Economics Chapter 5 Homework A public good is one where consumption in non-rival and non-excludable. Private goods are not profitable because of the free rider problem

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Chapter 05 – Market Failures: Public Goods and Externalities

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Chapter 05 Market Failures: Public Goods and Externalities

QUESTIONS

1. Explain the two causes of market failures. Given their definitions, could a market be affected

by both types of market failures simultaneously? LO1

Answer: A public good is one where consumption in non-rival and non-excludable.

Private goods are not profitable because of the free rider problem. If we want to set off

fireworks and charge for the event, we probably wouldn’t generate much revenue. We

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2. Draw a supply and demand graph and identify the areas of consumer surplus and producer

surplus. Given the demand curve, what impact will an increase in supply have on the amount of

consumer surplus shown in your diagram? Explain why. LO2

Answer:

3. Use the ideas of consumer surplus and producer surplus to explain why economists say

competitive markets are efficient. Why are below- or above-equilibrium levels of output

inefficient, according to these two sets of ideas? LO2

Answer: When the consumers’ utility exceeds the price paid, consumer surplus is

generated. Likewise, when producers receive a price greater than marginal cost, producer

surplus is created. By producing up to the point where MB = MC, the maximum

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4. What are the two characteristics of public goods? Explain the significance of each for public

provision as opposed to private provision. What is the free-rider problem as it relates to public

goods? Is U.S. border patrol a public good or a private good? Why? How about satellite TV?

Explain. LO3

Answer: Public goods are nonrival (one person’s consumption does not prevent

consumption by another) and nonexcludable (once the goods are produced nobody—

including free riders—can be excluded from the goods’ benefits). If goods are nonrival,

5. Draw a production possibilities curve with public goods on the vertical axis and private goods

on the horizontal axis. Assuming the economy is initially operating on the curve, indicate how the

production of public goods might be increased. How might the output of public goods be

increased if the economy is initially operating at a point inside the curve? LO3

Answer: On the curve, the only way to obtain more public goods is to reduce the

production of private goods (from C to B).

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6. Use the distinction between the characteristics of private and public goods to determine

whether the following should be produced through the market system or provided by government:

(a) French fries, (b) airport screening, (c) court systems, (d) mail delivery, and (e) medical care.

State why you answered as you did in each case. LO3

Answers:

(a) French fries—market system (rival and excludable)

7. What divergences arise between equilibrium output and efficient output when (a) negative

externalities and (b) positive externalities are present? How might government correct these

divergences? Cite an example (other than the text examples) of an external cost and an external

benefit. LO4

Answers:

(a) When negative externalities are present, the equilibrium output will be greater than

the efficient output. This is because the producer, who is not bearing the full cost of

production, will be able to produce more at a lower price than the efficient level,

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8. Why are spillover costs and spillover benefits also called negative and positive externalities?

Show graphically how a tax can correct for a negative externality and how a subsidy to producers

can correct for a positive externality. How does a subsidy to consumers differ from a subsidy to

producers in correcting for a positive externality? LO4

Answers: Spillover costs are called negative externalities because they are external to the

participants in the transaction and reduce the utility of affected third parties (thus

9. An apple grower’s orchard provides nectar to a neighbor’s bees, while the beekeeper’s bees

help the apple grower by pollinating his apple blossoms. Use Figure 5.6b to explain why this

situation of dual positive externalities might lead to an underallocation of resources to both apple

growing and beekeeping. How might this underallocation get resolved via the means suggested

by the Coase theorem? LO4

Answers: Using Figure 5.6b in the text the following can be said: The market demand

curves for apples and honey, Da and Dh, would not include the spillover benefits

10. The Lojack car recovery system allows the police to track stolen cars. As a result, they not

only recover 90% of Lojack-equipped cars that are stolen but also arrest many auto thieves and

shut down many “chop shops” that take apart stolen vehicles to get at their used parts. Thus,

Lojack provides both private benefits and positive externalities. Should the government consider

subsidizing Lojack purchases? LO4

Answers: If the government were to subsidize Lojack purchases, this would reduce the

private cost of the anti-theft devices. This reduction in the private cost would, in-turn,

