Deck 16: Externalities and Public Goods

Question 1

At several places in previous chapters, we have illustrated ''deadweight loss'' triangles. Explain why the triangle ABE in Figure represents exactly the same kind of deadweight loss as in the monopoly case.
Figure An Externality in Charcoal Production Causes an Inefficient Allocation of Resources

Answer 1

Generally dead weight loss refers to loss of either consumer surplus or producer surplus which results from either increase or decrease of production. Figure 16.1 is as follows:-
Figure
Externalities produce the dead weight loss due to increased social marginal cost ( MCS ). Difference between the marginal cost ( MC ) and social marginal cost ( MCS ) is the extra cost that is bear by society.
Equilibrium has been set up where the marginal cost and marginal revenue or price intersects each other. But at this point social marginal cost is greater than the marginal cost. Society is bearing more than the specified by private marginal cost. Cost equal to BE per unit is not taken into account by price mechanism.
Equilibrium price must be established at the point A where the social marginal cost has been reduced to price level. Equilibrium output is
. If firm does not decrease the production to the level of
, society is made to pay or suffer cost equivalent to ABE. This is called dead weight loss.

Question 2

A firm in a perfectly competitive industry has patented a new process for making widgets. The new process lowers the firm's average costs, meaning this firm alone (although still a price taker) can earn real economic profits in the long run.
a. If the market price is $20 per widget and the firm's marginal cost curve is given by MC = 0.4q, where q is the daily widget production for the firm, how many widgets will the firm produce?
b. Suppose a government study has found that the firm's new process is polluting the air and the study estimates the social marginal cost of widget production by this firm to be MCS = 0.5q. If the market price is still $20, what is the socially optimal level of production for the firm? What should the amount of a government-imposed excise tax be in order to bring about this optimal level of production?

Answer 2

In perfect competition price and equilibrium quantity is determined by interaction of demand and supply. Firm is price taker. Price remains same if demand and supply forces do not change. Price, average revenue and marginal revenue are equal.
a) Equilibrium production
The market price is $20 per widget and marginal cost curve of firm is given by
. Following is important condition for equilibrium
Marginal revenue is equal to the price in perfect competition and marginal cost is
b) Socially optimum production
The firm's new process is polluting the air and social marginal cost
. Price does not change. Condition for equilibrium is as follows:-
Now equilibrium quantity has reduced from the 50 to 40.
On substituting the value of
in marginal cost function,
Excise tax is equal to difference between market price and marginal cost:-
Excise tax will be
.

Question 3

If one firm raises the costs of another firm by bidding against it for its inputs, that is not an externality by our definition. But, if a firm raises the costs of another firm by polluting the environment, that is an externality. Explain the distinction between these two situations. Why does the second lead to an inefficient allocation of resources but the first does not?

Answer 3

Externality arises when social cost and private cost diverge. Price mechanisms do not provide solutions to this problem. It is very difficult to quantify externality and to assign responsibility for it to someone else. Bidding is a process whereby the price is determined through bids. A price mechanism fully works in such a process. The highest bidder gets to buy the item or items. The input price increases due to competition and not due to environmental damage.
On the other hand, in the case of pollution, the social cost is higher than the private cost. Environmental degradation causes negative externalities on other firms, which may resort to taking remedial actions. It is very difficult to quantify the cost of externalities and to penalize the polluting firms until the property rights are rigidly defined. Price mechanism does not offer a solution to this problem. In negative externality, the optimum production level is lower than the individual optimum output.

Question 4

The Coase theorem requires both that property rights be fully specified and that there be no transactions costs.
1. Would efficiency be achieved if transactions costs were zero but property rights did not exist?
2. Would efficiency be achieved if transactions costs were high but property rights were fully defined? Would your answer to this question depend on which party was assigned the property rights?

Question 5

On the island of Pago-Pago, there are two lakes and 20 fishers. Each fisher gets to fish on either lake and gets to keep the average catch on that lake. On Lake X, the total number of fish caught is given by
F X = 10L x - L X 2
where LX is the number of fishers on the lake. The amount an additional fisher will catch is MP X =10-L X. For Lake Y, the relationship is
F y - 5L y
a. Under this organization of society, what will the total number of fish caught be? Explain the nature of the externality in this equilibrium.
b. The chief of Pago-Pago, having once read an economics book, believes that she can raise the total number of fish caught by restricting the number of fishers allowed on Lake X. What is the correct number of fishers on Lake X to allow in order to maximize the total catch of fish? What is the number of fish caught in this situation?
c. Being basically opposed to coercion, the chief decides to require a fishing license for Lake X. If the licensing procedure is to bring about the optimal allocation of labor, what should the cost of a license be (in terms of fish)?

