Solution Manual for Microeconomics 4th Edition

Hubbard Brien 0132911981 9780132911986

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CHAPTER 5 | Externalities, Environmental

Policy, and Public Goods
Brief Chapter Summary and Learning Objectives
5.1 Externalities and Economic Efficiency (pages 138–141)
Identify examples of positive and negative externalities and use graphs to show how
externalities affect economic efficiency.

▪ A negative externality is a cost that affects someone who is not directly involved in the
production or consumption of a good or service.
▪ A positive externality is a benefit that affects someone who is not directly involved in the
production or consumption of a good or service.

5.2 Private Solutions to Externalities: The Coase Theorem (pages 141–147)

Discuss the Coase theorem and explain how private bargaining can lead to economic
efficiency in a market with an externality.

▪ The Coase theorem states that if transactions costs are low, private bargaining can result in
an efficient solution to the problem of externalities.

5.3 Government Policies to Deal with Externalities (pages 147–153)

Analyze government policies to achieve economic efficiency in a market with an
externality.

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92 CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

▪ When private solutions to externalities are not feasible, government intervention in the
form of a tax (negative externality) or subsidy (positive externality) can bring about an
efficient level of output.
▪ Government policies to deal with negative externalities include a command and control
approach and a market-based approach.

5.4 Four Categories of Goods (pages 153–161)

Explain how goods can be categorized on the basis of whether they are rival or
excludable and use graphs to illustrate the efficient quantities of public goods and
common resources.

▪ The four categories of goods are private, public, quasi-public, and common resources.

Key Terms
Coase theorem, p. 146. The argument of
economist Ronald Coase that if transactions
costs are low, private bargaining will result in an
efficient solution to the problem of externalities.
Command-and-control approach, p. 151. An
approach that involves the government imposing
quantitative limits on the amount of pollution
firms are allowed to emit or requiring firms to
install specific pollution control devices.
Common resource, p. 154. A good that is rival
but not excludable.
Excludability, p. 154. The situation in which
anyone who does not pay for a good cannot
consume it.
Externality, p. 138. A benefit or cost that
affects someone who is not directly involved in
the production or consumption of a good or
service.
Free riding, p. 154. Benefiting from a good
without paying for it.
Market failure, p. 140. A situation in which the
market fails to produce the efficient level of
output.
Pigovian taxes and subsidies, p. 151.
Government taxes and subsidies intended to
bring about an efficient level of output in the
presence of externalities.
Private benefit, p. 138. The benefit received by
the consumer of a good or service.
Private cost, p. 138. The cost borne by the
producer of a good or service
Private good, p. 154. A good that is both rival
and excludable.
Property rights, p. 140. The rights individuals
or businesses have to the exclusive use of their
property, including the right to buy or sell it.
Public good, p. 154. A good that is both
nonrivalrous and nonexcludable.
Rivalry, p. 154. The situation that occurs when
one person’s consuming a unit of a good means
no one else can consume it.
Social benefit, p. 138. The total benefit from
consuming a good or service, including both the
private benefit and any external benefit.
Social cost, p. 138. The total cost of producing a
good or service, including both the private cost
and any external cost.
Tragedy of the commons, p. 159. The tendency
for a common resource to be overused.
Transactions costs, p. 146. The costs in time
and other resources that parties incur in the
process of agreeing to and carrying out an
exchange of goods or services.

©2013 Pearson Education, Inc. Publishing as Prentice Hall

Chapter Outline
Can Government Policies Help Protect the Environment?
Pollution is a part of economic life. Government policies to reduce pollution have proven to be
controversial. In 2011, New Jersey Governor Chris Christie announced that his state would opt out of a
coalition of states that agreed to reduce their emissions of carbon dioxide by 10 percent by 2018. The U.S.
Environmental Protection Agency (EPA) plans to implement standards for air pollution that will affect the
entire nation. Some economists and business leaders worried that the new standards might shut down coal-
fired power plants and raise electricity prices.

Externalities and Economic Efficiency (pages 138–141)

5.1 Learning Objective: Identify examples of positive and negative externalities and use
graphs to show how externalities affect economic efficiency.

An externality is a benefit or cost that affects someone who is not directly involved in the production or
consumption of a good or service. In the case of air pollution, there is a negative externality because people
with asthma, for example, may bear a cost even though they were not involved in the buying or selling of
the electricity the generation of which caused the pollution. Medical research is an example of a positive
externality because people who are not directly involved in producing it or paying for it can benefit.

A. The Effect of Externalities

A competitive market achieves economic efficiency by maximizing the sum of consumer and producer
surpluses. But that result holds only if there are no externalities in production or consumption. An
externality causes a difference between the private cost of production and the social cost, or the private
benefit from consumption and the social benefit. The private cost is the cost borne by the producer of a
good or service. The social cost is the total cost of producing a good or service, including both the private
cost and any external cost. The private benefit is the benefit received by the consumer of a good or service.
The social benefit is the total benefit from consuming a good or service, including both the private benefit
and any external benefit. When there is a negative externality in the production of a good or service, too
much of the good or service will be produced at market equilibrium. When there is a positive externality in
consuming a good or service, too little of the good or service will be produced at market equilibrium.

B. Externalities and Market Failure

Market failure is a situation in which the market fails to produce the efficient level of output.

C. What Causes Externalities?

Governments need to guarantee property rights for a market system to function well. Property rights are
the rights individuals or businesses have to the exclusive use of their property, including the right to buy or
sell it. In certain situations, property rights do not exist or cannot be legally enforced. Externalities and
market failures result from incomplete property rights or from the difficulty of enforcing property rights in
certain situations.

