CHAPTER 18
Externalities, Commons, and Public Goods
MULTIPLE CHOICE
Choose the one alternative that best completes the statement or answers the question.
1) If children go to school and become productive members of society,
A) a negative externality is created by the schools.
B) a positive externality is created by the schools.
C) no externality is created by the schools.
D) an externality is created that may be positive or negative.
Answer: B
Diff: 0
Topic: Externalities
2) Positive externalities are created when
A) other consumers reduce their demand for coffee and price thereby declines.
B) farmers spray pesticide in their fields and it washes into the local river after the first
rainstorm.
C) your neighbor plants beautiful trees and flowers in her yard.
D) you purchase the "Mona Lisa" and lock it in a vault.
Answer: C
Diff: 0
Topic: Externalities
3) Negative externalities are created when
A) an increase in the price of butterfat drives up the price of ice cream.
B) a driver leaves his car in a parking space after the meter expires and receives a ticket.
C) a driver drives recklessly on a busy highway.
D) a driver pulls over to help a stranded motorist fix a flat tire.
Answer: C
Diff: 0
Topic: Externalities
4) If a production process creates pollution, a competitive market produces excessive pollution
because
A) the firms do not include the social cost of the pollution in their profit-maximizing
decisions.
B) the firms place too high a price on society's cost of inflation.
C) people are not injured by the pollution.
D) zero pollution is optimal.
Answer: A
Diff: 1
Topic: The Inefficiency of Competition with Externalities
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5) If a production process creates pollution, a competitive market produces excessive pollution
because
A) private marginal cost of pollution exceeds its social marginal cost.
B) social marginal cost of pollution exceeds its private marginal cost.
C) the marginal benefit of pollution to the firm is zero.
D) zero pollution is optimal.
Answer: B
Diff: 1
Topic: The Inefficiency of Competition with Externalities
6) In the presence of no externalities,
A) social marginal cost exceeds private marginal cost.
B) social marginal cost is less than private marginal cost.
C) social marginal cost equals private marginal cost.
D) social marginal cost and private marginal cost cannot be compared.
Answer: C
Diff: 1
Topic: The Inefficiency of Competition with Externalities
7) If a production process generates pollution, then a competitive market will
A) produce more of the good than is socially optimal.
B) produce less of the good than is socially optimal.
C) produce the socially optimal quantity of that good.
D) produce zero output.
Answer: A
Diff: 1
Topic: The Inefficiency of Competition with Externalities
8) In the presence of an externality, a specific tax can achieve the social optimum because
A) output is reduced to zero as a result.
B) it internalizes the external cost.
C) it directly charges the producer for polluting.
D) the price of the good rises by the full amount of the tax.
Answer: B
Diff: 1
Topic: The Inefficiency of Competition with Externalities
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9) If a production process generates pollution, then a competitive market will produce more of
the good than is socially optimal because
A) firms take all costs into consideration.
B) firms incur all costs of production but ignore some of them.
C) firms ignore the costs of production that they do not incur.
D) firms set price equal to social marginal cost.
Answer: C
Diff: 1
Topic: The Inefficiency of Competition with Externalities
Figure 18.1
10) Figure 18.1 shows the market for steel ingots. If the market is competitive, then
A) the socially optimal quantity of steel is zero.
B) the socially optimal quantity of steel of 50 units is produced.
C) the socially optimal quantity of steel of 100 units is produced.
D) more than the socially optimal quantity of 50 units of steel is produced.
Answer: D
Diff: 1
Topic: The Inefficiency of Competition with Externalities
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11) Figure 18.1 shows the market for steel ingots. An externality can be seen because
A) the social marginal cost exceeds the private marginal cost.
B) the private marginal cost exceeds the social marginal cost.
C) the optimal quantity of steel is zero.
D) not enough steel gets produced by the competitive market.
Answer: A
Diff: 1
Topic: The Inefficiency of Competition with Externalities
12) Figure 18.1 shows the market for steel ingots. If the market is competitive, then the
deadweight loss to society is
A) a.
B) b.
C) c.
D) zero.
Answer: C
Diff: 1
Topic: The Inefficiency of Competition with Externalities
13) Figure 18.1 shows the market for steel ingots. If the market is competitive, then to achieve
the socially optimal level of pollution, the government can
A) outlaw the production of steel.
