ECON 101 Tutorial: Week 13
Shane Murphy
s.murphy5@lancaster.ac.uk
Office Hours: Monday 3:00-4:00 – LUMS C85
Outline
• Roll Call
• Problems
• Notes about macroeconomics
Chapter 11: Problem 1
Do you believe in the following statements? Why or why not?
a) The benefits of Pigouvian taxes as a way to reduce pollution have
to be weighed against the deadweight losses that these taxes
cause.
In fact, Pigovian taxes reduce the inefficiency of pollution by reducing
the quantity of the good being produced that has pollution as a byproduct. So, Pigovian taxes reduce deadweight loss, they do not
increase it.
b) When deciding whether to levy a Pigovian tax on consumers or
producers, the government should be careful to levy the tax on
the side of the market generating the externality.
It does not matter on whom the tax is imposed, the incidence of the
tax will be identical (see chapter 6). So whether the externality is
caused by the seller or the buyer of a good, a tax on either producers
or consumers will lead to the same reduction of quantity and change
in the prices producers receive or consumers pay.
Chapter 11: Problem 2
Consider the market for fire extinguishers.
a) Why might fire extinguishers exhibit positive externalities?
b) Draw a graph of the market for fire extinguishers.
c) Indicate the market equilibrium and efficient output. Why do these
differ?
Fire extinguishers exhibit positive externalities
because even though people buy them for their
own use, they may prevent fire from damaging
the property of others.
The market equilibrium and efficient output
quantities differ because in deciding to buy fire
extinguishers, people don't account for the
benefits they provide to other people.
d) If the external benefit is 10 per extinguisher,
describe a government policy that would
result in an efficient outcome.
Subsidize people €10 for every fire extinguisher
they buy
Chapter 11: Problem 3
In many countries, contributions to charitable organizations are
deductible from income tax. In what way does this government policy
encourage private solutions to externalities.
Charitable organizations are often organized to deal with externalities.
By allowing charitable contributions to be made from pre-tax income,
the government raises charities’ incomes above what they would
otherwise be, thus encouraging private solutions to the externality.
People can give to the organization that they feel provides the most
benefit to society, so the tax relief may be more effective than if the
government itself tried to solve the externality. For example, local
community groups may be better at helping the needy than
government welfare programs.
Chapter 11: Problem 4
It is rumored that the Swiss government subsidizes cattle farming, and
that the subsidy is larger in areas with more tourist attractions. Can
you think of a reason why this policy might be efficient?
If the Swiss government subsidizes cattle farming, it could be because
there are externalities associated with it. Since tourists come to
Switzerland to see the beautiful countryside, encouraging farms, as
opposed to industrial development, is important to maintaining the
tourist industry. Thus farms produce a positive externality by keeping
the land beautiful and unspoiled by development. The government's
subsidy thus helps the market provide the optimal amount of farms.
Chapter 11: Problem 5
Consider the market for train travel. At certain times of the day, trains are extremely
crowded going to major towns and cities but at other times of the day carriages are
virtually empty. Is this an example of market failure? What externalities exist on the
train system if the situation described persists? Can you think of a way in which the
government might step in to make the market outcome more efficient?
Both an over use and underuse of trains during any day can be seen as market
failure. For example, every time an individual chooses to travel by train during the
rush hour, he or she is imposing external costs on other people who have to stand.
Therefore main negative externality is that trains are so overcrowded at peak times
that customers have to stand. However there are also some positive externalities
associated with train travel. More people using trains make roads less congested.
Trains are also safer than road travel and less polluting per passenger mile.
The government could subsidise off peak travel to encourage more users. It could tax
peak travel to attempt to reduce demand, but private rail companies already have
high peak fares when people have little choice over their travel arrangements. In the
long term the government could give train companies grants to invest in a new
infrastructure, because in general, train transportation has significant positive
externalities and so it can be argued that it is under supplied by the private sector.
Chapter 11: Problem 6
Greater consumption of alcohol leads to more motor vehicle accidents
and, thus, imposes costs on people who do not drink and drive.
Illustrate the market for alcohol.
Chapter 11: Problem 7
Many observers believe that the levels of pollution in our economy are
too high.
a. If society wishes to reduce overall pollution by a certain amount,
why is it efficient to have different amounts of reduction at
different firms?
It is efficient to have different amounts of pollution reduction at
different firms because the cost of reducing pollution differs across
firms. If they were all made to reduce pollution by the same amount,
the costs would be low at some firms and prohibitive at others,
imposing a greater burden overall.
Chapter 11: Problem 7
b. Command-and-control approaches often rely on uniform
reductions amoung firms. Why are these approaches generally
unable to target the firms that should undertake bigger
reductions?
Command-and-control approaches usually rely on uniform pollution
reduction among firms because government regulators do not have
sufficiently detailed knowledge of firms’ costs and technologies to
enable them to target reductions on the firms that would be able
reduce pollution most cheaply.
Chapter 11: Problem 7
c. Economists argue that appropriate Pigovian taxes or tradable
pollution rights will result in efficient pollution reduction. How do
these approaches target the firms that should undertake bigger
reductions?