Teaching Tips
Industrial pollution is often cited as an example of a negative externality, but you can also use smoking as
a classroom example. Most college students grew up in an era where smoking was much less socially
94 CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

acceptable than when their parents and grandparents were young. Students are often stunned to learn that
smoking—by both students and instructors—was allowed in many college classrooms as late as the 1970s.
Although few, if any, colleges allow smoking in classroom buildings now, many bars and restaurants have
smoking sections. Ask your students (a) if they would be willing to pay smokers to not smoke while they
are in the same restaurant, or (b) if they have ever chosen to sit in a restaurant’s smoking section to avoid a
longer wait for a table in a non-smoking section.

Extra Solved Problem 5.1

Smoking at Ike’s Bar-B-Q Pit
By 2011, twenty-seven states, including California, Florida, Massachusetts, and New York, had enacted
laws to prohibit smoking in workplaces. But Ike’s Bar-B-Q Pit is not located in any of these states. Some
of Ike’s non-smoking customers, including some who suffer from asthma, have petitioned Ike to adopt a
no-smoking rule for his restaurant. Upon hearing of the petition, some of Ike’s other customers complained
that they have smoked in Ike’s restaurant for years and would not patronize the restaurant if the no-smoking
rule were adopted. Ike is greatly concerned because he does not wish to lose business from either his
smoking or non-smoking customers.

Draw a graph illustrating the externality associated with smoking in Ike’s Bar-B-Q Pit and explain how this
externality causes a deviation from economic efficiency in this market.

Solving the Problem

Step 1: Review the chapter material.
This problem is about externalities, so you may want to review the section “Externalities and
Economic Efficiency,” which begins on page 138 of the textbook.
Step 2: Draw a graph to illustrate the externality at Ike’s Bar-B-Q Pit.
This is a negative externality because there are external costs imposed on Ike’s non-smoking
customers as a result of breathing in second-hand smoke. These are costs that neither Ike nor
his smoking customers have to pay.

Step 3: Describe how the externality causes a deviation from economic efficiency.

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 CHAPTER 5 | Externalities, Environmental Policy, and Public Goods 95

The economically efficient outcome is for the quantity of meals served at Ike’s restaurant to be
Q2 and the price of the meals to be P2. (Ike’s, no doubt, has a varied menu with different meals
with different prices. To simplify this problem, assume P2 is an average meal price.) This
outcome would be economically efficient because it is where the market supply curve that
represents social costs, including the negative health effects on non-smokers, crosses the
demand curve. At this point, the marginal benefit from Ike’s meals would equal the marginal
social cost. However, because neither Ike nor his smoking patrons have to pay for the negative
externality, the market supply curve represents only private costs. As a result, the equilibrium
market price and quantity are P1 and Q1. At this point, the marginal social cost from Ike’s meals
exceeds the marginal benefit.

Extra Making
the The Mystery of the Missing Bees
Connection
In over two dozen states, beekeepers are scratching their heads over the disappearance of significant
numbers of their bees. In addition to providing honey, bees are used to pollinate more than $14 billion worth
of seeds and crops in the United States annually, mostly fruits, vegetables, and nuts. Experts searched for
explanations for the crisis—called “colony collapse disorder”—as growers of almonds, avocados, and kiwis
worried about the ability of the remaining bee colonies to pollinate their crops. The symbiotic relationship
between beekeepers and farmers is a classic example of positive externalities: The production activities of
each group benefit the other. Jeff Pettis, researcher at the U.S. Department of Agriculture, helped to conduct
a survey that found a 30 percent reduction in the honey bee population nationwide during the winter of
2010–2011. This followed similar annual reductions from 2006–2007 on. Pettis explained “. . . continued
losses of this size put tremendous pressure on the economic sustainability of commercial beekeeping.”
Experts believe that more than one factor may have caused the problem. Some researchers have responded
by attempting to develop almond trees that require fewer bees to pollinate. One company is attempting to
commercialize a “blue orchard bee” that is stingless and works at colder temperatures than the honeybee.
Sources: Alexi Barrionuevo, “Mystery of the Vanishing Bees” New York Times, February 27, 2007; Wendy Lyons Sunshine, “Is
Life Too Hard for Honeybees?” Scientific American, March 31, 2009; and Kim Kaplan, “USDA/AIA Survey Reports 2010/2011
Winter Honey Bee Losses,” U.S. Department of Agriculture, May 23, 2011.

Private Solutions to Externalities: The Coase Theorem (pages 141–147)

5.2 Learning Objective: Discuss the Coase theorem and explain how private bargaining can
lead to economic efficiency in a market with an externality.

Although government intervention may increase economic efficiency in markets where externalities are
present, it is possible for people to find private solutions to the problem of externalities. Ronald Coase made
this argument in a 1960 article. To understand Coase’s argument, it is important to understand that
completely eliminating an externality is usually not economically efficient.

A. The Economically Efficient Level of Pollution Reduction

The optimal decision is to continue any activity up to the point where the marginal benefit equals the
marginal cost. This applies to reducing pollution just as much as other activities. As pollution declines,
society benefits, but the marginal benefit from eliminating another unit of pollution declines as emissions
are reduced. As pollution declines, the marginal cost of further reductions rises. The net benefit to society
from reducing pollution is equal to the difference between the benefit of reducing pollution and the cost.
To maximize the net benefit to society, any type of pollution should be reduced to the point where the
marginal benefit from another ton of reduction is equal to the marginal cost.

