated market allocates
the use of these resources optimally, or is this also a case of market failure?
Suggested Answer: According to economic analysis, a good indicator of the degree of
depletion of a resource is its price. Increasing scarcity of a resource such as oil is not
Chapter 16/Externalities, the Environment, and Natural Resources
6. Chemical companies along the Forlorn River dump effluent into the river. For each pound
of chemicals they produce, the effluent causes $10 worth of damage to the river and to
the communities downstream. Devise a tax that addresses the pollution problem. Explain
how it works, how it affects pollution, how it affects output, and who in the end pays the
tax, with the aid of a diagram.
Suggested Answer: A sample diagram that will aid in the discussion is shown below:
