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Besanko & Braeutigam – Microeconomics, 5th editionSolutions Manual

Chapter 17 Externalities and Public Goods Solutions to Review Questions 1. What is the difference between a positive externality and a negative externality? Describe an example of each. With a negative externality, the marginal private cost of a good is less than the marginal social cost of a good. For example, the private costs associated with driving to work on the highway include personal time, gasoline, wear and tear on the vehicle, etc. In addition, by entering the highway, a vehicle creates congestion that increases the time it takes all other drivers to get where they are going. Thus, the social cost exceeds the private cost and entering the highway creates a negative externality. With a positive externality, the marginal private benefit is less than the marginal social benefit. For example, when parents immunize a child they reduce the risks of the child contracting a disease. In addition, by immunizing the child, the child is less likely to pass on certain diseases to other people. Thus, the social benefits from immunizing exceed the private benefits and immunization creates a positive externality. 2. Why does an otherwise competitive market with a negative externality produce more output than would be economically efficient? A competitive market with a negative externality produces more output than is socially optimal. This occurs because the firms in the industry do not take into account the external costs associated with production; they only take into account their private costs. Because they view the cost as lower than it actually is, they produce more than would be produced if they were forced to take into account the external costs. 3. Why does an otherwise competitive market with a positive externality produce less output than would be economically efficient? A competitive market with a positive externality produces less output than is socially optimal. This occurs because consumers do not take into account the external benefits associated with consumption; they only take into account their private benefits. Because they view the benefit as lower than it actually is, they consume less than they would if they were forced to take into account the external benefits. 4. When do externalities require government intervention, and when is such intervention unlikely to be necessary? Negative externalities may require government intervention when there is significant disparity between the socially optimal production level of a good and the unregulated equilibrium production level. To limit production, the government might impose taxes on production or a Copyright © 2014 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 5th editionSolutions Manual

production quota limiting production. If property rights are clearly defined and bargaining is costless, the market may reach the socially efficient level of production without government intervention. Positive externalities may also require government intervention when there is significant disparity between the socially optimal production level of a good and the unregulated equilibrium production level. To encourage production, the government might provide production subsidies. If property rights are clearly defined and bargaining is costless, the market may reach the socially optimal level of production without government intervention. 5. How might an emissions fee lead to an efficient level of output in a market with a negative externality? With a negative externality, an emissions fee might lead to an efficient level of output. By imposing a fee on production, producers are forced to take into account not only their private costs but also the external costs (as measured by the emissions fee) of production. This has the effect of raising the firm’s costs and reducing the firm’s production. If the level of the emissions fee is set so that, for the last unit produced, the fee equals the external cost, this fee could lead to an efficient level of output. 6. How might an emissions standard lead to an efficient level of output in a market with a negative externality? An emissions standard could lead to an efficient level of output. By setting a standard and only selling the rights to a limited amount of emissions, the government can reduce the level of emissions. In addition, by implementing a system whereby the rights can be traded, the government could reduce emissions and distribute the rights so that abatement costs are as low as possible. 7. What is the Coase Theorem, and when is it likely to be helpful in leading a market with externalities to provide the socially efficient level of output? The Coase Theorem states that, regardless of how property rights are assigned with an externality, the allocation of resources will be efficient when the parties can costlessly bargain with each other. This Theorem will be helpful in leading a market with externalities to the socially efficient level when the cost of bargaining is low and when all parties involved can agree on the costs and benefits associated with the externality. 8. How does a nonrival good differ from a nonexclusive good? A nonexclusive good is one that no consumer can be prevented from consuming. A nonrival good is one that a consumer’s consumption does not eliminate or prevent another consumer’s consumption. 9. What is a public good? How can one determine the optimal level of provision of a public good?

Copyright © 2014 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 5th editionSolutions Manual

A public good is any good that is nonexclusive and nonrival. To determine the optimal level of provision of a public good, one should determine the marginal social benefits from the public good, which is equal to the sum of the marginal private benefits for the individual consumers, and equate that to the marginal cost of providing the public good. Units of the good should be provided as long as the marginal social benefit exceeds the marginal cost. This will occur up to the point where the marginal social benefit equals the marginal cost. 10. Why does the free-rider problem make it difficult or impossible for markets to provide public goods efficiently? It is difficult to provide public goods efficiently when free riders exist. Free riders will consume the good, but will pay nothing for the good, anticipating that others will pay. It may therefore prove difficult to raise funds to finance a project with a public good, leading to an underproduction of the good, or possibly even no provision of a good with positive net benefits.

Copyright © 2014 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 5th editionSolutions Manual

Solutions to Problems 17.1. Why is it not generally socially efficient to set an emissions standard allowing zero pollution? If the government were to set an emissions standard requiring zero pollution, this standard would probably not be socially efficient. By setting the standard at zero, the government could reduce pollution by preventing polluting industries from producing goods that society values. By setting the standard at zero, however, the government will also eliminate the benefits to society from production of these goods. In general, the social benefits from producing will likely exceed the social costs up to some non-zero level of production (pollution) implying the socially efficient level of production is non-zero.

