Homework 10: Externalities (to be handed in on Thursday 29th April 2004)
1. Which of the following describes an externality and which does not? Explain your answer (1
point)
a) A policy of restricted coffee exports in Brazil causes the US price of coffee to rise – an increase
which in turn also causes the price of tea to rise: The restriction of coffee exports leading to
increase coffee and tea prices is a market effect, not an externality.
b) An advertising blimp distracts a motorist who then hits a telephone pole: The blimp creates a
negative externality that influences the drivers’ safety (since the price charge by the firm does not
reflect the negative externality, too much of this type of advertising is produced from society’s
point of view)
c) Planting flowers in your front garden: The whole neighborhood benefits from you planting flowers
so it is a positive externality. Too little will be planted from society’s point of view.
2. Compare and contrast the following three mechanisms for treating pollution externalities when the
costs and benefits of abatement are uncertain: a) an emission fee; b) an emissions standard; c) a
system of transferable emissions permits (1.5 points)
Since pollution is not reflected in the marginal cost of production, its emission creates an externality.
The choice between a fee and a standard will depend on the marginal cost and marginal benefit of
reducing pollution. If small changes in abatement yield large benefits while adding little to cost, the
cost of not reducing emissions is high. Thus, standards should be used. However, if small changes in
abatement yield little benefit while adding greatly to cost, the cost of reducing emissions is high and
fees/taxes should be used.
A system of transferable permits combines fees and standards. First, a standard is set, and then fees are
used to transfer permits across firms (the firm with the highest MCA will buy the most permits). Note
a problem arises id the total number of permits is incorrectly chosen.
3. Suppose a clothing factory is located downwind from a copper smelting plant. The copper smelting
plant emits particulates into the air that cause $100,000 in damage per year to the clothing factory
in terms of fabric discoloration. The plant could eliminate its emissions by installing a superior
scrubbing technology at a cost of $50,000 per year. Existing regulations do not prohibit the
emission of these particulates. The only way to remedy this inefficiency is through government
intervention. True or false? Explain your answer (1 point)
That the only way to remedy this inefficiency through government intervention is a false statement.
According to the Coase theorem, given that existing regulations do not prohibit the emission of these
particulates, the clothing factory could offer at least $50,000 per year, and no more than $100,000 per
year to the copper smelting plant to install the superior scrubbing technology and thereby eliminate
these emissions.
4. The United Nations Kyoto Protocol of1997 requires most industrial nations to reduce their carbon
dioxide and other greenhouse gas emissions during the ensuing decade to about 5% of 1990 levels.
Explain why such a policy is inefficient. (1 point)
The Kyoto Protocol doesn’t allow for trade in emissions targets between countries. The same total
emissions target could be achieved at lower cost if each country weren’t constrained to reduce
emissions by the same percentage amount and could trade with other countries to achieve a
lower/higher emissions target if it was a higher/lower cost producer of emissions reductions.
5. Using an example, explain why free access to a common resource generates an inefficient outcome
(1 point)\
If you can’t ensure excludability (i.e. no property rights), then we will observe a Tragedy of the
Commons (overfishing, overhunting, etc.). Individual incentives differ from private incentives so the
marginal private cost is less than the social cost. Thus, the common resource will tend to be overused,
generating an inefficient outcome.
6. Public television is funded in part by private donations even though anyone with a TV set can
watch for free? Can you explain this phenomenon in light of the free rider problem? (1 point)
The free rider problem is that if given the opportunity to avoid paying for the use of a good, people
will take that opportunity. Public TV is funded in part by contributions. Some contribute, but most
watch it without paying hoping that someone else will pay so that they do not have to. To combat this
problem, these stations (1) ask consumers to assess their true WTP, then (2) ask consumers to
contribute up to this amount, and (3) attempt to make everyone else feel guilty for free-riding.
7. Assume that scientific studies provide you with the following information concerning the benefits
and costs of sulfur dioxide emissions, where A is the quantity abated in millions of tons (1.5
points):
Benefits of abating (reducing) emissions:
Costs of abating emissions:
MB = 400 – 10A
MC = 100 + 20A
a) What is the socially efficient level of emissions abatement? MB = MC. 400 – 10A = 100 + 20A.
Solving for A gives us A = 10. At A = 10, MB = $300 million, MC = $300 million.
b) What happens to net social benefits (benefits minus costs) if you abate one million more tons than
the efficient level? If you abate one million tons more than the socially efficient level, then MC >
MB. MB = 290; MC = 320. Cost to society = ½ * (320 – 290) * (11 – 10) = $15 million dollars. I.e.
net social benefits decrease by $15 million as compared to the efficient level.
c) Why is it socially efficient to set marginal benefits equal to marginal costs rather than abating until
total benefits equal total costs? In the case of abatement, the more we abate, the costlier it is. Given
that funds are scarce, dollars should be allocated to abatement only as long as the benefit of the last
unit of abatement is greater than or equal to the cost of the last unit of abatement (same principle as
setting MR = MC, and not TR = TC).
8. Initially, the styrofoam cup industry produces with a constant marginal cost of $4. The market
demand for its product is given by P = 22 – Q. Suppose the industry produces air pollution along
with cups. These pollution costs are represented by the marginal external cost function, MEC =
0.2Q. Draw a graph to illustrate this scenario, using your answers to the questions below. (2
points)
a) What output will the free market choose to produce? What is total welfare (the sum of CS and PS)?
In perfect competition, P = MC. Thus, 22 – Q = 4. Q = 18, P = $4. Total welfare = Σ (CS + PS) =
(½ * 18 * 18) + 0 = $162
b) Given the pollution costs, how many styrofoam cups should be produced from society’s point of
view? Total social cost = MC + MEC = 4 + 0.2Q. Thus 22 – Q = 4 + 0.2Q. Socially optimal level
of Q = 15, socially optimal P = $7
c) The EPA requires the industry to adopt a new “lower pollution production technology” that raises
the marginal cost of production to MC = $10. Given this required new technology, how much will
the industry produce? What is the sum of CS and PS at this point? If MC = 10, then 22 – Q = 10.
Thus, Q = 12, and P = $10. At this point, Σ (CS + PS) = (½ * 12 * 12) + 0 = $72
d) A consulting firm estimates the total benefits of reducing pollution using this new technology at
$80. Is the reduction in pollution worth its costs to the producers and consumers of styrofoam
cups? The benefits or reducing pollution are $80, whereas the loss in total welfare = 162 – 72 =
$90. The reduction in pollution is not worth its costs to producers and consumers of Styrofoam
cups.