AP Economics:
Externalities Review FRQs
May 1, 2015
Externalities FRQs
1. Production of good X imposes costs on people who are neither producers nor
consumers of good X.
(a) A Senator proposes a per unit sales tax on good X. Explain how
this tax will affect each of the following:
(i) the price paid by consumers Supply curve shifts up (left) by
the amount of the tax. Price paid by consumers goes up,
though not by the full amount of the tax, due to the
downward slope of the demand curve.
(ii) the quantity of good X produced Supply curve shifts up (left)
by the amount of the tax. Quantity produced decreases.
(iii) the total after-tax revenues received by producers of good X
After-tax revenues decline due to lower quantity and lower
after-tax price. A graph may help explaining:
(b) Explain how imposing this tax might result in greater economic
efficiency than would be achieved in an unregulated competitive market.
Tax will move supply curve to the left, making equilibrium closer to
where MSC=MSB.
2. The graph below shows the price (P0) and quantity (Q0) at which there is an
efficient allocation of resources.
However, in some cases the market fails to allocate resources efficiently.
(a) Assume the chemical industry is polluting the air.
(i) Using marginal benefit and marginal cost analysis, explain how
the chemical industry is misallocating resources. Air pollution
imposes a cost on society not borne by the industry. MSC >
MPC, so MSC > MSB and the industry will overallocate
resources.
(ii) Identify one policy or action the government could take to
correct this market failure. 1) Impose a per unit tax on the
industry, or 2) limit quantity produced, 3) impose a
price ceiling that effectively limits quantity produced or
4) limit production by requiring permits, or 5) initiate
liability lawsuits
(b) Assume it is difficult to exclude nonpayers from enjoying the
benefits of national defense.
(i) Using marginal benefit and marginal cost analysis, explain how
the private market will fail to produce the efficient level of
national defense. MSB > MSC, but the private market will
produce at the intersection of MPC and MPB, a lower
quantity.
(ii) Identify one policy or action the government could take to
correct this market failure. Subsidize producers or
government produces public product
3. Assume that product X is produced in a perfectly competitive industry and
product X yields costs to individuals who are neither consumers nor
producers of product X.
(a) Using one correctly labeled graph, show the industry output and
price under each of the following conditions:
(i) the industry ignores the externality
Correct labels; show MPC curve and higher MSC curve; MSB
demand curve; equilibrium at intersection of MPC and MSB
curves
(ii) the industry produces the socially optimal level of output
Correct labels; show MPC curve and shift to higher MSC curve;
downward sloping MSB demand curve; increase in price and
decrease in quantity
(b) Assume the market is producing the level of output you
identified in (i). Identify one policy the government might use to
achieve the level of output you identified in (i). 1) Impose a per
unit tax on the industry, or 2) limit quantity produced, 3)
impose a price ceiling that effectively limits quantity produced
or 4) limit production by requiring permits, or 5) initiate
liability lawsuits