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96 CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

B. The Basis for Private Solutions to Externalities

In arguing that private solutions to the problem of externalities were possible, Ronald Coase emphasized
that when more than the optimal level of pollution is occurring, the benefits from reducing the pollution to
the optimal level are greater than the costs.

C. Do Property Rights Matter?

Ronald Coase pointed out that the amount of pollution reduction will be the same whether polluters or
the victims of pollution are legally liable for damages. Bargaining between the parties will result in the
same reduction in pollution, where the marginal benefit of the last unit of reduction is equal to the
marginal cost.

D. The Problem of Transactions Costs

There are frequently practical difficulties in the way of a private solution to the problem of externalities.
For example, if many people suffer from the negative effects of pollution, bringing all the victims together
with all the producers of the pollution and negotiating an agreement often fails due to high transactions
costs. Transactions costs are the costs in time and other resources that parties incur in the process of
agreeing to and carrying out an exchange of goods or services.

E. The Coase Theorem

The Coase Theorem is the argument of economist Ronald Coase that if transactions costs are low, private
bargaining will result in an efficient solution to the problem of externalities. Private bargaining is most
likely to reach an efficient outcome when the number of bargaining parties is small and all parties are
willing to accept a reasonable agreement.

Extra Solved Problem 5.2

Ike’s Bar-B-Q Pit Reaches a Coase Solution
Refer to Extra Solved Problem 5.1 in this Instructor’s Manual. Because Ike’s restaurant is not in a state that
regulates smoking in public places, Ike decides to meet with his smoking and non-smoking customers to
accommodate both of their wishes regarding his smoking policy. Suggest a solution that would be consistent
with the Coase Theorem.

Solving the Problem

Step 1: Review the chapter material.
This problem is about the Coase theorem, so you may want to review the section “Private
Solutions to Externalities: The Coase Theorem,” which begins on page 141.
Step 2: Describe the type of solution that would bring about an efficient outcome and be
consistent with the Coase Theorem.
Private bargaining between those who are the source of the externality and those who are
affected by the externality could result in a solution that is satisfactory to both parties.
Step 3: Suggest a solution that would enhance the well-being of Ike’s customers and
increase economic efficiency.
One possible solution is to construct a wall separating Ike’s restaurant into smoking and non-
smoking sections. This would raise the cost of providing meals at Ike’s and, in effect, shift to
the left the supply curve that represents private costs from the graph in Extra Solved Problem
5.1. The cost of the wall could be passed on to either or both groups of customers. It would not
matter if the cost was paid for by the smokers or non-smokers, as long as the economically

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 CHAPTER 5 | Externalities, Environmental Policy, and Public Goods 97

efficient rate of output was achieved where the marginal social cost equals the marginal benefit
from the meals served at Ike’s.

Government Policies to Deal with Externalities (pages 147–153)

5.3 Learning Objective: Analyze government policies to achieve economic efficiency in a
market with an externality.

When private solutions to externalities are not feasible, government can intervene to increase economic
efficiency. A.C. Pigou argued that to deal with a negative externality in production, the government should
impose a tax equal to the cost of the externality. Pigou argued that the government should deal with a positive
externality in consumption by giving consumers a subsidy equal to the value of the externality. Pigovian taxes
and subsidies are government taxes and subsidies intended to bring about an efficient level of output in the
presence of externalities. These taxes and subsidies internalize the externalities.

A. Command-and-Control versus Market-Based Approaches

A command-and-control approach to pollution involves the government imposing quantitative limits on
the amount of pollution firms are allowed to emit or requiring firms to install specific pollution control
devices. Instead of a command-and-control approach, Congress decided to use a market-based approach to
deal with the problem of acid rain. The objective was to reduce emissions of sulfur dioxide to 8.5 million
tons annually by 2010. A system of tradable emissions allowances was set up. The federal government gave
electric utilities, the major sources of sulfur dioxide emissions that cause acid rain, allowances equal to the
total amount of allowable emissions. The utilities were then free to buy and sell the allowances. Utilities
that could reduce their emissions at a low cost did so and sold some or all of their allowances to utilities
that could reduce their emissions only at a high cost. The program has so far been successful not only in
reducing emissions but in doing so at a much lower cost than had been expected.

B. Are Tradable Emissions Allowances Licenses to Pollute?

Some environmentalists have labeled tradable emissions allowances “licenses to pollute.” But this criticism
ignores a central economics lesson: resources are scarce and trade-offs exist. Resources spent reducing
pollution are not available for any other use. Because reducing acid rain using allowances cost utilities $870
million, rather than $7.4 billion as originally estimated, society has saved more than $6.5 billion per year.

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98 CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

Teaching Tips
Economists working for the private research group, Resources for the Future (RFF), are among the strongest
supporters of a system of tradable emissions allowances to reduce the problem of acid rain. In formulating
environmental policy, it is often difficult to put a dollar value on environmental damage. For example, what
is the dollar value of the breathing difficulty that people with asthma experience due to sulfur dioxide
pollution? Economists at RFF have pioneered techniques for measuring the value of things for which no
market price exists. You can refer students interested in environmental economic issues to the RFF Web
site: www.rff.org. RFF, located in Washington D.C., has a summer internship program that provides
opportunities for undergraduates to do research with environmental economists.

Four Categories of Goods (pages 153–161)

5.4 Learning Objective: Explain how goods can be categorized on the basis of whether they
are rival or excludable and use graphs to illustrate the efficient quantities of public goods
and common resources.

