1.

In 1997, representatives from 170 nations met in Kyoto, Japan, to discuss global
warming, which is caused by the:
A) burning of fossil fuels such as coal and oil.
B) use of renewable sources of energy.
C) natural conversion of carbon dioxide into oxygen.
D) attempts by various governments to reduce acid rain.

2. _____ arise whenever the actions of one party make another party worse or better
off, yet the first party neither bears the cost nor receives the benefits of doing so.
A) Internalities
B) Externalities
C) Moral hazard
D) Adverse selection

3. _____ is a problem that causes the market economy to deliver an outcome that
does not maximize efficiency.
A) Internalities
B) Externalities
C) Moral hazard
D) Market failure

4. If plumes of exhaust from passing buses are inhaled by bicyclists, a _________

externality is being imposed on __________.
A) positive; bus riders
B) negative; bus riders
C) positive; bicyclists
D) negative; bicyclists

5. Suppose a company that produces chemicals disposes of PCBs (a cancer-causing

toxin) in the local lake. The private costs of production are incurred by
__________; the social costs of production are incurred by ____________.
A) the company; the company
B) the company; people affected by the PCBs and the company
C) people affected by the PCBs; the company
D) people affected by the PCBs; people affected by the PCBs and the company

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 6. The purchase of coal by a utility is best described as a:
A) social cost.
B) private cost.
C) private benefit.
D) negative externality.

7. Which of the following is defined as the private marginal benefit to the

consumers plus any costs associated with the consumption of the good that are
imposed on others but for which those others are not fully compensated?
A) total social benefit
B) total private benefit
C) social marginal benefit
D) private marginal benefit

8. To maximize social welfare, which of the following must always be TRUE?

A) Marginal social benefit equals marginal social cost.
B) Marginal private benefit equals marginal social cost.
C) Marginal social benefit equals marginal private cost.
D) Marginal private benefit equals marginal private cost.

9. Someone else playing music loudly on the radio in a dormitory the night before
your economics exam is an example of which of the following?
A) negative production externality
B) positive production externality
C) positive consumption externality
D) negative consumption externality

10. Suppose that a market is in equilibrium and that there is no government

intervention in the market. If the private marginal cost of producing an item is $4
and the social marginal cost of production is $6, what is the private marginal
benefit of the item?
A) $2
B) $4
C) $10
D) $6

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 11. Without government intervention, it is ___________ true that ___________ in
equilibrium.
A) always; private marginal benefit equals private marginal cost
B) sometimes; private marginal benefit equals private marginal cost
C) always; private costs equal private benefits
D) always; social marginal benefit equals social marginal cost

12. To maximize social welfare when there are no externalities, marginal private
costs must be:
A) equal to marginal social costs.
B) less than marginal private benefits.
C) equal to marginal private benefits
D) greater than marginal private benefits.

13. In a free market in which there is pollution, the optimal amount of pollution
reduction occurs when:
A) social marginal benefits of reduction equal its total social costs.
B) social total benefits of reduction are maximized.
C) social marginal benefits of reduction equal its social marginal costs.
D) social marginal benefits of reduction equal zero.

14. To maximize total welfare, one must equate ________ with ________.
A) total social benefit; total social cost
B) marginal social benefit; total social cost
C) total social benefit; marginal social cost
D) marginal social benefit; marginal social cost

15. The ____________ is the direct benefit to consumers of consuming an additional

unit of a good.
A) private total benefit
B) private marginal benefit
C) social total benefit
D) social marginal benefit

16. Which of the following activities is most likely to impose a negative externality?
A) smoking
B) drinking coffee
C) going to a movie
D) riding a bicycle

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 17. Suppose your neighbor enjoys letting the grass in his yard grow wild and free, a
practice with which you disagree. This is an example of a:
A) negative production externality.
B) positive production externality.
C) positive consumption externality.
D) negative consumption externality.

18. Suppose your neighbor decides to secure his single-room air conditioner with
duct tape and black plastic, creating a view from your house that you consider
visually unappealing. The duct tape and black plastic are an example of:
A) a negative production externality.
B) a positive production externality.
C) a positive consumption externality.
D) a negative consumption externality.