B) institute a specific tax of $25.
C) institute a specific tax of $50.
D) institute a specific tax equal to area b.
Answer: C
Diff: 1
Topic: The Inefficiency of Competition with Externalities
14) Figure 18.1 shows the market for steel ingots. If the market is competitive, and the
government institutes a $100 specific tax on steel, then
A) less than the socially optimal quantity of steel is produced.
B) the socially optimal quantity of steel of 50 units is produced.
C) the socially optimal quantity of steel of 100 units is produced.
D) more than the socially optimal quantity of steel is produced.
Answer: A
Diff: 1
Topic: The Inefficiency of Competition with Externalities
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15) Figure 18.1 shows the market for steel ingots. The socially optimal quantity of steel is
A) 0 units.
B) 50 units.
C) 100 units.
D) produced if the market were competitive.
Answer: B
Diff: 1
Topic: The Inefficiency of Competition with Externalities
16) Figure 18.1 shows the market for steel ingots. The optimal quantity of pollution
A) is 0 units.
B) is 50 units.
C) is 100 units.
D) cannot be determined from the information provided.
Answer: D
Diff: 1
Topic: The Inefficiency of Competition with Externalities
17) In the presence of a negative externality in production, a monopoly will produce
A) more than the social optimum.
B) less than the social optimum.
C) the social optimum.
D) All of the above are possible.
Answer: D
Diff: 1
Topic: Market Structure and Externalities
18) Because a monopoly ignores external costs, it is possible that it will
A) produce the socially optimal quantity of a good.
B) produce more than the socially optimal quantity of a good.
C) produce less than the socially optimal quantity of a good.
D) produce zero pollution.
Answer: B
Diff: 1
Topic: Market Structure and Externalities
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19) A monopoly might produce less than the socially optimal amount of pollution because
A) it likes to be a good citizen.
B) it sets price above marginal cost.
C) it earns economic profit.
D) it internalizes the external costs.
Answer: B
Diff: 1
Topic: Market Structure and Externalities
20) If the social marginal cost of a good is very high relative to the private marginal cost, then a
monopoly will most likely
A) produce more than the social optimum.
B) produce less than the social optimum.
C) produce the social optimum.
D) produce zero pollution.
Answer: A
Diff: 1
Topic: Market Structure and Externalities
21) If both a monopoly and a competitive market with the same marginal would produce a
quantity that is greater than the social optimum in a market because of externalities, then
A) welfare is greater under monopoly.
B) welfare is greater under competition.
C) welfare is the same for both market structures.
D) the social optimum must be zero.
Answer: A
Diff: 1
Topic: Market Structure and Externalities
22) A specific tax in a monopoly market equal to the marginal harm of pollution
A) will increase welfare.
B) will decrease welfare.
C) will leave welfare unchanged.
D) All of the above are possible.
Answer: D
Diff: 1
Topic: Market Structure and Externalities
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23) The existence of externalities is due mainly to the fact that
A) monopolies tend to produce too little of a good anyway.
B) the optimal level of pollution is zero.
C) pollution is not a serious problem.
D) property rights are poorly defined.
Answer: D
Diff: 1
Topic: Allocating Property Rights to Reduce Externalities
24) Suppose two neighbors share a park. One neighbor, Al, leaves trash in the park. This bothers
the other neighbor, Bert. According to Coase's theorem, the optimal level of trash in the park
can be achieved if
A) Al is fined by the government.
B) Al has the right to leave trash and Bert cannot do anything about it.
C) Al has the right to leave trash and Bert can pay him to limit his dumping.
D) Bert moves.
Answer: C
Diff: 1
Topic: Allocating Property Rights to Reduce Externalities
25) Suppose two neighbors share a park. One neighbor, Al, leaves trash in the park. This bothers
the other neighbor, Bert. According to Coase's theorem, one necessary condition to alleviate
the externality is that
A) Al is fined by the government.
B) Al has the right to leave trash and Bert cannot do anything about it.
C) Bert has the right to a clean park and Al cannot leave trash.
D) Either Al or Bert owns the park.