Goods differ on the basis of whether their consumption is rival and excludable. Rivalry is the situation that
occurs when one person’s consuming a unit of a good means no one else can consume it. Excludability is
the situation in which anyone who does not pay for a good cannot consume it. There are four categories of
goods. A private good is a good that is both rival and excludable. Food, clothing, and many other goods
and services fall into this category. A public good is a good that is both nonrival and nonexcludable. Public
goods are often, but not always, supplied by a government rather than by private firms. The classic example
of a public good is national defense. Your consumption of national defense does not interfere with your
neighbor’s consumption, so consumption is nonrival. You cannot be excluded from consuming it, whether
you pay for it or not. The behavior of consumers in this situation is referred to as free riding. Free riding
is benefiting from a good without paying for it. Quasi-public goods are goods that are excludable but not
rival. For example, people who do not pay for cable television do not receive it, but one person’s watching
it doesn’t affect other people’s watching it. A common resource is a good that is rival but not excludable.
Forest land in many poor countries is a common resource. If one person cuts down a tree, no one else can
use the tree. But if no one has a property right to the forest, no one can be excluded from using it.

A. The Demand for a Public Good

We can determine the market demand curve for a private good or service by adding horizontally the quantity
of the good demanded at each price by each consumer. To arrive at a demand curve or marginal social
benefit curve for a public good, we don’t add quantities at each price; instead, we add the price each
consumer is willing to pay for each quantity of the public good. This value represents the total dollar amount
consumers as a group would be willing to pay for that quantity of the public good.

B. The Optimal Quantity of a Public Good

The optimal quantity of any public good will occur where the marginal social benefit curve intersects the
supply curve. One difficulty with the market providing the economically efficient quantity of a public good
is that the individual preferences of consumers are not revealed in this market. Because no consumer can
be excluded from consuming the services provided by the good, no one has an incentive to reveal his or her
preferences. Governments sometimes use cost-benefit analysis to determine the quantity of a public good
that should be supplied. However, for many public goods, including national defense, the quantity supplied
is determined by a political process involving Congress and the president.

C. Common Resources
In England during the Middle Ages, each village had an area of pasture, known as a commons, on which
any family in the village was allowed to graze its cows or sheep without charge. Because the grass that one
cow ate was not available to another cow, consumption was rival. But every family in the village had the

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 CHAPTER 5 | Externalities, Environmental Policy, and Public Goods 99

right to use the commons, so it was nonexcludable. Without some type of restraint on usage, the commons
would end up being overgrazed. The tendency for a common resource to be overused is called the tragedy
of the commons. The source of the tragedy of the commons is the same as the source of negative
externalities: a lack of clearly defined and enforced property rights. Over the years, most of the commons
in England were converted to private property. In some situations, though, enforcing property rights is not
feasible. An example is the oceans. Because no country owns the oceans beyond its own coastal waters, the
fish and other resources of the ocean remain a common resource. In such situations, two types of solutions
to the tragedy of the commons are possible. If the geographic area involved is limited and the number of
people involved is small, access to the commons can be restricted through community norms and laws. If
the geographic area or the number of people is large, legal restrictions on access to the commons are
required.

Teaching Tips
According to the U.S. Department of Agriculture, the average American consumes 223 pounds of beef,
pork, and chicken annually. Despite the large and continuing demand for this meat, we do not see news
reports of shortages of cows, pigs, and chickens. In contrast, there are occasional media reports of over-
fishing and the possible extinction of some animal species. When resources are privately owned, owners
have incentives to conserve their use; producers have strong incentives to maintain the stocks of cows, pigs,
and chickens to ensure future supplies. Property rights to some parts of oceans, rivers, lakes, and habitat
areas of endangered species are nonexistent or are poorly enforced.

Extra Making
the Paying for Speed
Connection
Economists often have used public highways as examples of a common resource. Highways are
nonexcludable because all automobile drivers have access to them, and rival because as more drivers enter
a highway, the amount of congestion increases. For busy interstate highways near large cities, congestion
can become severe. For example, during rush hour Minneapolis commuters can spend over an hour on
Interstate 394 for a drive that can take as little as twelve minutes without traffic. In 2005, Minnesota began
using a market-based approach to its common resource problem: commuters on I-394 were allowed to pay
tolls to use carpool lanes. The most interesting part of this solution is that technology has allowed the toll
to vary based on the amount of congestion, from 25 cents to $8. The goal is to regulate traffic so that those
willing to pay the toll can maintain a speed close to 55 miles per hour. Although charging drivers to avoid
traffic is not a new idea, it has become increasingly popular among municipalities. Additional revenue is
raised, but only from those drivers who are willing to pay to save time. “The congestion problem is bad and
getting worse, and we aren’t in the position where we can dismiss possible solutions that involve changing
the way we pay for travel,” notes Tim Lomax, a research engineer from Texas A&M University. Sensors
in highway pavement keep track of the number of cars and their speed. When traffic slows, computers
increase the toll, which discourages drivers from entering the toll lanes. Toll amounts are displayed on signs
visible to drivers and are deducted from an electronic card placed inside a driver’s vehicle. Some critics of
this program are concerned that the toll lanes cater to the needs of wealthy drivers, but the toll lanes appeal
to other drivers as well. The program has another benefit: Drivers who use the lanes report using less
gasoline than when they spend more time fighting traffic.
Source: Daniel Machalaba, “Paying for VIP Treatment in a Traffic Jam,” Wall Street Journal, June 21, 2007.

