Economics Chapter 19 Proponents of Pigou taxes argue that they can improve

Chapter 19

GOVERNMENT IN THE MARKET ECONOMY

QUESTIONS & ANSWERS

Q19.1 Air pollution costs the U.S. billions of dollars per year in worker absenteeism,

healthcare, pain and suffering, and loss of life. Discuss some of the costs and benefits of

a Pigou tax on air pollution.

Q19.1 ANSWER

Proponents of Pigou taxes argue that they can improve the allocation of resources by

forcing producers and consumers to pay the full costs of production. Advocates of such

taxes sometimes go further and argue that revenues from Pigou taxes could be used to

Q19.2 What role does the price elasticity of demand play in determining the short-run effects of

regulations that increase fixed costs? What if they lead to increased variable costs?

Q19.2 ANSWER

For a profit maximizing firm, a change in fixed costs does not alter the optimal short-run

Q19.3 What is the essential difference between public and private goods? Give some examples

of each and some examples of goods and services that involve elements of both.

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Q19.3 ANSWER

If the consumption of a product by one individual does not reduce the amount available

for others, the product is referred to as a public good. Once public goods are provided

The distinguishing characteristic of public goods is the concept of nonrival

consumption. In the case of public goods, use by certain individuals does not reduce

The concept of nonrival consumption must be distinguished from the nonexclusion

concept. A good or service is characterized as nonexclusionary if it is impossible or

consumption would not be provided in the optimal amount by the private sector.

Health-care is a good example of a service that embodies elements of both public

and private goods. Inoculations prevent the spread of communicable disease, and can be

Q19.4 In the 1880s, cattlemen in the American West crowded more and more animals onto

common grazing land to feed a growing nation. Cattlemen contended, “None of us

knows anything about grass outside of the fact that there is lots of it, and we aim to get it

while the getting is good.” Explain this attitude as a manifestation of the tragedy of the

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commons, and discuss how to solve the problem. Does resolving the cattlemen’s

dilemma of the 1880s suggest how the world today can save the African elephant?

Q19.4 ANSWER

The commons is an ancient cultural and economic organizing principle. Before the

agricultural revolution, each clan or tribe staked out a territory and all members had the

right to hunt and gather within it. They often did so cooperatively. This worked well so

Q19.5 Does the fact that public decisions are sometimes made by self-interested politicians and

bureaucrats undermine the efficiency of public-sector decision making?

Q19.5 ANSWER

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Q19.6 A pipeline break reduced the supply of gasoline to the Phoenix, Arizona, area in August,

2003. Press reports indicated that some stations ran out of gasoline, consumers waited

in line for hours, and some drivers started following gasoline tankers as they made their

deliveries. Explain the efficiency and equity considerations tied to a competitive- market

allocation of supply versus government-controlled rationing in such circumstances.

Q19.6 ANSWER

When an unexpected supply disruption occurs, and both prices and consumer behavior

remained unchanged, there will not be enough gasoline supplied to satisfy consumer

demand at pre-supply disruption prices. The result is a gas shortage. To eliminate such

a shortage, some form of rationing is required to ensure that the quantity of gasoline

Q19.7 In 1848, the idea of cost-benefit analysis originated with a French engineer by the name

of Jules Dupuit. Economists argue that underlying calculations of costs and benefits

must be based upon actual market behavior and not based upon consumer and producer

surveys or “informed estimates.” Why?

Q19.7 ANSWER

Effective estimates of costs and benefits in cost-benefit analysis should be based upon

consumer and producer valuations as revealed by actual market transactions. Consumer

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Q19.8 To measure public project desirability, positive and negative aspects of the project must

be expressed in terms of a common monetary unit. Explain the importance of the

present value concept in benefit/cost ratio calculations using a 5 percent interest rate

assumption and a 5-year project life.

Q19.8 ANSWER

Not only do the benefits and costs of a given public project need to be expressed in

terms of monetary value, they have to be expressed in terms of dollars at a particular

point in time. This is not just because of differences in the value of dollars at different

Q19.9 The former chairman of the Federal Communications Commission heralded Voice over

Internet Protocol, or VoIP, as “the most important shift in the entire history of modern

communications since the invention of the telephone.” Using cheap computer software

and the Internet, VoIP offers consumers bargain-priced voice and data communication

services. In the process, VoIP threatens to make obsolete the regional bell operating

Government in the Market Economy 593

companies (RBOCs) $125 billion investment in conventional telephone networks.

Explain the risks involved with regulatory policies that encourage or discourage VoIP

adoption. What should the government do?