Answer: D
Diff: 1
Topic: Allocating Property Rights to Reduce Externalities
26) Suppose two neighbors share a park. One neighbor, Al, leaves trash in the park. This bothers
the other neighbor, Bert. According to Coase's theorem, the optimal level of trash in the park
can be achieved if
A) someone is assigned property rights to the park.
B) government limits the use of the park.
C) nobody catches Al leaving the trash.
D) Bert moves.
Answer: A
Diff: 1
Topic: Allocating Property Rights to Reduce Externalities
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27) Suppose twenty neighbors share a park. One of the neighbors, Al, leaves trash in the park.
This bothers the other neighbors. According to Coase's theorem, assigning the property rights
to the park to Al
A) will achieve the socially optimal quantity of trash.
B) will result in zero trash being dumped in the park.
C) might still not achieve the social optimum since coordinating the other nineteen neighbors
can be costly.
D) is unfair.
Answer: C
Diff: 1
Topic: Allocating Property Rights to Reduce Externalities
Figure 18.2
28) Figure 18.2 shows the marginal benefit to a firm of polluting in the local river while
producing its output, and the marginal cost to the surrounding neighbors. The marginal cost
of production is zero for the firm. If property rights are not defined, how much pollution will
occur?
A) 0 units
B) 500 units
C) 1000 units
D) more than 1000 units
Answer: C
Diff: 1
Topic: Allocating Property Rights to Reduce Externalities
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29) Figure 18.2 shows the marginal benefit to a firm of polluting in the local river while
producing its output, and the marginal cost to the surrounding neighbors. The marginal cost
of production is zero for the firm. If the firm owns the river and there are thousands of
surrounding neighbors, how much pollution is likely to occur?
A) 0 units
B) 500 units
C) 1000 units
D) more than 1000 units
Answer: C
Diff: 1
Topic: Allocating Property Rights to Reduce Externalities
30) Figure 18.2 shows the marginal benefit to a firm of polluting in the local river while
producing its output, and the marginal cost to the firm's neighbor. The marginal cost of
production is zero for the firm. If there is just one neighbor who owns the river, how much
pollution is likely to occur?
A) 0 units
B) 500 units
C) 1000 units
D) more than 1000 units.
Answer: B
Diff: 1
Topic: Allocating Property Rights to Reduce Externalities
31) Figure 18.2 shows the marginal benefit to a firm of polluting in the local river while
producing its output, and the marginal cost to the surrounding neighbors. The marginal cost
of production is zero for the firm. If the firm owns the river and there is just one neighbor
affected by the pollution, how much pollution is likely to occur?
A) 0 units
B) 500 units
C) 1000 units
D) more than 1000 units
Answer: B
Diff: 1
Topic: Allocating Property Rights to Reduce Externalities
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32) Figure 18.2 shows the marginal benefit to a firm of polluting in the local river while
producing its output, and the marginal cost to the surrounding neighbors. The marginal cost
of production is zero for the firm. According to Coase's Theorem, which of the following
scenarios is most likely to lead to the socially optimal level of pollution?
A) The firm owns the river and there are a thousand surrounding neighbors.
B) The firm owns the river and there is just one nearby neighbor.
C) The river is jointly owned by one thousand surrounding neighbors.
D) The firm owns the river, and therefore produces the social optimum no matter what.
Answer: B
Diff: 1
Topic: Allocating Property Rights to Reduce Externalities
Figure 18.3
33) Figure 18.3 shows the marginal benefit from pollution for two firms. If each firm receives a
marketable permit to pollute 25 units of pollution, which one of the following is most likely
to happen?
A) Firm B will sell some pollution rights to firm A.
B) Firm A will sell some pollution rights to firm B.
C) Firm A will produce all 50 units of pollution.
D) Both firms will produce 25 units of pollution.
Answer: A
Diff: 1
Topic: Allocating Property Rights to Reduce Externalities
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Figure 18.4
34) Figure 18.4 shows the payoff matrix for two firms. A chemical firm must choose between a
low level of production which yields one ton of pollution into a nearby lake and a high level
of production which yields two tons of pollution into the nearby lake. A private beach on the
lake must decide whether to operate or not. Increased pollution reduces the number of people
who wish to visit the beach. If nobody owns the lake, then
A) the beach shuts down and the chemical firm produces 1 ton of pollution.
B) the beach shuts down and the chemical firm produces 2 tons of pollution.
