Solution Manual for Microeconomics 5th Edition

Hubbard OBrien 0133455548 9780133455540

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

▪ If transactions costs are low, private bargaining can result in an efficient solution to
externality problems.

5.3 Government Policies to Deal with Externalities (pages 147–154)

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

▪ 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.

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5.4 Four Categories of Goods (pages 154–161)

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. 147. 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. 152. 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. 155. 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. 155. 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. 152.
Government taxes and subsidies intended to
bring about an efficient level of output in the
presence of externalities.
Private benefit, p. 139. 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. 155. A good that is both
nonrival and nonexcludable.
Rivalry, p. 154. The situation that occurs when
one person consuming a unit of a good means no
one else can consume it.
Social benefit, p. 139. The total benefit from
consuming a good or service, including both the
private benefit and any external benefit.
Social cost, p. 139. The total cost of producing a
good or service, including both the private cost
and any external cost.
Tragedy of the commons, p. 160. 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.

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Chapter Outline
Can Economic Policy Help Protect the Environment?
Most scientists believe burning fossil fuels generates greenhouse gases that increase global warming. A
majority of respondents to a Duke University survey believed the government should regulate greenhouse
gases. Most economists agree, but disagree with the public about which government policies would be
best. Many economists endorse market-based policies, such as a carbon tax, that rely on incentives rather
than administrative rules. Some businesses oppose the carbon tax because they believe it would raise their
costs of production. Other businesses believe a carbon tax would be less costly and effective than other
government policies.

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
100 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, some bars and restaurants have
smoking sections. Ask your students (1) if they would be willing to pay smokers to not smoke while they
are in the same restaurant, or (2) if they have ever chosen to sit in a restaurant’s smoking section to avoid a
longer wait for a table in a nonsmoking section.

Extra Solved Problem 5.1

Smoking at Ike’s Bar-B-Q Pit
By 2013, only 10 states had not issued statewide bans on smoking in any nongovernment-owned spaces.
Ike’s Bar-B-Q Pit is located in a state that allows smoking in restaurants and bars. Some of Ike’s
nonsmoking 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 nonsmoking 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 nonsmoking
customers as a result of breathing in secondhand 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. 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

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

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 nonsmokers, 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
North American beekeepers have suffered the loss of more than 10 million beehives since 2007. 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 have searched in vain for an explanation 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. Experts now believe that the problem could result from a combination of various
chemicals used in different types of pesticides and fungicides. Fungicides are used to control things like
fungus on apples and weren't expected to have an impact on healthy bees. But research has shown that
healthy bees that ate fungicides were much more likely to become infected with a deadly parasite. Some
scientists have are attempting to develop almond trees that require fewer bees to pollinate and one company
is attempting to commercialize a “blue orchard bee” that is stingless and works at colder temperatures than
the honeybee.

Sources: Wendy Lyons Sunshine, “Is Life Too Hard for Honeybees?” Scientific American, March 31, 2009; and Jeff Nesbit,
“Bee Colony Collapses Are More Complex Than We Thought,"”US News &World Report, August 7, 2013.

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.

B. The Basis for Private Solutions to Externalities

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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 to negotiate 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 nonsmoking 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 nonsmoking sections. Doing so 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 smokers or nonsmokers paid the
cost, as long as the economically efficient rate of output was achieved where the marginal
social cost equals the marginal benefit from the meals served at Ike’s.

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 CHAPTER 5 | Externalities, Environmental Policy, and Public Goods 103

Government Policies to Deal with Externalities (pages 147–154)

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 is a policy 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. Instead of a command-and-control approach, Congress decided to use a cap-and-
trade system of tradable emission allowances 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. 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 was successful not only in reducing
emissions but in doing so at a much lower cost than had been expected.