Pigovian taxes or tradable pollution rights give firms greater incentives
to reduce pollution. Firms that find it relatively easy to reduce
pollution have an on-going incentive to reduce pollution and they are
likely to reduce pollution by more than might be required by
command-and-control regulations. By doing so they avoid tax or
enable themselves to sell pollution permits they don’t need to other
firms. Firms that find it very costly to reduce pollution will continue to
pollute and pay the tax or buy more pollution permits. The
government does not have to work out which firms can reduce
pollution the most cheaply – the tax and tradable permits approaches
both let the market decide which firms should reduce pollution.
Chapter 11: Problem 8
The Pristine River (or the Blue Pristine, as it is affectionately known)
has two polluting firms on its banks. European Industrial and Creative
Chemicals each dump 100 tonnes of effluent into the river each year.
The cost of reducing effluent emissions per tonne equals €10 for
European Industrial and €100 for Creative. The government wants to
reduce overall pollution from 200 tonnes to 50 tonnes per year.
a. If the government knew the cost of reduction for each firm, what
reductions would it impose to reach its overall goal? What would
be the cost to each firm and the total cost to the firms together?
If the government knew the cost of reduction at each firm, it would
have European Industrial eliminate all its pollution (at a cost of €10 per
tonne times 100 tonnes = €1,000) and have Creative eliminate half of
its pollution (at a cost of €100 per tonne times 50 tonnes = €5,000).
This minimizes the total cost (€6,000) of reducing pollution to 50
tonnes.
Chapter 11: Problem 8
b. In a more typical situation, the government would not know the
cost of pollution reduction at each firm. If the government decided
to reach its overall goal by imposing uniform reductions on the
firms. Calculate the reduction made by each firm, the cost to each
firm and the total cost to the firms together.
If each firm had to reduce pollution to 25 tonnes (so each had to
reduce pollution by 75 tonnes), the cost to European Industrial would
be 75 x €10 = €750 and the cost to Creative would be 75 x €100 =
€7,500. The total cost would be €8,250.
Chapter 11: Problem 8
c. Compare the total cost of pollution reduction in parts a and b. If
the government does not know the cost of reduction for each firm,
is there still some way to reduce pollution to 50 tonnes at the total
cost you calculated in part a?
In part a, it costs €6,000 to reduce total pollution to 50 tonnes, but in
part b it costs €8,250. So it is definitely less costly to have European
Industrial reduce all of its pollution and have Creative cut its pollution
in half. Even without knowing the costs of pollution reduction, the
government could achieve the same result by auctioning off pollution
permits that would allow only 50 tonnes of pollution. This would
ensure that European Industrial reduced its pollution to zero (since
Creative would outbid it for the permits) and Creative would then
reduce its pollution to 50 tonnes.
d. Assume that the chief executive officers of the firms have
considerable influence with politicians. How might market
outcome be influenced as a consequence?
Chapter 11: Problem 9
Suppose that the government decides to issue tradable permits for a
certain form of pollution.
a. Does it matter for economic efficiency whether the government
distributes or auctions the permits? Does it matter in any other
ways?
In terms of economic efficiency in the market for pollution, it does not
matter if the government simply distributes the permits to polluters
free of charge or auctions them off, as long as firms can sell the
permits to each other. The only difference would be that the
government could make money if it auctioned the permits off, thus
allowing it to reduce taxes, which would help reduce the deadweight
loss from taxation. There could also be some deadweight loss
occurring if firms use resources to lobby for additional permits.
Chapter 11: Problem 9
Suppose that the government decides to issue tradable permits for a
certain form of pollution.
b. If the government chooses to distribute the permits, does the
allocation of permits among firms matter for efficiency? Does it
matter in any other way?
If the government allocated the permits to firms who did not value
them as highly as other firms, the firms could sell the permits to each
other so they would end up in the hands of the firms who value them
most highly. Thus the allocation of permits among firms would not
matter for efficiency. But it would affect the distribution of wealth,
since those who got the permits and sold them would be better off.
Chapter 11: Problem 10
Some people argue that the primary cause of global warming is carbon
dioxide, which enters the atmosphere in varying amounts from
different countries but is distributed equally around the globe within a
year. In order to solve this problem, some economists have argued
that carbon dioxide emissions should be reduced in countries where
the costs are least, with the countries that bear that burden being
compensated by the rest of the world.
a. Why is international cooperation necessary to reach an efficient
outcome?
International cooperation is needed because the externality from
global warming is worldwide, so the benefits from solving the problem
are worldwide. Further, the efficient solution to the problem involves
minimizing the costs to society; in this case, society means the entire
world.
Chapter 11: Problem 10
b. Is it possible to devise a compensation scheme such that all
countries would be better off than under a system of uniform
emission reductions? Explain.
Since it would be efficient to reduce carbon dioxide most in countries
where the costs of reducing carbon dioxide emissions are low, some
compensation scheme needs to be put in place to encourage the
reduction of emissions. One possibility would be to monitor emissions,
taxing those countries whose emissions are high and using the
proceeds to subsidize those who reduce their emissions. This gives the
incentive to reduce emissions in those areas where the cost of doing
so is the least. In countries where the cost of reducing emissions is
high, they will just pay the tax. A system of uniform emission
reductions would impose high costs on some countries and low costs
on others, and would not give anyone the incentive to reduce
emissions beyond the compulsory amount.
A word about macroeconomics
• Deep down, macroeconomics is about growth and
inequality
• We want to maximize growth
• We want to minimize inequality
• The UK government can do this by getting things
right:
– Tax rates
– Interest rates, inflation, and money supply
– Unemployment and government spending
–…
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