C) the beach operates and the chemical firm produces 1 ton of pollution.
D) the beach operates and the chemical firm produces 2 tons of pollution.
Answer: D
Diff: 2
Topic: Allocating Property Rights to Reduce Externalities
35) Figure 18.4 shows the payoff matrix for two firms. A chemical firm must choose between a
low level of production which yields one ton of pollution into a nearby lake and a high level
of production which yields two tons of pollution into the nearby lake. A private beach on the
lake must decide whether to operate or not. Increased pollution reduces the number of people
who wish to visit the beach. If the beach owner also owns the lake, and the chemical firm
must pay $10 per ton to pollute, then
A) the beach shuts down and the chemical firm produces 1 ton of pollution.
B) the beach shuts down and the chemical firm produces 2 tons of pollution.
C) the beach operates and the chemical firm produces 1 ton of pollution.
D) the beach operates and the chemical firm produces 2 tons of pollution.
Answer: C
Diff: 2
Topic: Allocating Property Rights to Reduce Externalities
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36) Figure 18.4 shows the payoff matrix for two firms. A chemical firm must choose between a
low level of production which yields one ton of pollution into a nearby lake and a high level
of production which yields two tons of pollution into the nearby lake. A private beach on the
lake must decide whether to operate or not. Increased pollution reduces the number of people
who wish to visit the beach. If the chemical firm owns the lake, and the beach owner must
pay $10 to keep the chemical firm at just one ton of pollution, then
A) the beach shuts down and the chemical firm produces 1 ton of pollution.
B) the beach shuts down and the chemical firm produces 2 tons of pollution.
C) the beach operates and the chemical firm produces 1 ton of pollution.
D) the beach operates and the chemical firm produces 2 tons of pollution.
Answer: C
Diff: 2
Topic: Allocating Property Rights to Reduce Externalities
37) Figure 18.4 shows the payoff matrix for two firms. A chemical firm must choose between a
low level of production which yields one ton of pollution into a nearby lake and a high level
of production which yields two tons of pollution into the nearby lake. A private beach on the
lake must decide whether to operate or not. Increased pollution reduces the number of people
who wish to visit the beach. As long as someone owns the lake and the two parties can
negotiate, then
A) the beach shuts down and the chemical firm produces 1 ton of pollution.
B) the beach shuts down and the chemical firm produces 2 tons of pollution.
C) the beach operates and the chemical firm produces 1 ton of pollution.
D) the beach operates and the chemical firm produces 2 tons of pollution.
Answer: C
Diff: 2
Topic: Allocating Property Rights to Reduce Externalities
38) Figure 18.4 shows the payoff matrix for two firms. A chemical firm must choose between a
low level of production which yields one ton of pollution into a nearby lake and a high level
of production which yields two tons of pollution into the nearby lake. A private beach on the
lake must decide whether to operate or not. Increased pollution reduces the number of people
who wish to visit the beach. Joint profits are maximized when
A) the beach shuts down and the chemical firm produces 1 ton of pollution.
B) the beach shuts down and the chemical firm produces 2 tons of pollution.
C) the beach operates and the chemical firm produces 1 ton of pollution.
D) the beach operates and the chemical firm produces 2 tons of pollution.
Answer: C
Diff: 2
Topic: Allocating Property Rights to Reduce Externalities
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39) Figure 18.4 shows the payoff matrix for two firms. A chemical firm must choose between a
low level of production which yields one ton of pollution into a nearby lake and a high level
of production which yields two tons of pollution into the nearby lake. A private beach on the
lake must decide whether to operate or not. Increased pollution reduces the number of people
who wish to visit the beach. If nobody owns the lake, then
A) joint profits are zero.
B) joint profits are maximized.
C) joint profits are not maximized.
D) the beach will not operate because of too much pollution.
Answer: C
Diff: 2
Topic: Allocating Property Rights to Reduce Externalities
40) A common resource is best described as a resource where
A) there is a positive externality in consumption.
B) there is a negative externality in consumption.
C) there is a positive externality in production.
D) there is a negative externality in production.
Answer: B
Diff: 2
Topic: Common Property
41) To alleviate the commons problem, the government can
A) apply a tax.
B) set a quota.
C) assign property rights.
D) All of the above.