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100 CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

Extra Economics in Your Life:

Can You Do Anything to Reduce Acid Rain?

The tradable emissions allowances program that has been used to reduce sulfur dioxide emissions has been
targeted at electric utilities. Utilities buy allowances when the cost of reducing their emissions exceeds the
cost of the allowances. Each allowance represents one ton of sulfur dioxide.

Question: Should utilities be the only ones that can trade allowances, or should college students or other
individuals concerned about pollution also be able to buy allowances?

Answer: In fact, although utilities have the greatest interest in trading allowances, anyone can purchase
them. Trades can take place through brokers or through environmental groups such as the Clean Air
Conservancy Trust and the Acid Rain Retirement Fund. Another option is to participate in an annual auction
conducted by the Environmental Protection Agency (EPA). Once a year at the end of March, the EPA
auctions off a certain number of sulfur dioxide emissions allowances to the highest bidders. Successful
bidders in past auctions include students from Environmental Economics classes from several universities.
Although allowances can be resold, student groups and environmental groups typically hold onto
allowances to prevent them from being used by utilities to cover their emissions. For more information
about the auctions, go the EPA Web site (http://www.epa.gov/).

SOLUTIONS TO END-OF-CHAPTER EXERCISES

Answers to Thinking Critically Questions
1. With a command-and-control approach, the government imposes quantitative limits on the amount of
pollution that firms are allowed to emit, or they require firms to install specific pollution control devices.
This may not be the most economically efficient solution to the pollution problem because the polluting
firms would likely have very different costs of reducing pollution, with some firms having to pay much
higher costs to meet the new standards than other firms.

2. Before the implementation of the tax, the price consumers pay and the price producers receive is
represented by PMarket, and the quantity produced is represented by QMarket. With the tax, the supply curve
shifts up from S1 to S2, raising the price paid by consumers to PEfficient , reducing the quantity produced to
QEfficient, and lowering the price received by producers to P. The cost of the smog is equal to the amount of
the tax, which is represented by the vertical distance between S1 and S2, which is the same as the vertical
distance between PEfficient and P.

©2013 Pearson Education, Inc. Publishing as Prentice Hall

 CHAPTER 5 | Externalities, Environmental Policy, and Public Goods 101

Externalities and Economic Efficiency

5.1 Learning Objective: Identify examples of positive and negative externalities and use
graphs to show how externalities affect economic efficiency.

Review Questions
1.1 An externality is a benefit or cost that affects someone who is not directly involved in the
production or consumption of a good or service. Examples of positive externalities include a) the benefits
received by a passerby who enjoys a beautiful garden, and b) the benefits from a college education that go
to one’s children, grandchildren, co-workers, or complete strangers. Examples of negative externalities
include a) the noise from a loud party or from a jetliner, and b) the pollution emitted by a factory.

1.2 The private cost of producing a good will differ from the social cost when there is an externality.
For example, the private cost of producing electricity includes the costs of the fuel and running the power
plant, but the social cost also adds the costs of the pollution emitted (a negative externality)—which can
reduce visibility and cause health problems. The private benefit of consuming a good differs from the social
benefit when there is an externality. For example, the private benefit from your college education includes
your enjoyment of the experience and the increase in income you’ll receive as a college graduate, but the
social benefits add the benefits to third parties (a positive externality), such as your potential co-workers’
improved productivity because you know more, or the gains to people who receive more services from the
government because you earn more and pay more taxes.

1.3 Economic efficiency occurs when the marginal benefit to consumers of the last unit produced is
equal to its marginal cost of production, and where the sum of consumer surplus and producer surplus is
maximized. Externalities generally reduce economic efficiency because buyers and firms ignore the
external cost or benefit, which leads firms to either overproduce the good if there is an external cost, or
underproduce the good if there is an external benefit.

1.4 Market failure is the failure of the market to produce the efficient level of output. Externalities,
public goods, and common resources all cause market failure (as does monopoly, which will be covered in
a later chapter).

1.5 Externalities generally arise because of incomplete property rights or from the difficulty in
enforcing property rights.

Problems and Applications

1.6 Under these circumstances, consumption of Big Macs causes a small negative externality. These
types of externalities also exist on highways, particularly at rush hour, when your decision to drive on the
highway causes other motorists to take slightly longer to complete their trips. Governments sometimes deal
with traffic externalities by charging higher tolls during peak commuting hours. Governments are unlikely
to intervene to relieve congestion in lines at MacDonald’s, however. Because the people being
inconvenienced by you are also MacDonald’s customers, the firm is in the best position to decide how best
to deal with congestion in its stores.

1.7 The neighbor’s barking dog serves as a positive externality when it makes you aware of or prevents
a dangerous situation like a thief going into your house. The barking dog serves a negative externality when
it barks at almost anything and disturbs you.

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102 CHAPTER 5 | Externalities, Environmental Policy, and Public Goods

1.8 Obtaining human food often leads to the bear seeking more human food, which causes the bear to
be destroyed or removed from the park. For campers and hikers, the bear seeking human food could lead
to the bear mauling or killing a camper or hiker.

1.9 Driving cars increases traffic congestion and air pollution. Bikers and bike lanes could decrease
both congestion and air pollution. Whether a city should install more bike lanes depends partly upon how
many additional people would bike rather than drive.

1.10 The efficient amount of alcohol consumption is Q2, but because the negative externality is ignored,
actual consumption is Q1. The deadweight loss is area A.

