Section 11: Market Failure and the Role of Government
Question 1
1. What type of externality (positive or negative) is present in each of the following examples? Is
the marginal social benefit of the activity greater than or equal to the marginal benefit to the
individual? Is the marginal social cost of the activity greater than or equal to the marginal cost
to the individual? Without intervention, will there be too little or too much (relative to what
would be socially optimal) of this activity?
a. Mr. Chau plants lots of colorful flowers in his front yard.
b. Your next-door neighbor likes to build bonfires in his backyard, and sparks often drift onto
your house.
c. Maija, who lives next to an apple orchard, decides to keep bees to produce honey.
d. Justine buys a large SUV that consumes a lot of gasoline.
Solution 1
Question 2
2. Many dairy farmers in California are adopting a new technology that allows them to produce
their own electricity from methane gas captured from animal waste. (One cow can produce up
to 2 kilowatts a day.) This practice reduces the amount of methane gas released into the
atmosphere. In addition to reducing their own utility bills, the farmers are allowed to sell any
electricity they produce at favorable rates.
a. Explain how the ability to earn money from capturing and transforming methane gas
behaves like a Pigouvian tax on methane gas pollution and can lead dairy farmers to emit
the efficient amount of methane gas pollution.
b. Suppose some dairy farmers have lower costs of transforming methane into electricity than
others. Explain how this system of capturing and selling methane gas leads to an efficient
allocation of emissions reduction among farmers.
Solution 2
Question 3
3. According to a report from the U.S. Census Bureau, “the average [lifetime] earnings of a full–
time, year round worker with a high school education are about $1.2 million compared with
$2.1 million for a college graduate.” This indicates that there is a considerable benefit to a
graduate from investing in his or her own education. Tuition at most state universities covers
only about two-thirds to three-quarters of the cost, so the state applies a Pigouvian subsidy to
college education.
If a Pigouvian subsidy is appropriate, is the externality created by a college education a
positive or a negative externality? What does this imply about the differences between the
costs and benefits that accrue privately to students compared to social costs and benefits?
What are some reasons for the differences?
Solution 3
Question 4
4. The city of Falls Church, Virginia, subsidizes the planting of trees in homeowners’ front yards
when they are within 15 feet of the street.
a. Using concepts in the section, explain why a municipality would subsidize planting trees on
private property, but near the street.
b. Draw a diagram similar to Figure 34-2 that shows the marginal social benefit, the marginal
social cost, and the optimal Pigouvian subsidy on planting trees.
Solution 4
Question 5
5. Fishing for sablefish has been so intensive that sablefish were threatened with extinction. After
several years of banning such fishing, the government is now proposing to introduce tradable
vouchers, each of which entitles its holder to a catch of a certain size. Explain how
uncontrolled fishing generates a negative externality and how the voucher scheme may
overcome the inefficiency created by this externality.
Solution 5
Question 6
6. The two dry-cleaning companies in Collegetown, College Cleaners and Big Green Cleaners,
are a major source of air pollution. Together they currently produce 350 units of air pollution,
which the town wants to reduce to 200 units. The accompanying table shows the current
pollution level produced by each company and each company’s marginal cost of reducing its
pollution. The marginal cost is constant.
Companies
Initial
pollution
level (units)
Marginal cost of reducing
pollution (per unit)
College
Cleaners
230
$5
Big Green
Cleaners
120
$2
a. Suppose that Collegetown passes an environmental standards law that limits each company
to 100 units of pollution. What would be the total cost to the two companies of each
reducing its pollution emissions to 100 units?
Suppose instead that Collegetown issues 100 pollution vouchers to each company, each
entitling the company to one unit of pollution, and that these vouchers can be traded.
b. How much is each pollution voucher worth to College Cleaners? To Big Green Cleaners?
(That is, how much would each company, at most, be willing to pay for one more
voucher?)
c. Who will sell vouchers and who will buy them? How many vouchers will be traded?
d. What is the total cost to the two companies of the pollution controls under this voucher
system?
Solution 6
Question 7
7. The government is involved in providing many goods and services. For each of the goods or
services listed, determine whether it is rival or nonrival in consumption and whether it is
excludable or nonexcludable. What type of good is it? Without government involvement,
would the quantity provided be efficient, inefficiently low, or inefficiently high?
a. Street signs
b. Amtrak rail service
c. Regulations limiting pollution
d. A congested interstate highway without tolls
e. A lighthouse on the coast
Solution 7
Question 8
8. An economist gives the following advice to a museum director: “You should introduce ‘peak
pricing.’ At times when the museum has few visitors, you should admit visitors for free. And
at times when the museum has many visitors, you should charge a higher admission fee.”
a. When the museum is quiet, is it rival or nonrival in consumption? Is it excludable or
nonexcludable? What type of good is the museum at those times? What would be the
efficient price to charge visitors during that time, and why?
b. When the museum is busy, is it rival or nonrival in consumption? Is it excludable or
nonexcludable? What type of good is the museum at those times? What would be the
efficient price to charge visitors during that time, and why?