Answer: D
Diff: 0
Topic: Common Property
42) In the case of a good that has no exclusion and no rivalry, private markets fail because
A) of free ridership.
B) this is a natural monopoly.
C) profit is driven down to zero.
D) the quantity produced will exceed the social optimum.
Answer: A
Diff: 0
Topic: Public Goods
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43) A public good in which exclusion is possible is called
A) an exclusive good.
B) a common good.
C) an impure good.
D) a club good.
Answer: D
Diff: 0
Topic: Public Goods
44) Markets tend to produce too little of an excludable public good because
A) transaction costs are high.
B) of the lack of rivalry.
C) these goods are depletable.
D) All of the above.
Answer: B
Diff: 1
Topic: Public Goods
45) The total demand for a public good is found by
A) horizontally summing all individual demands.
B) vertically summing all individual demands.
C) finding the demand from the median voter.
D) dividing the marginal cost of the good by the number of voters.
Answer: B
Diff: 1
Topic: Public Goods
46) The efficient quantity of a pure public good occurs when the marginal cost of producing that
good equals the
A) marginal benefit to the median voter.
B) marginal benefit to each individual.
C) sum of all individual marginal benefits.
D) sum of all individual marginal benefits divided by the number of voters.
Answer: C
Diff: 1
Topic: Public Goods
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47) When majority rule voting is used to determine whether to purchase a public good,
A) the efficient outcome is not assured.
B) the median voter gets her way.
C) the sum of the marginal benefits is ignored.
D) All of the above.
Answer: D
Diff: 2
Topic: Public Goods
48) When majority rule voting is used to determine whether to purchase a public good,
A) the efficient outcome is assured.
B) the median voter gets her way.
C) the sum of the marginal benefits must equal marginal cost.
D) the marginal benefit of the good to the median voter equals the good's marginal cost.
Answer: B
Diff: 2
Topic: Public Goods
TRUE/FALSE/EXPLAIN
1) In the presence of a negative externality generated by producing a good, a competitive
market will produce more of that good than is socially optimal.
Answer: True. Firms in that market only consider their private costs and produce a quantity
that equates price with the private marginal cost. Producers ignore the external costs to
others. As a result, p = M Cp instead of p = M Cs.
Diff: 0
Topic: The Inefficiency of Competition with Externalities
2) To maximize welfare in a competitive market that has a negative externality in production,
government should tax a pollution-generating good at a specific tax equal to the marginal
cost of producing the good.
Answer: False. The tax should equal the marginal harm of the pollution at the socially
optimal quantity of the good.
Diff: 1
Topic: The Inefficiency of Competition with Externalities
3) Because a monopoly will produce less of a good than a competitive market will, welfare is
always greater under monopoly than under competition in the presence of a negative
externality.
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Answer: False. If monopoly produces more than the social optimum, then it does generate
greater welfare than competition. If monopoly produces less than the social optimum, then it
may or may not generate greater welfare.
Diff: 2
Topic: Market Structure and Externalities
4) Firms that are most likely to buy marketable pollution rights are those that produce the most
pollution per unit of output produced.
Answer: False. Firms that will buy pollution rights are those whose products are worth a lot
relative to the harm from pollution they create.
Diff: 2
Topic: Allocating Property Rights to Reduce Externalities
5) The efficient quantity of a public good occurs when the marginal cost of providing that good
equals the sum of the marginal benefits to all individuals.
Answer: True. The demand for the public good is found by vertically summing so that we
have the sum of the marginal benefits at each quantity.
Diff: 2
Topic: Public Goods
PROBLEMS
1) Suppose that in the market for paper, demand is p = 100 - Q. The private marginal cost is
MCp = 10 + Q. Pollution generated during the production process creates external marginal
harm equal to MCe = Q. What specific tax would result in a competitive market producing
the socially optimal quantity of paper?
Answer: The socially optimal quantity of paper is found by setting MCp+ MCe = p or 10 + Q
+ Q = 100 - Q. Rearranging yields Q = 30. At this level of output society incurs an external
cost of 30. This is the specific tax that would yield the socially optimal quantity. To check set
MCp + tax = 100 - Q. This yields Q = 30.