Question 6

Our general definition of economic efficiency focuses on mutually beneficial transactions. Explain why the presence of externalities may result in some mutually beneficial transactions being forgone. Illustrate these using Figure.
Figure An Externality in Charcoal Production Causes an Inefficient Allocation of Resources

Question 7

Suppose that the government does not have detailed information about the costs of the firms that produce pollution.
1. Why are the three methods described here for attaining R* superior to a regulatory strategy that requires firms to install a specific technology that would allow them to attain R*?
2. How well do the three strategies minimize the information that the government needs?

Question 8

Suppose that the oil industry in Utopia is perfectly competitive and that all firms draw oil from a single (and practically inexhaustible) pool. Each competitor believes that he or she can sell all the oil he or she can produce at a stable world price of $10 per barrel and that the cost of operating a well for one year is $1,000.
Total output per year (Q) of the oil field is a function of the number of wells (N) operating in the field. In particular,
Q = 500N = N2
and the amount of oil produced by each well (q)is given by
q = Q/N = 500 = N
The output from the Nth well is given by
MP N = 500 = 2N
a. Describe the equilibrium output and the equilibrium number of wells in this perfectly competitive case. Is there a divergence between private and social marginal cost in the industry?
b. Suppose that the government nationalizes the oil field. How many oil wells should it operate? What will total output be? What will the output per well be?
c. As an alternative to nationalization, the Utopian government is considering an annual license fee per well to discourage overdrilling. How large should this license fee be to prompt the industry to drill the optimal number of wells?

Question 9

The proof of the Coase theorem requires that firms recognize both the explicit and implicit costs of their decision. Explain a situation where a firm's failure to curtail pollution may cause it to incur implicit costs. Why is the assumption of zero bargaining costs crucial if the firm is to take account of these costs?

Question 10

Explain why a public good must have the nonexclusivity feature if free riding is to occur.
2. Would a public good that had the nonrivalry property but not the nonexclusivity property be subject to free riding? Why might such a good be produced at inefficient levels anyway?

Question 11

Wile E. Coyote purchases a variety of equipment with which to catch roadrunners. Invariably he finds that the equipment fails to work as promised. For example, the Acme Road Runner Rocket he purchased misfired and pushed him backwards over a steep cliff, the Acme Flamethrower only singed his whiskers, and the spring-mounted net ended up capturing him instead of the roadrunner.
a. Show how the Coase theorem would apply to transactions between predators and companies manufacturing roadrunner-catching equipment. In the full information case, would the equipment have efficient operating characteristics regardless of how legal liability is defined?
b. Many predators, including Mr. Coyote, are rather careless in how they use their equipment. If this carelessness is not affected by assignment of legal liability and if it is fully understood by producers, would its presence change your answer to part a?
c. Suppose predators became even more careless when they knew manufacturers would have legal liability for any injuries. How would this affect your answer to part a?
d. Assume that a single firm (the Acme Manufacturing Company) has a monopoly in the supply of roadrunner-catching equipment. How, if at all, would this change your answer to part a?
Note: ( This question was motivated by the great comic essay by Ian Frazier, Coyote v. Acme, New York: Farrar, Straus and Giroux, 1996.)

Question 12

Explain why the level of emissions control R*in Figure is economically efficient. Why would the levels of abatement given by RL and RH result in inefficiency? What kinds of inefficient trades would be occurring at these levels of abatement?
Figure Optimal Pollution Abatement

Question 13

As an illustration of the apple-bee externality, suppose that a beekeeper is located next to a 20-acre apple orchard. Each hive of bees is capable of pollinating ^ acre of apple trees, thereby raising the value of apple output by $25.
a. Suppose the market value of the honey from one hive is $50 and that the beekeeper's marginal costs are given by
MC = 30 +.5Q
where Q is the number of hives employed. In the absence of any bargaining, how many hives will the beekeeper have and what portion of the apple orchard will be pollinated?
b. What is the maximum amount per hive the orchard owner would pay as a subsidy to the beekeeper to prompt him or her to install extra hives? Will the owner have to pay this much to prompt the beekeeper to use enough hives to pollinate the entire orchard?

