Chapter 10 Externalities
Consider two ways to protect your car from theft. The Club (a steering wheel lock) makes it difficult for a car thief to take your car. Lojack (a tracking system) makes it easier for the police to catch the car thief who has stolen it. If a car thief encounters a car with the Club and a car without it, the car with the Club imposes a (positive/negative) externality on the car without the Club. A policy implication from this result includes a (subsidy for/ tax on) those who use the Club. If a car thief encounters two cars without the Club, but the car thief fears a Lojack system might be installed in one of the cars, the car with the Lojack system imposes a (negative/positive) externality on the other car. A policy implication from this result includes a (tax on/ subsidy for) those who use the Lojack technology.
-negative -tax on The Club conveys a negative externality on other car owners because car thieves will not attempt to steal a car with the Club visibly in place. This means that they will move on to another car. A policy implication includes a tax on those who use the Club. See Section: Negative Externalities. -positive -subsidy for The Lojack system conveys a positive externality because thieves do not know which cars have this technology. Therefore, thieves are less likely to steal any car for fear that this technology is in place. A policy implication includes a subsidy for car owners that use the Lojack technology. See Section: Positive Externalities.
When the government levies a tax on a good equal to the external cost associated with the good's production, it ________ the price paid by consumers and makes the market outcome ________ efficient. A increases, more B increases, less C decreases, more D decreases, less
A When the government levies a corrective tax in the presence of a negative externality, it increases the price paid by consumers. Although many kinds of taxes distort the market in a negative way, corrective taxes alter incentives that market participants face to account for the presence of externalities and, thereby, move the allocation of resources closer to the social optimum. Thus, while corrective taxes raise revenue for the government, they also enhance economic efficiency. See Section: Market-Based Policy 1: Corrective Taxes and Subsidies.
Many observers believe that the levels of pollution in our society are too high. If society wishes to reduce overall pollution by a certain amount, which of the following reasons supports why it's efficient to have different amounts of reduction at different firms? Check all that apply. A The costs of reducing pollution differ across firms. B All firms should be allowed to produce some pollution. C The costs of reducing pollution are the same across firms. D Firms with the highest profit should bear the largest burden of reducing pollution.
A It is efficient to have different amounts of pollution reduction at different firms because the costs of reducing pollution differ across firms. If all firms were made to reduce pollution by the same amount, the costs would be low to some firms and prohibitive at others, imposing a greater burden overall. See Section: Command-and-Control Policies: Regulation.
Economists argue that appropriate corrective taxes or tradable pollution rights will result in efficient pollution reduction. Which of the following statements supports this claim? Check all that apply. A The government does not have to figure out which firms can reduce pollution the most. B Corrective taxes or tradable pollution rights give firms greater incentives to reduce pollution. C With corrective taxes or tradable pollution rights, firms spend less in research on pollution control.
A,B Corrective taxes or tradable pollution rights give firms greater incentives to reduce pollution. Firms are rewarded by paying lower taxes or spending less on permits if they find methods to reduce pollution, so they have the incentive to engage in research on pollution control. The government does not have to figure out which firms can reduce pollution the most—it lets the market give firms the incentive to reduce pollution on their own. See Sections: Market-Based Policy 1: Corrective Taxes and Subsidies; and Market-Based Policy 2: Tradable Pollution Permits.
The government auctions off 500 units of pollution rights. They sell for $50 per unit, raising total revenue of $25,000. This policy is equivalent to a corrective tax of _____ per unit of pollution. A $10 B $50 C $450 D $500
B In the case of a corrective tax, the supply curve for pollution rights is perfectly elastic because firms can pollute as much as they want by paying the tax, and the position of the demand curve determines the quantity of pollution. In the case of pollution permits, the supply curve for pollution rights is perfectly inelastic because the quantity of pollution is fixed by the number of permits, and the position of the demand curve determines the price of pollution. Hence, the government can achieve a pollution level of 500 units by setting a corrective tax of $50 per unit or by auctioning off 500 permits. See Sections: Market-Based Policy 1: Corrective Taxes and Subsidies; and Market-Based Policy 2: Tradable Pollution Permits.