Diff: 1
Topic: The Inefficiency of Competition with Externalities
2) Suppose that in the market for paper, demand is p = 100 - Q. The private marginal cost is
MCp = 10 + Q. Pollution generated during the production process creates external marginal
harm equal to MCe = Q. Is social welfare greater under monopoly or under competition?
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Answer: First, the socially optimal quantity of paper is found by setting MCp + MCe = p or 10
+ Q + Q = 100 - Q. Rearranging yields Q = 30. The competitive equilibrium is found by
setting MCp = p or 10 + Q = 100 - Q. Rearranging yields Q = 45. The deadweight loss of
those additional units equals (45 - 30) * 45/2 = 337.50. Under monopoly, the firm sets
MCp = 100 - 2Q or Q = 30. The monopoly produces the socially optimal quantity, and
therefore has no deadweight loss. Social welfare is greater under monopoly.
Diff: 1
Topic: The Inefficiency of Competition with Externalities
Figure 18.1
3) Suppose that the market for steel is shown in Figure 18.1. What specific tax would result in a
competitive market producing the socially optimal quantity of steel?
Answer: The social optimum occurs when 50 ingots are produced. At this level, the marginal
external cost is $50. Thus, a specific tax of $50 will yield the socially optimal quantity.
Diff: 1
Topic: The Inefficiency of Competition with Externalities
4) In terms of cost-benefit analysis, explain why a competitive market produces too
much pollution.
Answer: At the socially optimal level of production, welfare is maximized and the marginal
benefit from less pollution equals the marginal cost of less output. However, a competitive
market produces more pollution than is socially optimal, and the marginal cost of less output
is greater than the marginal benefit from less pollution.
Diff: 1
Topic: The Inefficiency of Competition with Externalities
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5) Suppose that the market for steel is shown in Figure 18.1. Is social welfare greater under
monopoly or under competition?
Answer: Under competition, the deadweight loss equals area C. To find the monopoly
outcome, draw the MR curve for the monopoly that has the same vertical intercept as the
demand curve but is twice as steep. Where MR = M Cp determines the level of output the
monopoly produces. This output is greater than 50 but less than 100. Social welfare is
therefore greater under monopoly, since the monopoly quantity is closer to the socially
optimal quantity than the competitive quantity.
Diff: 2
Topic: Market Structures and Externalities
6) Explain how a specific tax equal to the marginal harm of pollution can increase or
decrease total welfare in a monopoly market.
Answer: If the monopoly is producing more output and pollution than the social optimum,
then a specific tax equal to the marginal harm of pollution will increase total welfare.
However, a monopoly may produce less output and thus pollution than is socially optimal. If
this is the case, then a tax will decrease output more and lower welfare.
Diff: 1
Topic: Market Structures and Externalities
7) A firm operates and produces pollution that only harms an individual, Bob. The
firm and Bob both know the costs and benefits of reducing pollution. Neither the firm nor
Bob acts strategically while bargaining, and there are no transaction costs associated with
bargaining. Explain how the efficient level of pollution occurs no matter whether the firm or
Bob owns the property right to pollution.
Answer: If the firm has the right to pollute, then Bob can bargain with the firm. Bob will pay
the firm up to the point where his per unit payment to reduce the pollution equals the
marginal benefit he receives from pollution. This will be the efficient level of pollution. If
Bob has the right to have no pollution, then the firm will pay to pollute until this cost equals
the marginal benefit of a unit of production. This will result in the efficient level of
pollution. Thus, no matter which party owns the property right, the efficient level of
pollution will result.
Diff: 1
Topic: Allocating Property Rights to Reduce Externalities
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Figure 18.3
8) Figure 18.3 shows the marginal benefit from pollution for two firms. If both firms receive a
marketable permit to pollute 25 units of pollution each, how much will each firm pollute and
how much will a permit for one unit of pollution be worth?
Answer: Firm B will sell permits to firm A until the marginal benefits are the same for both
firms. Firm A will generate 37 tons of pollution and firm B will generate 13 tons of pollution.
The market value of a permit will be $5.
Diff: 2
Topic: Allocating Property Rights to Reduce Externalities
Figure 18.4
9) Figure 18.4 shows the payoff matrix for two firms. A chemical firm must choose between a
low level of production which yields one ton of pollution into a nearby lake and a high level
of production which yields two tons of pollution into the nearby lake. A private beach on the
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lake must decide whether to operate or not. Increased pollution reduces the number of people
who wish to visit the beach. Determine the Nash equilibrium without property rights.