19. In private equilibrium, a positive production externality will lead to __________;

a negative consumption externality will lead to ___________.
A) SMC less than PMC; SMC greater than PMC
B) SMC less than PMC; SMC less than PMC
C) SMB less than PMB; SMC greater than PMC
D) SMC less than PMC; SMB less than PMB

20. Suppose your neighbor's dog has been using your lawn in an unwanted way. If
the dog's owner agrees to compensate you for his dog's use of your yard, this is
an example of:
A) a tax.
B) a subsidy.
C) private bargaining.
D) a government solution to an external cost.

21. If you wish to assign property rights so that a previously existing externality is
now fully accounted for in a market transaction, you have to solve:
A) the holdout problem.
B) the assignment problem.
C) the free rider problem.
D) the problem of internalizing the externality.

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 22. Part I of the Coase Theorem states that when there are well-defined property
rights and costless bargaining, then, in a market in which there is an externality,
which statement is TRUE?
A) The socially optimal level of consumption can be achieved through the use of taxes
and subsidies by the government.
B) The socially optimal level of consumption can be achieved through the use of
quantity restrictions by the government.
C) The socially optimal level of consumption can be achieved through negotiations
between the affected parties.
D) The socially optimal level of consumption cannot be achieved without mediation
by the government.

23. Suppose your roommate smokes in your apartment, imposing a cost on you. The
Coase theorem suggests that one solution would involve:
A) the government establishing that your roommate owns the air in your apartment.
B) recognizing the fact that no one can own the air in your apartment.
C) the government establishing that it owns the air in your apartment.
D) a government ban against the production of tobacco products.

24. Suppose you often come home and find that an uninvited dog has left a calling
card in your yard. Determining whose dog is responsible is an example of which
of the following?
A) holdout problem
B) assignment problem
C) free rider problem
D) externality-internalization problem

25. An implication of part I of the Coase theorem is that in the presence of

externalities, government:
A) should primarily establish property rights to prevent market failure.
B) should primarily use taxes to prevent market failure.
C) should primarily use subsidies to prevent market failure.
D) can do nothing to prevent market failure.

26. According to part II of the Coase theorem, to achieve the efficient solution to an
externality:
A) the party imposing the externality must be assigned the property rights.
B) property rights must be periodically switched between the parties.
C) the government must impose taxes or subsidies.
D) property rights must be assigned to one party or the other.

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 27. The success of the Coase theorem depends crucially on:
A) one party internalizing the externality.
B) the ability of at least one party to make a credible threat.
C) negotiation between the parties.
D) one party internalizing the externality, and negotiation between the parties.

28. With respect to solving a problem of a negative externality, the assignment

problem refers to the difficulty in determining who:
A) to tax or subsidize.
B) is to blame for an externality.
C) bears the damage caused by an externality.
D) is not affected by an externality.

29. Which of the following results when shared ownership of property rights gives
each owner power over all the others?
A) the holdout problem
B) the assignment problem
C) the free rider problem
D) the problem of internalizing an externality

30. Your neighbor Gabriella plays loud music that irritates you and the rest of her
neighbors. She agrees to turn down the music by 5 decibels for every $25 she
receives from her neighbors, and even though you and your neighbors
collectively value reductions of 5 decibels at more than $25 per person, no one
pays. This is an example of:
A) the holdout problem.
B) the assignment problem.
C) the free rider problem.
D) the problem of internalizing an externality.

31. Suppose that factories in Chicago, Illinois, and Gary, Indiana, produce pollution
that affects people living in western Michigan. Even though the polluting plants
and affected individuals can be identified, the externality cannot be resolved
privately because of the large number of both polluters and affected individuals.
This is an example of:
A) the assignment problem.
B) the free rider problem.
C) the problem of internalizing an externality.
D) transaction costs and negotiating problems.

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 32. Which of the following suggests that when an investment has a personal cost but
a common benefit, individuals will invest too little?
A) holdout problem
B) assignment problem
C) free rider problem
D) externality-internalization problem

33. Corrective taxation is best used when:

A) it is difficult to internalize the externality.
B) the government can easily allocate property rights.
C) there are well-defined property rights and costless bargaining.
D) there are no external costs or benefits.