B. The End of the Sulfur Dioxide Cap-and-Trade System

Despite its success, the sulfur dioxide cap-and-trade system effectively ended in 2013. Research showed
that illnesses caused by sulfur dioxide emissions were greater than previously had been thought. Although
President George W. Bush proposed legislation to lower the cap on sulfur dioxide emissions, Congress did
not pass the legislation. As a result, the Environmental Protection Agency (EPA) reverted to setting limits
on sulfur dioxide emissions at the state or power plant level.

C. 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

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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 saved more than $6.5 billion per year.

Teaching Tips
Economists working for the private research group, Resources for the Future (RFF), are among the strongest
supporters of market-based systems, such as cap-and-trade systems, to reduce pollution. 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 internship programs that provide opportunities
for undergraduates to do research with environmental economists.

Four Categories of Goods (pages 154–161)

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.

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 CHAPTER 5 | Externalities, Environmental Policy, and Public Goods 105

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
right to use the commons, so it was nonexcludable, and 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. Enforcing property rights is not always feasible. For example, because no country
owns the oceans beyond its own coastal waters, the fish and other resources of the ocean remain a common
resource. Two types of solutions 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 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 more than an hour on Interstate
394 for a drive that can take as little as 12 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. 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. In response to worsening congestion, one research engineer at Texas A&M University notes that
municipalities should remain open to different ways for drivers to pay for travel. 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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Extra Economics in Your Life:

How Can the Adverse Impact of a Carbon Tax Be Minimized?

Economists Marc Hafstead and Lawrence Goulder argue that a tax on carbon dioxide emissions would be
an economically efficient means to reduce emissions that would have the added benefit of generating
billions of dollars annually for the U.S. government. But critics argue that a so-called “carbon tax” would
fall disproportionately on lower income households who spend a relatively large fraction of their income
on energy. To reduce the adverse impact of higher taxes, tax advocates recommend rebating some of the
revenue raised. But what type of tax rebate would be the most economically efficient? Hafstead and
Goulder compared the potential effects of: (1) cuts in taxes for businesses adversely affected by the
carbon tax, (2) a lump-sum rebate to all households, and (3) marginal tax rate reductions. Marginal tax
rates refer to the fraction of each additional dollar of income that must be paid in taxes.

Source: Marc Hafstead and Lawrence H. Goulder, “Recycling Revenue from a Carbon Tax,” Common Resources, Resources for
the Future, November 6, 2013.

Question: Which tax rebate would be the most economically efficient means to reduce the adverse
impact of a carbon tax?

Answer: Research by Hafstead and Goulder found that using revenue from a carbon tax to finance
marginal tax rate cuts would significantly lower the cost of a carbon tax compared to lump-sum rebates.
The impact of the tax would be even lower (the reduction in cost would be greater) if tax revenue would
be used to reduce tax rates of carbon-intensive industries such as coal mining, coal-fired electricity
generation, and petroleum refining.

Solutions to End-of-Chapter Exercises

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 (1) the
benefits received by a passerby who enjoys a beautiful garden, and (2) the benefits from a college
education that go to one’s children, grandchildren, coworkers, or complete strangers. Examples of
negative externalities include (1) the noise from a loud party or from a jetliner, and (2) 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 includes the private costs plus 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 include the benefits

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 CHAPTER 5 | Externalities, Environmental Policy, and Public Goods 107

to third parties (a positive externality), such as your potential coworkers’ 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 McDonald’s, however.
Because the people being inconvenienced by you are also McDonald’s customers, the firm is in the
best position to decide how 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 burglar going into your house. The barking dog serves as a negative
externality when it barks constantly and disturbs you.

1.8 Obtaining human food often leads the bear to seek 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 a. A positive externality arises from getting the flu shot because people in addition to the person
getting the shot receive benefits.
b. Because a positive externality arises from getting a flu shot, the efficient quantity (Qefficient)
and price (Pefficient) are found by locating where marginal social benefit (D2) and supply
intersect. The gray shaded area represents the deadweight loss.

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1.10 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 on
how many additional people would bike rather than drive.

1.11 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.