Answer: Without property rights, operating is a dominant strategy for the beach owner and 2
tons of pollution is a dominant strategy for the chemical firm.
Diff: 0
Topic: Allocating Property Rights to Reduce Externalities
10) Figure 18.4 shows the payoff matrix for two firms. A chemical firm must choose between a
low level of production which yields one ton of pollution into a nearby lake and a high level
of production which yields two tons of pollution into the nearby lake. A private beach on the
lake must decide whether to operate or not. Increased pollution reduces the number of people
who wish to visit the beach. If the chemical firm owns the lake and the beach owner must
pay the chemical firm $10 to produce only one ton of pollution, what is the outcome? If the
beach owner owns the lake and the chemical firm must pay $10 per ton of pollution, what is
the outcome? Compare this result to the case where nobody owns the lake.
Answer: If the chemical firm owns the lake, the bottom two cells do not change, the top cells
change from (15, 0) and (15, 25) to (25, -10) and (25, 15). Producing just 1 ton of pollution
is the firm's dominant strategy. The beach will operate, and both enjoy joint profits of 40. If
the beach owner owns the lake, the top cells become (5, 10) and (5, 35). The bottom cells
become (0, 0) and (0, 10). Producing 1 ton of pollution is a dominant strategy for the firm.
The beach operates and they enjoy joint profits of 40. Without property rights, the dominant
strategy for the chemical firm is to produce 2 tons of pollution.
Diff: 2
Topic: Allocating Property Rights to Reduce Externalities
11) Explain the externality generated when a shepherd grazes sheep in a field which is
common property that several other shepherds use.
Answer: The shepherd allows his sheep to graze in the field until the marginal benefit of
grazing there equals the marginal cost to the shepherd. However, by grazing his sheep in the
field, the shepherd increases the cost of grazing to all the other shepherds. This occurs
because less grass is available for all other sheep. Each shepherd's grazing decision affects
the costs to all the others, but the shepherds do not consider the effects on others when
making their own decisions.
Diff: 1
Topic: Common Property
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12) Explain why the social demand curve for a public good is the vertical sum of the
demand curves of each individual.
Answer: A public good lacks rivalry, so many people can get pleasure from the same unit of
output. Thus, for each unit of public good, the total willingness to pay is the sum of
everyone's willingness to pay because everyone can consume the good.
Diff: 1
Topic: Public Goods.
13) Suppose three neighbors must vote on the installation of a traffic light that costs $210. The
cost of the light will shared by all three. Voter A values the light at $50; voter B values the
light at $50; and voter C (who drives the most) values the light at $200. If the voting rule is
that the majority wins, does the light get purchased? Is it efficient to purchase the light?
Answer: The cost of the light to each voter is $70. Since MC > MB for two of them, the light
does not get purchased. It is efficient to purchase the light since SMB = 300 which exceeds
the MC of 210.
Diff: 1
Topic: Public Goods
14) Suppose 100 citizens each derive marginal benefit from submarines according to the function
MB = 10 - Q. If subs cost $100 each to produce, what is the efficient quantity of
submarines?
Answer: The market demand is SMB = 1000 - 100Q. Setting this equal to the MC of 100
yields a quantity of 9. If the cost is shared equally, each citizen pays $1 for the ninth
submarine, which they each value at $1.
Diff: 1
Topic: Public Goods
Figure 18.5
15) Two neighboring farmers must each decide whether to contribute to a fence that separates
their properties. The fence costs a total of $20. Both farmers currently have a profit of $30
each. With a fence to keep each farmer's animals from wandering onto the other's property,
both farmers would experience a $15 rise in profits. Draw the payoff matrix and discuss the
possible outcomes.
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Chapter 18/Externalities, Commons, and Public Goods
Answer: See Figure 18.5. This is a prisoners' dilemma. The dominant strategy for each is to
not contribute—to be a free rider. Yet, both farmers are better off contributing. The dilemma
can resolved through compulsion—for example a tax—or, since there are only two of them,
social agreement. Cooperation and trust are required to get the fence built. Good fences make
good neighbors, and good neighbors make good fences.
Diff: 2
Topic: Public Goods
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