11175 Introduction to Economics

Answers to exam review questions module 9

Compare your responses to those provided below.

Question 1
Define negative externality. Discuss the effect of negative externality in production on market efficiency
using a diagram. Indicate on your diagram the market equilibrium, efficient equilibrium and deadweight
loss.

What policy options are available for the government to deal with this negative externality?

An externality is a benefit or cost that affects third parties (others) who are not directly
involved in the production or consumption of a good or service. If third parties are affected
adversely, then the externality is a negative externality. If there is a negative externality in
production, consumers not directly involved in the consumption of the product pay (or bear)
some of the external cost of producing the product. In this case, the (marginal) social cost of
producing a good will exceed the (marginal) private cost. Please refer to graph below. S1 is
the market supply reflecting private cost of production while S2 is the market supply
reflecting social cost. The difference between the social cost and private cost is the
external cost being borne by third parties. Since the producer does not bear the entire cost
of production and the producer's marginal cost of production (the supply) is reduced, it
encourages the producer to produce more of the product, leading to a market equilibrium
(Qb in the graph) which is greater than the efficient equilibrium (Qa in the graph) and
resulting in a deadweight loss (DWL= area of triangle fab).

To remedy this situation, the government should impose a tax. Government tax intended to
bring about an efficient level of output in the presence of negative externalities is called a
Pigovian tax. A Pigovian tax would force the producer to internalise the cost of the
externality and move the marginal cost of production from S1 to S2. As a result, the efficient
level of output (Qa) would be produced and the deadweight loss eliminated. Another option
available for the government is to prohibit companies from polluting the environment by
banning certain activities (such as, the dumping of chemicals into the river, releasing
pollutants into the atmosphere, etc). This is called command and control approach. There is
also the option of introducing an ‘Emissions Trading scheme’ whereby companies need
permits to release pollutants and these permits can be traded in the market. Those
companies who want to release more pollutants have to pay for additional permits (which
can be considered as a penalty for polluting).

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Question 2
What are common resources? Why does the market fail in the provision of common resources? How
does the government deal with this market failure?

Common resources are rival and non-excludable resources. They are rival because the use
of these resources by one individual will reduce the amount (or quality) that will be available
for others. They are non-excludable because no one can be excluded from using these
resources. Examples include forest land, pasture land, fish in the ocean, lions in the wild,
shrimp population in the gulf waters, a public library, and space on a public beach.

Common resources are subject to overuse (and depletion) because each individual captures
the private benefit fully but only bears part of the cost of using the resource. As a result,
each individual has no incentive to maintain the quality or purity of the resource (i.e.
allocation of common resources cannot be left to the market- market would fail). This
problem arises because of lack of clearly defined and enforceable property rights over
common resources. So, the government would have to intervene to conserve these natural
resources from being overused. Some of the measures the government may adopt to deal
with this problem are: Assigning (or defining) property right over the common resource;
Charging for the use of the common resource; setting quotas or legal limits on the quantity
consumed of the common resource etc.

Question 3
What are public goods? Why does the market fail in the provision of public goods? How does the
government deal with this market failure?

Public goods are non-rival and non-excludable in consumption. This means an additional
consumer does not ‘use up’ or prevent another consumer from using a public good (i.e., non-
rival). In addition, no one can be excluded from using the public good (i.e., non excludable).
Examples include national Defence; Policing; street lighting; pavements; public drainage; air
traffic control, etc.

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Private producers have no incentive to provide public goods because such goods create a
free rider problem, and it would not be possible to exclude those who do not pay for the
good. A free rider is a person who enjoys the benefits from a good or service without paying
for it. Because everyone consumes the same quantity of a public good and no one can be
excluded from enjoying its benefits, no one has the incentive to pay for it. Everyone has the
incentive to free ride. The free rider problem is that the private market, left on its own,
would not provide public goods. Public goods can only be provided by the government or by
the government subsidising private firms. If the government believes the good or service is
required by the society, then the government can collect taxes and provide the public good.

Question 4
Define positive externality in consumption. Discuss the effect of positive externality on consumption
using a diagram.

What should the government do to deal with this positive externality?

If there is a positive externality in consumption, people not directly involved in the

consumption of the product capture some of the external benefits of the product being
consumed. Since the consumer does not reap the entire benefit of consumption, the
consumer's marginal benefit of consumption (the demand) is reduced. This results in the
consumer consuming less of the product, leading to a market equilibrium which is less than
the efficient equilibrium and resulting in a deadweight loss. [Appropriate figure is on slide 20
of week 9 lecture slides; Appropriate government policy to deal with this externality is
subsidy - please see slide 27 of week 9 lecture slides].