Chapter 18: Externalities and Public Goods
Short Answer Questions
1. What is an externality? Give an example of a negative externality.
Answer: An externality is defined as a direct effect of the actions of one person or
firm on the welfare of another person or firm, in a way that is not transmitted by
market prices. Externalities can be positive or negative. An example of a negative
externality is smoking (where the affected party are the non smokers).
2. Briefly explain how governments can intervene to internalise externalities.
Answer: Through the use of regulation, corrective taxation (e.g. Pigovian tax
schemes), subsidisation of the affected parties, and/or reallocation of property rights.
3. What are the implications of the Coase theorem for social welfare?
Answer: The Coase theorem states that, assuming there are no bargaining costs, once
ownership rights to a resource are established, individuals will bargain their way to an
efficient use of the resource.
4. Define the concept of public good and provide some examples.
Answer: A commodity that is non-rival and non-exclusive in consumption. Examples
are street light, national defence service, lighthouse, and law enforcement.
5. Explain the features of non-excludability and non-rivalness for public goods.
Answer: A good is said to be non-excludable if preventing its consumption is
prohibitively expensive (e.g. radio waves). A good is said to be non-rival if the
consumption of the good by one agent does not prevent another agent by also
consuming it.
6. What is the main condition for the optimal provision of public goods?
Answer: The efficient provision for public goods requires that the total valuation they
place on the last unit provided (the sum of the MRSs) equal the incremental cost to
society of providing it (the MRT).
For the remaining questions support your answers with the aid of appropriate
diagrams.
7. Using an appropriate diagram to why the actual level of emission is higher
than the efficient levels of emission in the absence of corrective action.
Answer: From society’s point of view the efficient amount of pollution is Z*, where
the marginal cost just equals the marginal benefit. The polluters incur no costs for the
damage they does due to missing market for emissions. Therefore, they continue to
pollute as long as there is any incremental benefit to themselves, regardless of the cost
of the pollution to other parties. That is, it pollutes just up to the point where the
marginal benefit of emissions is zero, level Z1 in the figure. Since Z1 is greater than
Z*, the equilibrium amount of pollution is inefficiently high.
8. Using an appropriate diagram, give an example of your choice to show how a
non-internalised negative externality can lead the market to the choice of an
inefficient outcome.
Answer: Using steel production as an example. In the absence of any intervention, the
actual level of output is X1, at the intersection of the demand (D) and supply (S)
curves. However, because steel production leads to marginal damages of MD, social
marginal cost (SMC) is greater than private marginal cost (PMC), which is embodied
in the supply curve. Efficiency requires that only output X* be produced. The
associated price, p*, embodies the entire social marginal cost. Hence, the actual
output is produced at the higher level than the socially efficient one.
9. Using the same diagram as in question 6, show the efficiency gains that can be
achieved if the externality is completely internalised.
Answer: If the externality is completely internalised, the output is produced at X*
instead of at X1. Consumption benefits fall by the associated area under the demand
curve, area (B + C). Simultaneously, private resource costs fall by the area under the
supply curve (C) and external costs fall by area (A + B). Hence, on balance, society
comes out ahead by area A.
10. Show the equilibrium outcome if the government creates the market for clean
air by selling producers permits to pollute through auction.
Answer: When the government auctions off pollution rights, the supply curve is
perfectly inelastic. The equilibrium effluent fee is p1. Firms that are not willing to buy
permission to pollute at this price must either cut output or change their technology.
Essay questions
1. Discuss the main characteristics of externalities. What are their implications?
Answer: (a) They can be produced by individuals as well as firms (consumption Vs
production externalities); (b) there is an important reciprocal aspect to externalities
(positive or negative); (c) externalities can be positive or negative; (d) zero pollution
is not, as a general rule, socially desirable. For full discussion see section 18.1.
2. Discuss how and why mergers can be used as a tool to internalise an
externality.
Answer: Once two firms merge, the externality is internalised – it is taken into
account by the party that generates the externality, since it now has a direct impact on
its profits. See section 18.2
3. What is a Pigouvian tax and how can it be used to restore the socially efficient
outcome, when a negative externality is present? Give examples.
Answer: A Pigouvian tax is a tax levied upon each unit of pollution in an amount just
equal to the marginal damage it inflicts upon society at the efficient level of output.
In this case, the Pigouvian tax of t shifts the effective supply curve from S to the
dashed line S
t, so that output is X*. The Pigouvian tax produces revenues equal to
the shaded area.
4. “Even if a public good is excludable, its private provision is likely to lead to
efficiency problems”. Discuss.
Answer: Indeed. For instance, assume an excludable private good X, marketed by a
private seller. Unless the seller has perfect knowledge of the shape of every
consumer’s demand curves, optimal provision cannot be ensured, as the seller cannot
price discriminate. By choosing a positive price, the seller essentially excludes these
consumers that place low, but positive value on the good. Thus, even if a public good
is excludable, private provision is likely to lead to efficiency problems.
5. Explain what the main efficiency concerns are associated with the provision of
public goods. How can governments respond to these problems?
Answer: Discuss here the implication of free-riding for optimal provision and how
bargaining may lead to inefficient outcomes in the presence of such problems. See
section 18.3.