34. Taxing the producer of an externality based on the amount of the externality
produced is equivalent to which of the following?
A) subsidizing the consumer
B) subsidizing those outside the market
C) increasing the producer's input costs
D) increasing the benefits of the consumers in the market

35. Which type of approach does the Environmental Protection Agency take toward
resolving externality problems?
A) public-sector solutions
B) Coasian bargaining
C) military action
D) free market solutions

36. If SUVs produce a negative externality, taxing the buyers of SUVs would do
which of the following?
A) shift the private demand curve to the left
B) shift the private demand curve to the right
C) shift the private supply curve to the right
D) shift the private supply curve to the left

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 37. Complete the following sentence so that it ALWAYS holds true: In the presence
of a positive production externality, ________ is produced relative to the optimal
level.
A) too much
B) too little
C) the right amount
D) any of the above

38. For a tax to lead to the optimal amount of pollution, it should be set:
A) greater than social marginal damage.
B) equal to social marginal damage.
C) greater than social marginal cost.
D) equal to social marginal cost.

39. If utilities pollute the air too much in private equilibrium, corrective taxation of
the utilities would:
A) shift the private marginal cost curve downward.
B) shift the private marginal cost curve upward.
C) reduce pollution and shift the private marginal cost curve downward.
D) reduce pollution and shift the private marginal cost curve upward.

40. Under an optimal tax system, polluting producers have the incentive to reduce
pollution up to the point at which the cost of the reduction is:
A) twice the tax imposed.
B) equal to the tax imposed.
C) equal to the total benefit of the reduction.
D) twice the total benefit of the reduction.

41. Government subsidizes producers of education in part because education is

believed to produce a positive externality. The subsidy:
A) shifts the private demand curve to the left.
B) shifts the private demand curve to the right.
C) shifts the private supply curve to the right.
D) shifts the private supply curve to the left.

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 42. Suppose government subsidized the consumption of education by giving
education vouchers to parents to spend at the school of their choice. The subsidy
would:
A) shift the private demand curve to the left.
B) shift the private demand curve to the right.
C) shift the private supply curve to the right.
D) shift the private supply curve to the left.

43. A subsidy on the production of education to change its equilibrium price and
quantity would:
A) increase price and quantity.
B) increase price and decrease quantity.
C) decrease price and quantity.
D) decrease price and increase quantity.

44. In a free market with pollution and no government intervention, the market
equilibrium quantity of pollution reduction is reached when:
A) pollution reduction is zero. (No pollution is reduced.)
B) the social marginal cost of reduction equals twice the marginal benefit of reduction.
C) the social marginal benefits of reduction equal its social costs.
D) the social marginal benefits of reduction equal its social marginal costs.

45. When firms in a polluting industry have different costs for the technology to
reduce pollution, which of the following is efficient?
A) mandating equivalent reductions in pollution from all firms
B) mandating that each firm reduce pollution up to the point at which the marginal
cost of reducing pollution is equal to the total social benefit of the reductions for
each firm
C) mandating that each firm reduce pollution up to the point at which the marginal
cost of reducing pollution for each firm is equal to the marginal social benefit of
the reductions
D) mandating that each firm reduce pollution up to the point at which the marginal
benefit of doing so is zero

46. If government knows the private and social benefit and cost curves associated
with reducing pollution, which type of instrument for intervention should the
government choose?
A) either price or quantity interventions
B) neither price nor quantity interventions
C) direct government provision of the product in question
D) no action because the free market level of pollution is efficient

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 47. A government payment to an individual or firm that lowers the cost of
consumption or production, respectively, is referred to as which of the following?
A) Coasian compensation
B) subsidy
C) tax
D) free rider problem

48. If the social marginal benefit curve of reducing pollution is locally flat, which
statement must be true?
A) The benefit to society pollution reduction is larger than if the curve is steep.
B) The marginal damage curve of pollution is steep.
C) The marginal damage curve of pollution is flat.
D) The marginal damage associated with reducing pollution is very large.