Question 14

Figure 16 shows that an emissions fee can be chosen that attains the same level of pollution reduction as does direct control. Explain why firms would make the same choices under either control method. Would this equivalence necessarily hold if government regulators did not know the true marginal costs of emissions control?
Figure Optimal Pollution Abatement

Question 15

A government study has concluded that the marginal benefits from controlling cow-induced methane production are given by
MB = 100 - R
where R represents the percentage reduction from unregulated levels. The marginal cost to farmers of methane reduction (through better cow feed) is given by
MC = 20 + R
a. What is the socially optimal level of methane reduction?
b. If the government were to adopt a methane fee that farmers must pay for each percent of methane they do not reduce, how should this fee be set to achieve the optimal level of R?
c. Suppose there are two farmers in this market with differing costs of methane reduction. The first has marginal costs given by
MC1 - 20 + 3 R1
whereas the second has marginal costs given by
MC2 = 20 + 2R2
Total methane reduction is the average from these two farms. If the government mandates that each farm reduce methane by the optimal percentage calculated in part a, what will the overall reduction be and what will this reduction cost (assuming there are no fixed costs to reducing methane)?
d. Suppose, instead, that the government adopts the methane fee described in part b. What will be the total reduction in methane and what will this reduction cost? e. Explain why part c and part d yield different results.

Question 16

Television receivers
b. Over-the-air television transmissions
c. Cable television transmissions
d. Elementary education
e. College education
f. Electric power
g. Delivery of first-class mail
h. Low-income housing

Question 17

Suppose there are only two people in society. The demand curve for person A for mosquito control is given by
q A a = 100 - P
For person B, the demand curve for mosquito control is given by
q B = 200 - P
a. Suppose mosquito control is a nonexclusive good-that is, once it is produced everyone benefits from it. What would be the optimal level of this activity if it could be produced at a constant marginal cost of $50 per unit?
b. If mosquito control were left to the private market, how much might be produced? Does your answer depend on what each person assumes the other will do?
c. If the government were to produce the optimal amount of mosquito control, how much would this cost? How should the tax bill for this amount be allocated between the individuals if they are to share it in proportion to benefits received from mosquito control?

Question 18

The Lindahl solution to the public-goods problem promises economic efficiency on a voluntary basis. Why would each person voluntarily agree to the tax assessments determined under the Lindahl solution? What choice is he or she being asked to make?

Question 19

Suppose there are three people in society who vote on whether the government should undertake specific projects. Let the net benefits of a particular project be $150, $140, and $50 for persons A, B, and C, respectively.
a. If the project costs $300 and these costs are to be shared equally, would a majority vote to undertake the project? What would be the net benefits to each person under such a scheme? Would total net benefits be positive?
b. Suppose the project cost $375 and again costs were to be shared equally. Now would a majority vote for the project and total net benefits be positive?
c. Suppose (presumably contrary to fact) votes can be bought and sold in a free market. Describe what kinds of results you might expect in part a and part b.

Question 20

Why is the ''paradox of voting'' a paradox? What, if anything, is undesirable about a voting scheme that cycles? How will issues be decided in such cases?

Question 21

The town of Pleasantville is thinking of building a swimming pool. Building and operating the pool will cost the town $5,000 per day. There are three groups of potential pool users in Pleasantville: (1) 1,000 families who are each willing to pay $3 per day for the pool, (2) 1,000 families who are each willing to pay $2 per day for the pool, and (3) 1,000 families who are each willing to pay $1 per day for the pool. Suppose also that the intended pool is large enough so that whatever number of families come on any day will not affect what people are willing to pay for the pool.
a. Which property of public goods does this pool have? Which does it not have?
b. Would building the pool be an efficient use of resources?
c. Consider four possible prices for family admission to the pool: (1) $3, (2) $2, (3) $1, and
(4) $0. Which of these prices would result in covering the cost of the pool? Which of the prices would achieve an efficient allocation of resources?
d. Is there any pricing scheme for admission to this pool that would both cover the pool's cost and achieve an efficient allocation of resources?
e. Suppose that this pool has a capacity of only 2,000 families per day. If more than 2,000 families are admitted, the willingness to pay of any family (with children or not) falls to $0.50 per day. Now what is the efficient pricing scheme for the pool?

Question 22

'Under perfect competition, voting with dollars achieves economic efficiency, but democratic voting (one person-one vote) offers no such promise.'' Do you agree? Why does the specification of one vote per person interfere with the ability to achieve economic efficiency?