17.2. Education is often described as a good with positive externalities. Explain how education might generate positive external benefits. Also suggest a possible action the government might take to induce the market for education to perform more efficiently. Education is a good that might generate positive external benefits. For example, when an individual furthers her education she benefits directly in terms of higher income. In addition, this individual, because of her increased education, might be able to develop a new technology that benefits all of society. Thus, while the education helped the individual, by allowing the development of the new technology (because she’s smarter!) many people benefited from her education. To induce the market to perform more efficiently, the government would like to entice more individuals to further their education since education generates positive externalities. The government could do this by providing grants or low interest student loans, for example.

17.3. a) Explain why cigarette smoking is often described as a good with negative externalities. b) Why might a tax on cigarettes induce the market for cigarettes to perform more efficiently? c) How would you evaluate a proposal to ban cigarette smoking? Would a ban on smoking necessarily be economically efficient? a) For one, by smoking in public, smokers force other individuals to breathe air with smoke, known as second-hand smoke. In addition, the health problems associated with smoking force society to pay higher health care costs to pay for smoking related illnesses, both for smokers and for those who breathe second-hand smoke, than if no one in society smoked. b) By imposing a tax on cigarettes the government increases the marginal private cost of smoking and forces the individual to take into account (at least some of) the negative externality associated with smoking. This would likely reduce the level of smoking in society, pushing the equilibrium toward the socially efficient level of smoking.

Copyright © 2014 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 5th editionSolutions Manual

c) A ban on smoking entirely is probably not socially efficient. To evaluate such a ban, one would need to compare the marginal benefits with the marginal social costs. The ban would only be socially efficient if the marginal social costs exceed the marginal benefits at a level of zero. This would not necessarily be socially efficient because it is possible that the marginal benefit of smoking exceeds the marginal social cost for low levels of smoking.

17.4. Consider Learning-By-Doing Exercise 17.2, with a socially efficient emissions fee. Suppose a technological improvement shifts the marginal private cost curve down by $1. If the government calculates the optimal fee given the new marginal private cost curve, what will happen to the following? a) The size of the optimal tax b) The price consumers pay c) The price producers receive a) If the marginal private cost shifts down by $1, we have MPC = 1 + Q . With demand P d = 24 − Q and marginal external cost MEC = −2 + Q , the social optimum occurs where P d = MPC + MEC 24 − Q = (1+ Q ) + (− 2 + Q ) Q = 8.33 At Q = 8.33 , the price is P = 15.67 . The size of the optimal tax is the difference between the equilibrium price, 15.67, and the MPC at the socially efficient quantity of 8.33. At this quantity the marginal private cost is MPC = 9.33 . Thus, the optimal tax is T = 15.67 − 9.33 = 6.34 . b) With this tax, consumers will pay the socially efficient price of 15.67. c) Producers will receive the difference between the price consumers pay, 15.67, and the tax, 6.34. Thus, producers will receive 9.33.

17.5. Consider the congestion pricing problem illustrated in Figure 17.5. a) What is the size of the deadweight loss from the negative externalities if there is no toll imposed during the peak period? b) Why is the optimal toll during the peak period not $3, the difference between the marginal social cost and the marginal private cost when the traffic volume is Q5? c) How much revenue will the toll authority collect per hour if it charges the economically efficient toll during the peak period? a) In Figure 17.5, the deadweight loss is area ABG. This is deadweight loss because for every vehicle beyond the optimum, Q4, the marginal social cost exceeds the marginal benefit. Area

Copyright © 2014 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 5th editionSolutions Manual

ABG is approximately (assuming the demand and MPC curves are nearly straight lines over this part of the graph ) 0.5(Q5 − Q4 )(8 − 5) = 1.5(Q5 − Q4 ) . b) The socially efficient traffic volume occurs where the marginal social cost curve intersects the marginal benefit curve. In Figure 17.5 this occurs at Q4. At Q4, the marginal benefit is $5.75 and the marginal private cost is $4.00. To achieve the social optimum the toll should be set so that the marginal benefit equals the marginal private cost plus the toll, effectively forcing the driver to take into account the external cost of entering the highway. At Q4, this is $5.75 − $4.00 = $1.75 . The toll is not $3.00 because the toll should be set to force the driver at Q4 to observe the external costs imposed by entering the highway. By setting the toll at $3.00, the difference between the MPC and MB at Q5, the toll would be set to force the driver at Q4 to observe the external costs imposed from the driver at Q5 entering the highway. But this cost is unimportant because at the optimum the driver at Q5 will not be on the highway. The $3.00 toll would create a level of traffic below the social optimum. c) If the toll authority sets a toll at the economically efficient level of $1.75, it will earn revenue equal to the toll multiplied by the number of drivers. In this case, revenue will be $1.75Q4.