Solution 8
Question 9
9. The accompanying table shows Tanisha’s and Ari’s individual marginal benefit of different
amounts of street cleanings per month. Suppose that the marginal cost of street cleanings is
constant at $9 each.
a. If Tanisha had to pay for street cleaning on her own, how many street cleanings would there
be?
b. Calculate the marginal social benefit of street cleaning. What is the optimal number of
street cleanings?
c. Consider the optimal number of street cleanings. The last street cleaning of the optimal
number of street cleanings costs $9. Is Tanisha willing to pay for that last cleaning on her
own? Is Ari willing to pay for that last cleaning on his own?
Solution 9
Question 10
10. Anyone with a radio receiver can listen to public radio, which is funded largely by donations.
a. Is public radio excludable or nonexcludable? Is it rival in consumption or nonrival? What
type of good is it?
b. Should the government support public radio? Explain your reasoning.
c. In order to finance itself, public radio decides to transmit only to satellite radios, for which
users have to pay a fee. What type of good is public radio then? Will the quantity of radio
listening be efficient? Why or why not?
Solution 10
Question 11
11. Your economics professor assigns a group project for the course. Describe the free-rider
problem that can lead to a suboptimal outcome for your group. To combat this problem, the
instructor asks you to evaluate the contribution of your peers in a confidential report. Will this
evaluation have the desired effects?
Solution 11
Question 12
12. The village of Upper Bigglesworth has a village “commons,” a piece of land on which each
villager, by law, is free to graze his or her cows. Use of the commons is measured in units of
the number of cows grazing on it. Assume that the marginal private cost curve of cow-grazing
on the commons is upward sloping (say due to more time spent herding). There is also a
marginal social cost curve of cow-grazing on the commons: each additional cow grazed
means less grass available for others, and the damage done by overgrazing of the commons
increases as the number of cows grazing increases. Finally, assume that the private benefit to
the villagers of each additional cow grazing on the commons declines as more cows graze,
since each additional cow has less grass to eat than the previous one.
a. Is the commons excludable or nonexcludable? Is it rival in consumption or nonrival? What
kind of good is the commons?
b. Draw a diagram showing the marginal social cost, marginal private cost, and the marginal
private benefit of cow-grazing on the commons, with the quantity of cows that graze on the
commons on the horizontal axis. How does the quantity of cows grazing in the absence of
government intervention compare to the efficient quantity? Show both in your diagram.
c. The villagers hire you to tell them how to achieve an efficient use of the commons. You tell
them that there are three possibilities: a Pigouvian tax, the assignment of property rights
over the commons, and a system of tradable licenses for the right to graze a cow. Explain
how each one of these options would lead to an efficient use of the commons. In the
assignment of property rights, assume that one person is assigned the rights to the
commons and the rights to all the cows. Draw a diagram that shows the Pigouvian tax.
Solution 12
Question 13
13. The accompanying table shows six consumers’ willingness to pay (his or her individual
marginal benefit) to download a Jay-Z album. The marginal cost of making the file accessible
to one additional consumer is constant, at zero.
Consumer
Adriana
Bhagesh
Chizuko
Denzel
Emma
Frank
a. What would be the efficient price to charge for a download of the file?
b. All six consumers are able to download the file for free from a file-sharing service,
Pantster. Which consumers will download the file? What will be the total consumer surplus
to those consumers?
c. Pantster is shut down for copyright law infringement. In order to download the file,
consumers now have to pay $4.99 at a commercial music site. Which consumers will
download the file? What will be the total consumer surplus to those consumers? How much
producer surplus accrues to the commercial music site? What is the total surplus? What is
the deadweight loss from the new pricing policy?
Solution 13
Question 14
14. Software has historically been an artificially scarce good—it is nonrival because the cost of
replication is negligible once the investment to write the code is made, but software
companies make it excludable by charging for user licenses. But then open-source software
emerged, most of which is free to download and can be modified and maintained by anyone.
a. Discuss the free-rider problem that might exist in the development of open-source
software. What effect might this have on quality? Why does this problem not exist for
proprietary software, such as the products of a company like Microsoft or Adobe?
b. Some argue that open-source software serves an unsatisfied market demand that
proprietary software ignores. Draw a typical diagram that illustrates how proprietary
software may be underproduced. Put the price and marginal cost of software on the
vertical axis and the quantity of software on the horizontal axis. Draw a typical demand
curve and a marginal cost curve (MC) that is always equal to zero. Assume that the
software company charges a positive price, P, for the software. Label the equilibrium point
and the efficient point.
Solution 14
Question 15
WORK IT OUT Interactive step-by-step help with solving this problem can be found
online.
15. The loud music coming from the sorority next to your dorm is a negative externality that can
be directly quantified. The accompanying table shows the marginal social benefit and the
marginal social cost per decibel (dB, a measure of volume) of music.
a. Draw the marginal social benefit curve and the marginal social cost curve. Use your
diagram to determine the socially optimal volume of music.
b. Only the members of the sorority benefit from the music, and they bear none of the cost.
Which volume of music will they choose?
c. The college imposes a Pigouvian tax of $3 per decibel of music played. From your diagram,
determine the volume of music the sorority will now choose.
Solution 15