1.12 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 at the number of hours the
marginal social benefits from studying exceed the marginal cost.

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 CHAPTER 5 | Externalities, Environmental Policy, and Public Goods 109

1.13 a. As a result of fracking, the supply of natural gas shifts to the right from S1 to S2, which lowers
the equilibrium price of natural gas to P2 and raises the equilibrium quantity of natural gas to
Q2 .
b. Because S1 and S2 reflect only marginal private cost, fracking that results in a negative
externality would result in S1 reflecting marginal social cost. So the efficient price is P1 and
the efficient quantity is Q1.
c. Based on the graph drawn, the efficient price and quantity of natural gas are the same as the
equilibrium price and quantity before fracking. However, it is hard to determine how the
efficient price and quantity change because they depend on how much supply increases due to
fracking and how large the external costs associated with the pollution from fracking are.

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1.14 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.

1.15 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.

Private Solutions to Externalities: The Coase Theorem

5.2 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.

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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 regulations could be so strict that they require pollution
reductions to level A in the figure below. The marginal cost 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 losses due to personal injury, stolen goods, and anxiety. Just as with pollution, it would
not be economically efficient to reduce the amount of crime to zero. In other words, there is an
economically efficient level of crime where the marginal benefit from crime reduction equals the
marginal cost.

2.7 As the level of pollution falls, further cleanup becomes increasingly costly because the marginal
cost curve typically is upward sloping. For example, 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 or factory
emissions 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 low-cost 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, such as education.

2.8 a. As the level of pollution falls, additional reductions in pollution become more costly. To reduce
pollution further will likely require new technology and innovation, which can be expensive.
The additional benefit to society of less pollution will decrease, so if the marginal benefit is less
than the marginal cost, society is actually worse off as a result of the pollution reduction.

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b. Although there would be health benefits of reducing pollution further, it is not clear that the
government should take action to do so. 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 Economists would typically 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 of money 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 and reduce the quantity of pollution it
emits.

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. However, 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 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.

3.2 To internalize an externality means that the producer or consumer that creates the externality bears
the costs or receives the 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

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approach is generally much costlier, and therefore less efficient, because it often forces firms to
adopt expensive methods of pollution control.

Problems and Applications

3.4 A Pigovian tax is set equal to the marginal cost of an externality. In the absence of the tax,
consumers have to bear the cost of the externality. For example, in the absence of a Pigovian tax
on a factory that emits air pollution, consumers are bearing the cost of breathing polluted air. So in
that sense, consumers are “paying” an amount equal to a Pigovian tax even if the government has
not imposed the tax.

3.5 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 subsidize the consumption of fruits and vegetables is
complex policy issue. It may be difficult for the government to accurately measure the size of the
positive externality from consuming fruits and vegetables. The government should also take into
account that the people who consume fruits and vegetables may live longer and receive more
publicly provided benefits, such as Social Security payments and Medicare benefits. The additional
cost of providing these government benefits offsets some of the effects of the positive externality
from consuming fruits and vegetables.

3.6 The production of antibiotics creates a positive externality to the extent that the value of new
antibiotics to society exceeds the profits pharmaceutical companies earn from producing the
antibiotics. 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 government’s transactions cost or administrative cost of providing the subsidy.

3.7 a. Annoying people, including babies who cry on busses and planes, cause a negative externality
because they impose costs on other people around them. Taxing annoying people, including the
parents of the crying children, may discourage people from being annoying (or encourage
parents of crying babies to find alternative methods of keeping their children quiet). However,
the administrative costs of monitoring crying babies and taxing their parents would be very high.
In addition, many people might oppose such a tax because it would represent a government
intrusion into what is usually considered a private matter.
b. People who plant flowers cause a positive externality because they give benefits (for instance,
higher property values) to other people in the neighborhood. Government subsidies may
encourage more people to plant flowers, but again, the administrative costs of identifying
beautiful gardens and deciding on the appropriate subsidy would be very large.
c. Every negative externality should not be taxed, and every positive externality should not be
subsidized. The government should compare the costs of imposing taxes and subsidies to the
benefits. So if the benefits associated with a Pigovian tax outweigh the costs, a Pigovian tax
would reduce deadweight loss (and increase efficiency). In the cases discussed in parts (b) and
(c) of this problem, administrative costs would likely be too high for taxes or subsidies to be
an effective way of dealing the externalities involved.