Q19.9 ANSWER

The shift to VoIP has the ready potential to unleash powerful new competition in the

historically regulated telecommunications industry. Many new and important players

have already emerged, particularly among the cable-TV operators. While the possibility

VoIP is not just cheaper voice telephone service, it is a cheaper and much better

voice and data communications service. The VoIP technology routes calls in “packets”

From the consumer’s standpoint, VoIP is attractive because it allows new

competitors into the phone business, especially the well-capitalized cable companies. If

regulatory policies are pro-competitive, the coming free-for-all will change the face of

the U.S. telecom business. Some now powerful RBOCs may face strong competitive

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Q19.10 “Regulation is often proposed on the basis of equity considerations and opposed on the

basis of efficiency considerations. As a result, the regulation versus deregulation

controversy is not easily resolved.” Discuss this statement.

Q19.10 ANSWER

The regulation versus deregulation debate often involves a tradeoff between equity and

SELF-TEST PROBLEMS AND SOLUTIONS

ST19.1 Pollution Control Costs. Anthony Soprano is head of Satriale Pork Producers, Inc., a

family-run pork producer with a hog-processing facility in Musconetcong, New Jersey.

Each hog processed yields both pork and a render by-product in a fixed 1:1 ratio.

Although the by-product is unfit for human consumption, some can be sold to a local pet

food company for further processing. Relevant annual demand and cost relations are as

follows:

PP = $110 – $0.00005QP,

(Demand for pork)

MRP = ∂TRP/∂QP = $110 – $0.0001QP,

(Marginal revenue from pork)

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MC = ∂TC/∂Q = $60.

(Marginal cost)

Here, P is price in dollars, Q is the number of hogs processed (with an average weight

of 100 pounds), and QP and QB are pork and render by-product per hog, respectively;

both total and marginal costs are in dollars. Total costs include a risk-adjusted normal

return of 15% on a $50 million investment in plant and equipment.

A. Calculate the profit-maximizing price/output combination and optimal total profit

level for Satriale.

B. How much by-product will the company dump into the Musconetcong sewage

treatment facility at the profit-maximizing activity level?

C. Calculate output and total profits if the city imposes a $35 per unit charge on the

amount of by-product Satriale dumps.

D. Calculate output and total profits if the city imposes a fixed $3-million-per-year

tax on Satriale to pay for the sewage treatment facility expansion.

E. Will either tax alternative permit Satriale to survive in the long run? In your

opinion, what should the city of Musconetcong do about its sewage treatment

problem?

ST19.1 SOLUTION

A. Solution to this problem requires that one look at several production and sales

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Thus, the profit-maximizing output level for production and sale of equal

Because the marginal revenue for B is negative, and Satriale can costlessly dump

excess production, the sale of 200,000 units of B is suboptimal. This invalidates

the entire solution developed above because output of P is being held down by the

Thus, 50,000 units of B are the maximum that would be sold. Any excess units

will be dumped into the city’s sewage treatment facility. The price for B at 50,000

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To determine the optimal production of P (pork), set the marginal revenue of P

equal to the marginal cost of hog processing because pork production is the only

and

Excess profits at the optimal activity level for Satriale are:

Because total costs include a normal return of 15% on $50 million in investment,

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C. In part A, it is shown that if all P and B produced is sold, an activity level of Q =

200,000 results in MRB = -$30. A dumping charge of $35 per unit of B will cause

Although eliminating dumping is obviously attractive in the sense of

reducing sewage treatment costs, the $35 fine has the unfortunate consequence of

cutting output substantially. Pork prices rise to PP = $110 – $0.00005(200,000) =

$100, and by product prices fall to PB = $10 – $0.0001(200,000) = -$10. This

means Satriale will pay the pet food company $10 per unit to accept all of its by–

product sludge. Employment will undoubtedly fall as well. In addition to these

obvious short-run effects, long-run implications may be especially serious. At Q =

200,000, Satriale’s excess profits are:

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D. In the short run, a $3 million tax on Satriale has no effect on dumping, output or

ST19.2 Benefit-cost Analysis Methodology. The benefit-cost approach first surfaced in France

during 1844. In this century, benefit-cost analysis has been widely used in the

evaluation of river and harbor projects since as early as 1902. In the United States, the

1936 Flood Control Act authorized federal assistance in developing flood-control

programs “if the benefits to whomsoever they may accrue are in excess of the estimated

costs.” By 1950, federal agency practice required the consideration of both direct and

indirect benefits and costs and that unmeasured intangible influences be listed. Despite

this long history of widespread use, it has only been since 1970 that public-sector

managers have sought to broadly apply the principles of benefit-cost analysis to the

evaluation of agricultural programs, rapid transit projects, highway construction, urban

renewal projects, recreation facility construction, job training programs, health-care

reform, education, research and development projects, and defense policies.

A. Briefly describe major similarities and differences between public-sector

benefit-cost analysis and the private-sector capital budgeting process.