1.11 a. A positive externality arises from studying.

b. Tom’s demand for studying is D2, the marginal social benefit curve, which adds together his
marginal private benefit and the marginal external benefit to his future children. He studies QT
hours, which is the efficient amount. Jacob’s demand for studying is D1, the marginal private
benefit curve. Jacob studies only QJ, which is inefficient because the marginal social benefits
from studying more exceed the marginal costs.

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1.12 It is a positive externality in production. Because of the way the cable provider packages channels,
popular programs on one channel will increase sales of other channels. It is possible to think of a private
agreement in which other cable channels assume some of the production costs of popular shows, but
negotiating such an agreement would be difficult.

1.13 By market failures, he means that an unregulated market will result in more than the economically
efficient amount of development of farmland. Inefficient land allocation refers to the conversion of
farmland into developed land. Because the market fails to take into account the external cost of lost
farmland, an inefficiently large quantity of land (Q1) is developed. The efficient level of land development
is Q2, which is determined by the intersection of demand and S2.

5.2

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Private Solutions to Externalities: The Coase Theorem

Learning Objective: Discuss the Coase theorem and explain how private bargaining can
lead to economic efficiency in a market with an externality.

Review Questions
2.1 The economically efficient level of pollution is the quantity at which the marginal cost of
eliminating another unit just equals the marginal benefit from eliminating it. The economically efficient
quantity of pollution isn’t zero in most cases. Eliminating all pollution would incur costs that are greater
than the benefits.

2.2 The Coase theorem argues that if transactions costs are low, private bargaining will result in an
efficient solution to the problem of externalities. Parties involved in an externality have an incentive to
reach an efficient solution because the benefits from reducing an externality are often greater than the costs.

2.3 Transactions costs are the costs in time and other resources that parties incur in the process of
agreeing to and carrying out an exchange of goods or services. Private solutions to the problem of
externalities are most likely when it is easy to define and enforce property rights and when the costs of
making a deal are low.

Problems and Applications

2.4 An increase in pollution could make society better off if the current level of pollution is below the
efficient quantity. For example, government restrictions could be so strict that they require pollution
reductions to level A in the figure. The marginal costs of the last unit of pollution reduction exceed the
marginal benefit, so society would be better off if pollution reduction was only level B—the efficient
quantity.

2.5 Yes, assuming that the marginal benefit does not drop to zero before all of that type of pollution is
eliminated.

2.6 The marginal cost of reducing crime would include resources devoted to police, courts, and prisons.
The marginal benefit to reducing crime would include the reduction in losses to crime victims, including

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losses due to personal injury and anxiety. Just as with pollution, it would not be economically efficient to
reduce the amount of crime to zero.

2.7 As the level of pollution falls, further cleanup becomes increasingly costly. Developing countries
that have significant air pollution can use existing technology. Proven pollution reduction methods can be
implemented at the beginning of the cleanup process, so air pollution resulting from automobile use or
factory production can be addressed. Because significant technological advances have already been made
in these areas, the cost of implementation would be relatively low. Cleaning up the last 10 percent would
be considerably more expensive because a viable method to completely eliminate air pollution in populated,
urban areas has yet to be developed. An important trade-off involves spending resources to develop a
method to completely eliminate air pollution versus using those resources for other purposes.

Although there would be health benefits of reducing pollution further, it is not clear that the government
should take action to do so. Remember that if the marginal benefit of reducing air pollution is greater than
the marginal cost, further reductions will make society better off. But if the marginal cost of reducing air
pollution is greater than the marginal benefit, reducing air pollution will actually make society worse off.
The government needs to quantify the marginal cost and the marginal benefit of a further reduction in air
pollution, and take steps to reduce air pollution further only if the marginal benefit exceeds the marginal
cost.

2.9 You should disagree because in deciding on the optimal amount of pollution reduction, we must
take into account the costs as well as the benefits. Because the marginal benefit of reducing sulfur dioxide
emissions all the way to zero will be very low, while the marginal cost will be very high, it would not be
economically efficient to completely eliminate sulfur dioxide emissions.

2.10 If the group affected by the air pollution offered the steel plant an amount to curtail production that
was equal to or greater than the marginal cost of the air pollution, it would be in the interest of the steel
plant to internalize the cost of the air pollution. The amount offered to curtail each unit of production would
be an opportunity cost (because the steel plant would lose the funds if it did not curtail production) and
would become part of the steel plant’s marginal cost of production. The property right to clean air does not
need to be assigned to the victims of air pollution to get the steel plant to reduce pollution. As just noted, if
the steel plant has the property right, but the victims offer the plant an amount at least equal to the marginal
cost of the air pollution, then the plant will internalize the cost of the air pollution.

2.11 It seems likely that private agreements will result in something close to the efficient quantities of
apple trees and beehives. We know that private agreements are detailed and enforceable so it is likely that
the externalities can be internalized successfully. The transactions costs involved in negotiating the
agreements may result in the efficient quantities of apple trees and beehives not being attained exactly.

Government Policies to Deal with Externalities

5.3 Learning Objective: Analyze government policies to achieve economic efficiency in a
market with an externality.

Review Questions
3.1 A Pigovian tax or subsidy aims to bring about an efficient level of output in the presence of
externalities. The tax is set equal to the marginal external cost, which is the difference between the marginal
social cost and the marginal private cost. The subsidy is set equal to the marginal external benefit, which is
the difference between the marginal social benefit and the marginal private benefit.