17.6. The accompanying graph (on next page) shows the demand curve for gasoline and the supply curve for gasoline. The use of gasoline creates negative externalities, including CO2, which is an important source of global warming. Using the graph and the table below, identify: • The equilibrium price and quantity of gasoline • The producer and consumer surplus at the market equilibrium • The cost of the externality at the free-market equilibrium • The net social benefits arising at the free-market equilibrium • The socially optimal price of gasoline • The consumer and producer surplus at the social optimum • The cost of the externality at the social optimum • The net social benefits arising at the social optimum • The deadweight loss due to the externality

Copyright © 2014 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 5th editionSolutions Manual

Consumer surplus Private producer surplus - Cost of externality Net social benefits Deadweight loss

Equilibrium price and quantity = P2 and Q2

Social optimum price and quantity = P1 and Q1

A+B+G+K E+F+R+H+N -R-H-N-G-K-M A+B+E+F-M M

A B+E+F+R+H+G -R-H-G A+B+E+F Zero

Difference between social optimum and equilibrium -B-G-K B+G-N M+N+K M M

17.7. The graph below shows conditions in a perfectly competitive market in which there is some sort of externality. In this market, a consumer purchases at most one unit of the good. There are many such consumers, and they have different maximum willingnesses to pay. Assume that the graph is drawn to scale. a) What type of externality is present in this market: positive or negative? b) What is the maximum level of social surplus that is potentially attainable in this market? c) What is the deadweight loss that arises in a competitive equilibrium in this market? d) Suppose a subsidy is given to producers: What is the magnitude of the subsidy per unit that would enable this market to attain the socially efficient outcome? For the remaining questions, please indicate whether the following government interventions would increase social efficiency relative to the competitive equilibrium outcome with no government intervention, decrease social efficiency, or keep it unchanged: e) A subsidy per unit equal to 0F given to consumers who purchase the good. f ) The government replaces private sellers and offers the good at a price of zero. (Assume that government has no inherent cost advantage or disadvantage relative to private producers. Assume, too, the government’s cost of production is financed by levying taxes.) g) The government imposes a price ceiling that sets a maximum price for the good equal to 0D. h) The government imposes a tax equal to NR on consumers who do not purchase the good.

Copyright © 2014 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 5th editionSolutions Manual

a) The externality is positive. We can see this because the marginal social cost at any quantity is less than the marginal private cost. b) The maximum level of social surplus that is potentially attainable in this market is AR0. The socially efficient outcome is at the intersection of marginal social cost and marginal social benefit (point R), and the maximum level of social surplus is the area between the SMC and SMB curves to the left of this point. c) The deadweight loss that arises in a competitive equilibrium in this market is KLR. The equilibrium point is K. The deadweight loss is the area between MSB and MSC, from the equilibrium quantity 0M to the efficient quantity 0S. d) The subsidy to producers that would enable this market to attain the socially efficient outcome is 0F (or equivalently, IH, LK, RN, VU, EC, DB). e) A subsidy equal to 0F given to consumers who purchase the good increases social efficiency. In fact, the efficient outcome is achieved. It does not matter that the subsidy is given to consumers, not producers. A subsidy to consumers shifts the demand curve upward by 0F so that it intersects the supply curve at N, which is the new equilibrium point. The equilibrium quantity is the efficient quantity 0S. f) If the government offers the good at a price of zero then social efficiency decreases. If the good is provided at a price of zero, consumers will purchase quantity 0W. The deadweight loss is RVW, which is the area between SMC and SMB over the range between the socially efficient quantity 0S and 0W. This deadweight loss is larger than the deadweight loss KLR with no government intervention, so efficiency is reduced.

Copyright © 2014 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 5th editionSolutions Manual

g) A price ceiling that sets a maximum price for the good equal to 0D decreases social efficiency. At this price, the consumers may wish to purchase the efficient quantity 0S, but the producers are only willing to supply quantity 0J, and the consumers are unable to buy more than that. The deadweight loss increases to (at least) IRG. h) If the government imposes a tax equal to NR on consumers who do not purchase the good, then social efficiency increases. This is a monetary incentive to purchase the good. By purchasing a unit of the good a consumer gets two things --- the value from the good and avoidance of the tax. Thus, a tax on consumers who do not purchase the good makes it “as if” the demand curve is NR above the actual demand curve. The result is an equilibrium in which the quantity is the socially efficient quantity 0S. Thus, this incentive is equally strong as the subsidy from part e), and it has the same effect.

17.8. A competitive refining industry produces one unit of waste for each unit of refined product. The industry disposes of the waste by releasing it into the atmosphere. The inverse demand curve for the refined product (which is also the marginal benefit curve) is Pd = 24 Q, where Q is the quantity consumed when the price consumers pay is Pd. The inverse supply curve (also the marginal private cost curve) for refining is MPC = 2 + Q, where MPC is the marginal private cost when the industry produces Q units. The marginal external cost curve is MEC = 0.5Q, where MEC is the marginal external cost when the industry releases Q units of waste. a) What are the equilibrium price and quantity for the refined product when there is no correction for the externality? b) How much of the chemical should the market supply at the social optimum? c) How large is the deadweight lo...