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11. Explain the following statement, using the MB curve in Figure 5.9 to illustrate: “The optimal

amount of pollution abatement for some substances, say, dirty water from storm drains, is very

low; the optimal amount of abatement for other substances, say, cyanide poison, is close to 100

percent.” LO5

Answers: Reducing water flow from storm drains has a low marginal benefit, meaning

the MB curve would be located far to the left of where it is in the text diagram. It will

12. Explain why zoning laws, which allow certain land uses only in specific locations, might be

justified in dealing with a problem of negative externalities. Explain why in areas where buildings

sit close together tax breaks to property owners for installing extra fire prevention equipment

might be justified in view of positive externalities. Explain why excise taxes on beer might be

justified in dealing with a problem of external costs. LO5

Answers: Zoning could force businesses producing negative externalities to locate in

regions where these costs would not spill over onto third parties, or where such costs

would at least be reduced. Businesses wanting to locate in regions where external costs

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13. LAST WORD Distinguish between a carbon-tax and a cap-and-trade strategy for reducing

carbon dioxide and other so-called greenhouse gases (that are believed by many scientists to be

causing global warming). Which of the two strategies do you think would have the most political

support in an election in your home state? Explain your thinking.

Answers: Scientific evidence suggests that carbon dioxide and other gas emissions are

accumulating and causing the average temperature of the atmosphere to increase. In the

PROBLEMS

1. Refer to Table 5.1. If the six people listed in the table are the only consumers in the market and

the equilibrium price is $11 (not the $8 shown), how much consumer surplus will the market

generate? LO2

Feedback: Consider the following table as an example:

Using the values above, and assuming an equilibrium price of $11 (not the $8 shown), we

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2. Refer to Table 5.2. If the six people listed in the table are the only producers in the market and

the equilibrium price is $6 (not the $8 shown), how much producer surplus will the market

generate? LO2

Feedback: Consider the following table as an example:

3. Look at Tables 5.1 and 5.2 together. What is the total surplus if Bob buys a unit from Carlos? If

Barb buys a unit from Courtney? If Bob buys a unit from Chad? If you match up pairs of buyers

and sellers so as to maximize the total surplus of all transactions, what is the largest total surplus

that can be achieved? LO2

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Feedback: Consider the following tables as an example:

If Bob buys a unit of the good from Carlos, then the economic surplus is the difference

between Bob’s “maximum price willing to pay” and Carlos’s the “minimum acceptable

price.” The economic surplus is $10 (= $13- $3)

If Barb buys a unit form Courtney, then the economic surplus equals $8 (= $12 – $4).

If Bob buys a unit form Chad, then the economic surplus is $5 (= $13 – $8).

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4. ADVANCED ANALYSIS Assume the following values for Figures 5.4a and 5.4b. Q1 = 20

bags. Q2 = 15 bags. Q3 = 27 bags. The market equilibrium price is $45 per bag. The price at a is

$85 per bag. The price at c is $5 per bag. The price at f is $59 per bag. The price at g is $31 per

bag. Apply the formula for the area of a triangle (Area = ½ x Base x Height) to answer the

following questions. LO2

a. What is the dollar value of the total surplus (producer surplus plus consumer surplus) when the

allocatively efficient output level is being produced? How large is the dollar value of the

consumer surplus at that output level?

b. What is the dollar value of the deadweight loss when output level Q2 is being produced? What

is the total surplus when output level Q2 is being produced?

c. What is the dollar value of the deadweight loss when output level Q3 is produced? What is the

dollar value of the total surplus when output level Q3 is produced?

Feedback: To answer this question, let us first find the mathematical representation of

the supply and demand schedules. To help us accomplish this objective we us the

following figures.

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Now consider the following values as an example. Assume the following values for

Figures 5.4a and 5.4b: The equilibrium quantity Q1 = 20, the market equilibrium price is

$45 per bag, the price at a is $85 per bag, the price at c is $5 per bag.

To derive the demand schedule (inverse demand schedule), we use the following ordered

pairs: (20,45) equilibrium and (0,85) point a.

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Part (a): What is the dollar value of the total surplus (producer surplus plus consumer

surplus) when the allocatively efficient output level is being produced? How large is the

dollar value of the consumer surplus at that output level?