3.8 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 technologies that don’t generate enough external benefits to justify the cost of the subsidy. The
U.S. government does subsidize the prooduction of new technology by providing grants to

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researchers through the National Science Foundation and other agencies, as well as granting
monopoly privileges through patents and copyrights. Of course, distinguishing between “good”
new technologies and mediocre new technologies is a very difficult task.

3.9 In the graph below of the market for gasoline, the equilibrium price is initially Pmarket and the
equilibrium quantity is QMarket. An increase in the tax on the sellers of gasoline would shift supply
from S1 to S2, resulting in an efficient price of PEfficient and an efficient quantity of Qefficient. In the
graph on page 151, consumers are paying a price P, which corresponds to the price PEfficient in the
graph below. So regardless of whether the gasoline tax is imposed on the buyer or the seller, the
price consumers pay for gasoline is increased to the efficient level.

3.10 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 number of items
to dry clean is 600,000 per week, but the market equilibrium 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). The deadweight loss is shown by area A of the
figure and has a value equal to: 0.5 × $0.35 × 150,000 = $26,250. (Note: We know that the

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base of the deadweight loss triangle must be $0.35 because S2 is parallel to S1, so the distance
between them is constant.)

3.11 The efficient level of toilet paper production will occur where the demand curve intersects with the
marginal social cost curve. So the efficient level of production will be 350,000 tons, and the
efficient price will be $150 per ton. If the government imposes a tax of $50 per ton (the difference
between the marginal private cost and the marginal social cost), supply will shift from S1 to S2,
resulting in the efficient price and quantity.

3.12 a. The “mortality effect” is the number of people who die prematurely. The number of people
who die prematurely from being obese is less than the number of people who die from
smoking. By living longer, people who are obese add more costs to society over their lifetimes.
In particular, they are less likely than smokers to die before collecting much in Social Security
and Medicare benefits.

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b. Far more people drink soda than smoke, so more people would visibly notice (and be affected
by) taxes on sodas. In addition, with so much discussion in the news over the years about the
negative effects of smoking—including the effects on nonsmokers of “secondhand smoke”—
more people are likely to accept taxes on cigarettes than on soda.
3.13 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, the cost
of building and operating additional prisons, 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.

3.14 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.

3.15 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 and specific pollution control devices can be very costly. In
addition, when the government dictates the details of how pollution will be reduced, it fails to
harness the ingenuity of business firms. After a carbon tax is imposed, utilities and car companies
may develop new ways of reducing pollution that are more efficient than the ways the government

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dictates under a command and control system. Finally, with a carbon tax, firms generating more
pollution have a greater incentive to reduce pollution than firms generating less pollution. The
command-and-control approach, on the other hand, is “one size fits all.”

3.16 a. The burden of a tax refers to who actually ends up paying the tax. In this case, the Congressional
Budget Office report suggests low-income households would disproportionately pay more of
the carbon tax in the form of higher gasoline and electricity prices.
b. Because lower-income households spend a larger fraction of their income on gasoline, heating
fuel, and electricity, they would bear a proportionally larger share of the tax. One way to reduce
the burden on these households would be to give them tax rebates.

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 consumption of 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 are 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 Free riding is benefitting from a good without paying for it. 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 four 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 to near 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
pastureland 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. Public goods are (a) television broadcast
(assuming that it an over-the-air broadcast; a cable broadcast would be a quasi-public good because
it is excludable but not rival) and (f) hiking in a park without a fence. 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

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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 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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