Question 23

The demand for gummy bears is given by
Q = 200 - 100P
and these confections can be produced at a constant marginal cost of $0.50.
a. How much will Sweettooth, Inc., be willing to pay in bribes to obtain a monopoly concession from the government for gummy bear production?
b. Do the bribes represent a welfare cost from rent seeking?
c. What is the welfare cost of this rent-seeking activity?

Question 24

Why would individuals or firms engage in rent-seeking behavior? How much will they spend on such behavior? Are there externalities associated with rent seeking?

Question 25

Some people argue that smokers create additional "externalities" in their behavior by driving up healthcare and insurance costs for nonsmokers. Are such effects "externalities"? How, if at all, do they distort the allocation of resources? How would an efficient market handle smoking risks in, say, health insurance premiums?

Question 26

efficient market handle smoking risks in, say, health insurance premiums?

Question 27

In the bees-apples case, considerable bargaining may be required to reach a satisfactory contract, and, in some instances, the bees may wander out of their contracted areas. What factors would determine whether it will be cost effective to develop private property contracts in such situations?

Question 28

Isn't the notion of ''privatizing wildlife'' (as Botswana has done for elephants) crass commercialism? Wouldn't a better solution be to develop a conservationist ethic under which everyone agreed to nurture the planet's wild heritage?

Question 29

This example shows that product liability law has a potentially beneficial role to play in improving the allocation of resources to risky products, especially when those risks are not understood by consumers. In actual practice, however, product liability cases have been criticized for yielding wildly differing results and for imposing unrealistic damage assessments on firms. Many observers have suggested that product liability law (and its close relative medical malpractice law) needs to be reformed by tightening up standards of scientific proof and by putting caps on certain types of claims. Achieving the right balance between such restric-tionsand helping markets to internalize harms is no easy task.

Question 30

Developing an efficient approach to regulating CO 2 emissions is perhaps the greatest policy challenge facing many nations over the next decade. Not only will policy responses have to be flexible enough to adapt to emerging scientific evidence, but they must also be robust to the variety of political attempts to manipulate them to special interest advantages that are sure to arise. A few of the questions that will need to be addressed include
• How stringent should CO 2 caps be? Answering this question will implicitly show how much we are willing to spend to achieve CO 2 reductions.
• Whose emissions should be capped? Operating a cap-and-trade policy for power plants is relatively easy because there are few of them, but designing CO 2 reduction policy for other emitters is much more difficult and vulnerable to political pressures. For example, in principle, reducing automobile emissions might be obtained through a higher gasoline tax, but such a tax would not directly tax CO 2 emissions, so its incentive effects are more complex than in the power plant case.
• What to do with emission permit revenues? A large-scale cap-and-trade program will generate significant revenues. These may be used to finance other forms of government spending or to reduce other taxes. Views on the desirability of these different approaches will (obviously) vary widely.

Question 31

The development of an optimal policy for protection of intellectual property requires a careful consideration of the trade-off between creating incentives for the production of such property and the deadweight losses arising from the monopoly that such property rights provide to their owners. In principle, one would imagine that this trade-off would yield different levels of protection for different types of property. That is, patent or copyright protection could vary in duration or could require various types of rights sharing, depending on these relative costs and benefits. For example, some health care advocates argue that drug patents should allow some creation of generics when the primary beneficiaries are residents of low-income countries (this is the case for AIDS-related drugs). Some creative artists argue that copyright protection should be enforced more rigorously, whereas many digital advocates argue against this view. Clearly, reaching a nuanced policy concensus can be very difficult.

Question 32

Is there a conflict between what advertisers will support and what viewers wish to see on television? Does the support mechanism for public broadcast mitigate these conflicts?

Question 33

In many countries, public broadcasting is supported through direct taxation. Does this solve the problem of free riders? How would you determine whether such direct government support improves welfare?

Question 34

Since World War II, the fraction of GDP devoted to government has risen substantially in virtually every Western country. How do you explain this rise? Is this an accurate reflection of changing demands for public goods, or is ita reflection ofa structural tendencytoward greater public spending in democracies?

Question 35

Two kinds of tax ''limitation'' provisions have been proposed at the national level in the United States: (1) a balanced-budget requirement, and (2) a limitation on the fraction of GDP devoted to government spending. Does the analysis ofthis chapter provide any reasons for thinking that either of these might be a good idea?