To calculate total surplus we use the following formula for the area of a triangle (Area =

½ (Base x Height)).

Part (b): What is the dollar value of the deadweight loss when output level Q2 is being

produced? What is the total surplus when output level Q2 is being produced?

The first thing we need to do is calculate the price at Q2 = 15 for the supply and demand

schedules. The price on the supply schedule is P = 5 + 2 x 15 = 35. The price on the

Part (c): What is the dollar value of the deadweight loss when output level Q3 is

produced? What is the dollar value of the total surplus when output level Q3 is produced?

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Here we follow the same procedure. We are given the price at point f is $59 and the price

at point g is $31 (we do not need to calculate these prices using the demand and supply

5. On the basis of the three individual demand schedules below, and assuming these three people

are the only ones in the society, determine (a) the market demand schedule on the assumption that

the good is a private good and (b) the collective demand schedule on the assumption that the good

is a public good. LO3

Answers: (a) Market demand schedule

Quantity Demanded

Price

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(b) Collective demand schedule

Quantity

Amount Society is

Willing to Pay

$19

$16

Feedback: Consider the following table:

Part (a): Derive the market demand schedule on the assumption that the good is a private

good. To accomplish we use the principle of horizontal summation. That is, we fix price

and add up the quantities demanded by the individuals.

At a price of $8: individual 1 (I1) demands 0, individual 2 (I2) demands 1, and individual

3 (I3) demands 0. Thus, we have the following market demand ordered pair (1,8).

$10

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At the quantity 1: I1 is willing to pay $5, I2 is willing to pay $8, and I3 is willing to pay

$6. Thus, we have the following collective demand ordered pair (1,19=5+8+6).

At the quantity 2: I1 is willing to pay $4, I2 is willing to pay $7, and I3 is willing to pay

$5. Thus, we have the following collective demand ordered pair (2,16).

At the quantity 3: I1 is willing to pay $3, I2 is willing to pay $6, and I3 is willing to pay

$4. Thus, we have the following collective demand ordered pair (3,13).

6. Use your demand schedule for a public good, determined in problem 5, and the following

supply schedule to ascertain the optimal quantity of this public good. LO3

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Feedback: From the example table in problem 5, we calculated the collective demand

schedule from the individual demand schedules:

Collective Demand Schedule:

Quantity

Price Society is

Willing to Pay

$19

$16

$13

$10

Combining this collective demand schedule with the following supply schedule, we can

determine the optimal provision (quantity) of the public good.

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7. Look at Tables 5.1 and 5.2, which show, respectively, the willingness to pay and willingness to

accept of buyers and seller of bags of oranges. For the following questions, assume that the

equilibrium price and quantity will depend on the indicated changes in supply and demand.

Assume that the only market participants are those listed by name in the two tables. LO4

a. What is the equilibrium price and quantity for the data displayed in the two tables?

b. What if instead of bags of oranges, the data in the two tables dealt with a public good like

fireworks displays. If all the buyers free ride, what will be the quantity supplied by private

sellers?

c. Assume that we are back to talking about bags of oranges (a private good), but that the

government has decided that tossed orange peels impose a negative externality on the public that

must be rectified by imposing a $2-per-bag tax on sellers. What is the new equilibrium price and

quantity? If the new equilibrium quantity is the optimal quantity, by how many bags were oranges

being overproduced before?

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Part (a): To determine the equilibrium price of oranges, we begin by comparing the

highest willingness to pay with the lowest minimum acceptable price. Bob is willing to

pay $13 and Carlos is willing to accept at minimum $3. This trade is made because Bob

is willing to pay more than Carlos requires for the sale. We then move on to the trade

quantity is 6 at the equilibrium price of $8.

Part (b): If instead of bags of oranges, the data in the two tables dealt with a public good

Part (c): If the government decides that tossed orange peels impose a negative externality

on the public that must be rectified by imposing a $2-per-bag tax on sellers, then the

“minimum acceptable price” will increase by the amount of the tax. The reason is that the

producers must now pay an additional $2 on top production costs. This implies that the

If this is the optimal quantity, then the market was overproducing by 1 unit before the tax

was imposed on orange producers.