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3.2 To internalize an externality means that the producer or consumer that creates the externality bears
or receives the cost or benefits of the externality. A tax equal to the cost of a negative externality will cause
producers to internalize the negative externality and a subsidy equal to the benefits of a positive externality
will cause consumers to internalize a positive externality. A private solution along the lines of the Coase
theorem would also internalize an externality.

3.3 Most economists prefer tradable emissions allowances because they allow pollution to be reduced
at the lowest cost. The firm that can reduce pollution cheaply will do so and sell its right to emit pollution
to another firm whose costs of reducing pollution are high. The command and control approach is generally
much costlier, because it often forces firms to adopt expensive methods of pollution control.

Problems and Applications

3.4 Consuming fruits and vegetables has a positive externality to the extent that such consumption
decreases medical expenses, which decreases the costs of private health insurance for all people who have
insurance and also decreases the cost of the government’s Medicare and Medicaid programs. Whether the
government should subsidy the consumption of fruits and vegetables is complicated in that the people who
consumer fruits and vegetables may live long and receive more Social Security payments and Medicare
benefits.

3.5 The production of antibiotics creates a positive externality to the extent that the value of new
antibiotics for society exceeds the returns the antibiotics provide to the drug companies. Whether every
firm producing a good with a positive externality should receive a subsidy depends partly on how large the
positive externality is. The positive externality would need to be larger than the transactions cost or
administrative cost of using a subsidy to cause firms to internalize the externality.

3.6 The negative externality causes a deadweight loss of area A where the marginal benefit is less than
the marginal social cost of output from QEfficient to QMarket. A Pigovian tax equal to the cost of the negative
externality per unit of output would internalize to the firm the cost of the externality. The supply curve
would shift from S1 to S2, and output would decrease to QEfficient. A positive externality causes a deadweight
loss of area B where the marginal social benefit is greater than the marginal cost of output from QMarket to
QEfficient. A Pigovian subsidy equal to the benefit of the positive externality per unit of output would
internalize to the consumer the benefit of the externality. The demand curve would shift from D1 to D2, and
output would increase to QEfficient.

3.7 Yes, subsidizing something that generates external benefits can help increase economic efficiency.
However, the funds used to subsidize new technologies may be wasted if the government subsidizes new

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technologies that don’t generate external benefits. The U.S. government does subsidize the production of
new technology by providing grants to researchers through the National Science Foundation and other
agencies. Distinguishing between “good” new technologies and mediocre new technologies is a very
difficult task.

3.8 a. The tax should be the amount necessary to shift up the supply curve from S1 to S2. That amount
is $7.50 – $7.15 = $0.35 per item dry-cleaned.

b. The deadweight loss from excessive dry cleaning arises because the efficient amount of items to
dry clean is 600,000 per week, but the market outcome is 750,000 per week. The following graph
shows that the deadweight loss equals the amount by which the marginal social cost (S2) of
cleaning the last 150,000 items exceeds the marginal benefit (the height of the demand curve for
each of these items). This is shown by area A of the figure: 0.5 × $0.35 × 150,000 = $26,250.
(Note: We know that the base of the deadweight loss triangle must be $0.35 because S2 is parallel
to S1, so the distance between them is constant.)

3.9 The negative externality from consuming sweetened soda causes a deadweight loss of area A, where
the marginal cost exceeds the marginal social benefit for the quantity of sodas from QEfficient to QMarket.

a. The government should not prohibit the consumption of sweetened soda, but should instead
implement a way to get the consumers of sweetened soda to internalize the negative externality.

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Prohibiting sweetened sodas would cause the equilibrium quantity to fall to zero, which is not
the economically efficient level of output.

b. The government could impose a tax on sweetened soda.

3.10 a. The efficient amount of crime is where the marginal benefit (from increased safety, reduced
property losses, increased peace of mind, and so forth) of reducing crime equals the marginal
cost (from the salaries of additional police officers, the cost of additional squad cars, and so
forth) of reducing crime.

b. The tax is a Pigovian tax because it attempts to push the quantity of crime toward its efficient
level. Assuming that the marginal benefit of reducing crime is currently greater than the marginal
cost—so that the current level of crime is inefficiently high—Governor Patrick’s proposal would
increase economic efficiency.

3.11 A normal good is a product that consumers demand more of as income rises. Environmental
protection is a normal good. Western, developed nations already had higher incomes than third world
countries do today when the West first began to take significant steps to protect the environment. Because
third-world countries have low incomes, they do not demand nearly as much environmental protection as
developed countries do. As an economy develops and people get richer and can afford to pay more for a
clean environment, their willingness to pay for a clean environment rises—so the marginal benefit curve
for pollution reduction rises. Economic development also brings new technologies that reduce the marginal
cost of reducing pollution.

3.12 a. Marginal external cost is the difference between the marginal social cost and the marginal private
cost curve. In this case, the marginal external cost must be rising as output increases, so the gap
between the marginal private cost curve and the marginal social cost curve gets larger as output
increases.

b. The optimal Pigovian tax can be found by first finding the efficient level of output, which is
found at the intersection of the demand curve and the marginal social cost curve. At this output,
the optimal tax equals the gap between the social cost and the private cost curves—that is, it
equals the amount of the marginal external cost. Therefore, in the large city the optimal tax is
$6.60 − $5.40 = $1.20, but in the small city the optimal tax is only $5.60 – $5.00 = $0.60. The
efficient tax is larger in the large city because demand is greater and marginal social cost
increases as the quantity of items cleaned per week increases.