49. When the social marginal benefit curve of reduction of pollution is locally flat
and the costs of reduction are uncertain, which of the following generally makes
sense?
A) quantity intervention
B) price (tax) intervention
C) direct government provision of the product in question
D) no action

50. Suppose government wants to get the amount of pollution right. Which
instrument for intervention should the government choose?
A) quantity intervention
B) price (tax) intervention
C) direct government provision of the product in question
D) no action

51. Suppose your town wishes to build a dam to protect itself from the risk of flooding.
Despite the fact that each family in the town is willing and able to pay up to $200 to
have the dam built and it will cost only $150 per family, a voluntary contribution
campaign is unable to raise enough funds to build the dam. Why? What type of problem
is this, and what solution would you recommend?

52. Suppose your neighbor enjoys riding around his yard on a rather loud dirt bike. What
kind of externality is this (positive or negative, consumption or production)? What
would the government have to do, if anything, to facilitate a Coasian solution to this
externality? Would the result be socially optimal? Explain.

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53. People who live on the edge of small lakes sometimes have break walls constructed on
their property by the shore. A break wall is typically a vertical column of wood or
concrete that prevents high water levels from covering part of the owner's property,
reducing the size of the beach, and/or eroding the yard. However, several communities
have restricted property owners from building break walls. Can you think of a reason for
that? Hint: Think about potential externalities of building a break wall.

54. Suppose that the demand for a chemical is given by Q = 100 – 2P, where quantity is
measured in pounds. The market supply is given by MC = 5. Assume that the marginal
external damage of this product is $3 per unit.
(a) What is the equilibrium price and quantity of this good without government
intervention?
(b) What level of taxation would generate the socially efficient level of the good?

55. When are quantity restrictions not the same as price restrictions (via taxes)? Describe
one situation in which the government would be better off imposing quantity restrictions
than setting a tax, and explain why quantity restrictions are better in that case.

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Answer Key

1. A
2. B
3. D
4. D
5. B
6. B
7. C
8. A
9. D
10. B
11. A
12. C
13. C
14. D
15. B
16. A
17. D
18. D
19. D
20. C
21. D
22. C
23. A
24. B
25. A
26. D
27. D
28. B
29. A
30. C
31. D
32. C
33. A
34. C
35. A
36. A
37. B
38. B
39. D
40. B
41. C
42. B
43. D
44. A

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45. C
46. A
47. B
48. C
49. B
50. A
51. This is an example of the free rider problem. Since one family benefits if the other
families invest in the dam and since the effect of one family's contribution is quite small,
each family will want to free-ride off the other families' contributions. One solution to
the free rider problem would be to have the local government levy a tax and coerce
everyone to pay the $150 per family.
52. This is a negative consumption externality. To facilitate a Coasian solution, the
government would need to establish clear property rights—either your neighbor should
have the right to ride around on the dirt bike or you should have the right to quiet. The
result would likely be socially optimal: bargaining costs between you and your neighbor
are low, there is no assignment problem, and because there are only two parties there is
no free rider or holdout problem.
53. If one person builds a break wall, the water that ordinarily would have covered a bit
more of that person's property now goes to the next lowest spot around the lake.
Consequently, by building a break wall, a property owner increases the benefit to
another lakefront property owner of building a break wall to protect against the
somewhat higher water levels. That is, building a break wall imposes a negative
externality on other lakefront property owners. As a result, some lakefront communities
have imposed the rule that no one may build a break wall.
54. (a) Solving P in terms of Q from the demand curve, we get that inverse demand is given
by P = 50 – 0.5Q. Setting that equal to the supply, we get 5 = 50 – 0.5Q, which implies
that Q = 90. Find the price by plugging 90 in for Q in the inverse demand, and we find
that P = 5.

(b) Suppose we tax the producer of this product $3 per pound for every pound it makes.
This tax would shift up the private marginal cost curve so that it equals the social
marginal cost curve. Then we find that 8 = 50 – 0.5Q, which means that Q = 84 and P =
$8. Thus, 84 pounds is the socially optimal amount to produce, the amount at which
social marginal benefit equals social marginal cost.
55. If the government knows the relevant marginal cost and marginal damage functions,
quantity and price regulation are equivalent. However, when there is uncertainty
regarding the marginal cost of reducing the negative externality, one approach may be
better than the other. Quantity restriction will be better when the social marginal damage
curve is steep—when small amounts of additional production make society significantly
worse off. The example given in the text is that of nuclear leakage, where increasing the
amount of leakage even a small amount can have a very negative effect people's lives.

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