B. What major questions must be answered before meaningful benefit-cost analysis is

possible?

ST19.2 SOLUTION

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A. Benefit-cost analysis is a method for assessing the desirability of social programs

B. Before meaningful benefit-cost analysis is possible, a number of important policy

questions must be answered. Among these policy questions are

▪ What is the social objective function that is to be maximized?

C. A number of constraints impinge upon society’s ability to maximize the social

benefits derived from public expenditures. Among these constraints are

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D. An important potential use of benefit-cost analysis is as the structure for a general

philosophy of government resource allocation. As such, the results of benefit-cost

studies have the potential to serve as a guide for resource-allocation decisions

Although a benefit-cost approach to evaluating all levels and forms of

government is conceptually appealing on an efficiency basis, it suffers from a

number of serious practical limitations. Perhaps most importantly, the

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PROBLEMS & SOLUTIONS

P19.1 Market Imperfections. Markets usually allocate resources in a manner that creates the

greatest net benefit to society. An efficient allocation is one that maximizes the net

benefits to society. Indicate whether each of the following statements is true or false,

and explain your answer.

A. Markets sometimes fail to allocate resources efficiently. Under such

circumstances, it always makes sense for the government to impose taxes in the

case of negative externalities or subsidies in the case of positive externalities.

B. A negative externality exists when a voluntary market transaction between two

parties imposes involuntary costs on a third party.

C. Efficiency mandates that the prices of goods and services reflects all incremental

costs of production, including the cost of inputs, the value of producer time and

effort, and any spillover effects.

D. With a Pigou tax, the costs that pollution imposes on the public will be considered

when the firm decides where to locate a plant, which technologies to use, or how

much to produce.

E. In all cases, the best remedy for externalities is to define property rights and allow

the affected parties to transact privately to achieve mutually beneficial outcomes.

P19.1 SOLUTION

A. False. Poorly designed or unnecessary government regulations can reduce

society’s overall well-being. Costs of government regulation include the expenses

Government in the Market Economy 603

D. True. With an appropriate Pigou tax the costs that pollution imposes on the public

will be considered when the firm decides where to locate a plant, which

technologies to use, or how much to produce. When external costs tied to

P19.2 Negative Externalities. Coal-fired electricity-generating plants emit substantial

amounts of sulfur dioxide and particulate pollution into the atmosphere. Concerned

citizens are appalled at the aesthetic and environmental implications of such pollution,

as well as the potential health hazard to the local population.

In analyzing remedies to the current situation, three general methods used to

control air pollution are generally considered:

▪ Regulations — licenses, permits, compulsory standards, and so on.

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Answer the following questions in light of these alternative methods of pollution

control.

A. Pollution is a negative externality and a major cause of market failure. Explain

why markets fail.

B. What is the incentive provided to polluters under each method of pollution

control?

C. Who pays for a clean environment under each form of control?

P19.2 SOLUTION

A. Market failure sometimes occurs because the number of buyers and sellers is too small

B. Each alternative method of pollution control provides producers with a different set of

incentives. With rules and regulations, producers often have an incentive to litigate or

Government in the Market Economy 605

C. When polluters are forced to respond to rules and regulations, the company, customers,

employees, and stockholders are all faced with the prospect of paying the costs of

pollution reduction. The incidence of pollution cleanup costs depends on the elasticity

D. Efficiency considerations typically favor payments and charges over rules and

regulations as the more efficient methods of pollution control. From an efficiency

standpoint, pollution charges are especially attractive in that they recognize pollution as

a sometimes necessary cost of doing business, and they force cleanup costs to be borne

P19.3 Costs of Regulation. Hathaway-Ross Instruments, Inc., manufactures an innovative

piece of diagnostic equipment used in medical laboratories and hospitals. OSHA has

determined that additional safety precautions are necessary to bring radioactive leakage

occurring during use of this equipment down to acceptable levels. Total and marginal

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production costs, including a normal rate of return on investment but before additional

safeguards are installed, are as follows:

TC = $5,000,000 + $5,000Q

MC =



TC/



Q = $5,000

Market demand and marginal revenue relations are the following:

A. Assuming that the company faces two distinct markets, calculate the profit–

maximizing price/output combination in each market and economic profits.

B. Describe the short- and long-run implications of meeting OSHA standards if doing

so raises marginal cost by $1,000 per machine.

C. Calculate the point price elasticity at the initial (part A) profit-maximizing activity

level in each market. Are the differential effects on sales in each market that were

seen in part B typical or atypical?

P19.3 SOLUTION

A. With two distinct markets, the company will maximize profits by setting MR = MC in

each market and solving for Q.

Medical Laboratories

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B. The short-run implications of a $1,000 per unit in OSHA-mandated cost increases can be