3.13 a. Command-and-control rules are when the government imposes quantitative limits on the amount
of pollution firms are allowed to emit or require firms to install specific pollution control devices.
Quantitative limits per power plant (as opposed to capping the total quantity of emissions) and
specific pollution control devices can be very costly.

b. Power plant managers might favor a cap-and-trade system of tradable emissions allowances. The
federal government would cap the total amount of air pollution emissions and power plant
managers would be free to buy and sell the allowances. Power plants that could reduce emissions
at a low cost would do so and sell their allowances to power plants that could only reduce
emissions at a high cost.

3.14 The success of using tradable permits to reduce sulfur dioxide emissions has led many economists
to believe that they may be similarly successful in reducing emissions of carbon dioxide. Tradable permits
are likely to reduce carbon dioxide emissions more efficiently than would command-and-control proposals

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that would mandate certain reductions in emissions. Some economists, though, favor using a Pigovian tax
on carbon-based fuels, sometimes referred to as a “carbon tax,” as an alternative to tradable permits.
Because there are many more sources of carbon dioxide emissions than there are sources of sulfur dioxide
emissions, some economists do not believe tradable permits will be as effective in reducing carbon dioxide
emissions.

Four Categories of Goods

5.4 Learning Objective: Explain how goods can be categorized on the basis of whether they
are rival or excludable, and use graphs to illustrate the efficient quantities of public goods
and common resources.

Review Questions
4.1 Rivalry occurs when one person’s consuming a unit of a good means that no one else can consume
it. Excludability occurs when anyone who doesn’t pay for a good cannot consume it. Goods that are both
rival and excludable are called private goods, which comprise most of the goods we consume. Goods that
are rival, but nonexcludable, are called common resources—such as fish in the sea. Goods that are both
nonrival and nonexcludable are called public goods. Goods that are nonrival, but excludable, are called
quasi-public goods.

4.2 A public good is nonrival and nonexcludable. Because anyone can get it without paying for it once
it has been produced—attempting to “free ride” in this manner—there is often little incentive for firms to
supply the good, because they can’t cover their costs if people don’t pay for the good. Free riding will lead
to market failure; less than the economically efficient amount of a public good will be produced.

4.3 The tragedy of the commons is the tendency of a common resource to be overused. It can be avoided
if there is a way to block overuse. One method is to give someone or some group a property right to the
resource, which would give the person or group the incentive to use it efficiently. However, this won’t work
well if the person or group cannot easily enforce the property right.

Problems and Applications

4.4 a. The optimal quantity of a public good is the quantity where the public’s marginal benefit from
the good—as represented by the demand curve—is equal to the marginal cost of providing the
good. To solve the problem, we need to know the demand curve for the city park and the
marginal cost to the town of providing acres of park land. To calculate their overall demand, we
need to add the dollar amounts that Jill and Joe are willing to pay for each quantity:

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The graph shows that the optimal size park—where marginal social cost equals marginal social
benefit—is 4 acres.

b. The marginal cost of supplying the second acre is $13. But the demand curve tells us that the
marginal benefit Jill and Joe receive from the second acre is $21. Because the marginal benefit
to society is well above the marginal cost, two acres cannot be the optimal size for the town park.

4.5 The tragedy of the commons is the tendency for a common resource to be overused. Because whales
are a common resource, in the absence of agreements among governments to control whaling, several
species have been hunted toward extinction.

4.6 Clean air and the village green are both common resources: they are rival and not excludable. Just
as one farmer using the pasture leaves less grazing space for the other farmers, one person polluting the air
leaves less clean air for other people. Because they are not private goods, neither the pasture land nor the
air can be excluded from use.

4.7 The tragedy of the commons arises because each person using the commons neglects the effects
his use has on other users. This is similar to each person neglecting to take into account the effects on
others—in the form of creating resistant microorganisms that cause hard-to-treat infections—from using
antibiotics.

4.8 Private goods are (b) home mail delivery (you’ll be excluded if you don’t use a stamp), (d)
education in a private school, and (g) an apple. A (a) TV broadcast and (f) hiking in a park without a fence
are public goods. Hiking in a park surrounded by a fence (e) is a quasi-public good, because it is excludable
but not rival. Education in a public school (c) is a common resource—at least for people within the school
district who won’t be excluded. It is rival because as more students crowd into a classroom, the amount of
attention the teacher gives to each student declines. In cases where it isn’t rival, it would be a public good
for those who are eligible.

4.9 A few aspects of health care indeed do generate large positive externalities that are not excludable
and in these cases it is likely that a private system will not provide the efficient amount. But these cases
(such as vaccines) are a relatively small share of the total health care market. Most services (such as an
appendectomy or open heart surgery) are private because they are rival and excludable, and the reason for
the government to provide them cannot be due to their being public goods. There may be other reasons the
market does not provide the efficient quantity of these services, such as patients, medical care providers,
and insurance companies not all having access to the same information, distortions due to individuals not

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being taxed on the medical insurance provided by their employers, and the overuse of health care by the
insured.

4.10 The land where several clubs hunt is similar to a commons. If one hunt club does not harvest the
small buck, another club will. The land where the club has exclusive rights is similar to private property,
where the hunt club can control overharvesting.

4.11 Buffalo on the Great Plains during the 1800s were a common resource (rival, but not excludable),
and were overharvested to near extinction. Cattle were privately owned, and therefore, not overharvested.

4.12 The village elders were trying to prevent the tragedy of the commons. Their solution worked quite
well given the small size of the village.

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