If the production of a good yields a negative externality, then the social-cost curve lies ________ the supply curve, and the socially optimal quantity is ________ than the equilibrium quantity. A above, greater B above, less C below, greater D below, less
B Because of the externality, the cost to society of producing the good is larger than the cost to the producers of that good. Therefore, the social-cost curve is above the supply curve because it takes into account the external costs imposed on society by the production of the good. This causes the equilibrium quantity to be larger than the socially optimal quantity because the market equilibrium reflects only the private costs of production. See Section: Negative Externalities.
Why are command-and-control approaches generally unable to target the firms that should undertake bigger reductions? Check all that apply. A The costs of reducing pollution are the same across firms. B Command-and-control approaches often rely on uniform reductions among firms. C There is no incentive to reduce pollution beyond the mandated amount.
B,C Command-and-control approaches that rely on uniform pollution reduction among firms give the firms no incentive to reduce pollution beyond the mandated amount. Instead, every firm will reduce pollution by just the amount required and no more. See Section: Command-and-Control Policies: Regulation.
4. Multiple Choice Q4 Which of the following statements about corrective taxes is not true? A Economists prefer them to command-and-control regulation. B They raise government revenue. C They cause deadweight losses. D They reduce the quantity sold in a market.
C When the government levies a corrective tax in the presence of a negative externality, it increases the price paid by consumers, reduces the quantity sold in a market, and raises government revenue. Although many kinds of taxes distort the market and cause deadweight losses, corrective taxes alter incentives that market participants face to account for the presence of externalities and, thereby, move the allocation of resources closer to the social optimum, which reduces the deadweight loss already present with the negative externality. Additionally, economists usually prefer corrective taxes to regulations as a way to deal with pollution because they can reduce pollution at a lower cost to society. See Section: Market-Based Policy 1: Corrective Taxes and Subsidies.
Which of the following is an example of a positive externality? A. Bob mows Hillary's lawn and is paid $100 for performing the service. B. While mowing the lawn, Bob's lawnmower spews out smoke that Hillary's neighbor Kristen has to breathe. C. Hillary's newly cut lawn makes her neighborhood more attractive. D. Hillary's neighbors pay her if she promises to get her lawn cut on a regular basis.
C A positive externality arises when a person engages in an activity that influences the well-being of a bystander in a beneficial way but that person neither pays nor receives any compensation for that effect. In this case, Hillary having her lawn mowed positively benefits her neighbors by beautifying the neighborhood. See Section: Positive Externalities.
The Coase theorem does not apply if A there is a significant externality between two parties. B the court system vigorously enforces all contracts. C transaction costs make negotiating difficult. D both parties understand the externality fully.
C According to the Coase theorem, if private parties can bargain over the allocation of resources at no cost, then the private market will always solve the problem of externalities and allocate resources efficiently. Therefore, the Coase theorem does not apply if transaction costs make negotiating difficult. See Section: The Coase Theorem.
Fire extinguishers exhibit positive externalities because, even though people buy them for their own use, they may prevent fire from damaging the property of others. The following graph shows the market for fire extinguishers. Determine whether the private and social values are equal in this case. If they are not, shift the demand curve in the appropriate direction to reflect this difference. Then determine whether the private and social costs are equal in this case. Again, if they are not, shift the supply curve to reflect this difference. Use the black point (plus symbol) to indicate the market equilibrium level of output. Then use the grey point to indicate the efficient level of output in this case. Close Explanation Explanation: If the external benefit is $10 per extinguisher, which of the following government policies would yield the efficient outcome? Check all that apply. A Subsidize people $10 for every fire extinguisher they buy. B Tax people $10 for every fire extinguisher they buy. C Mandate that every household has three fire extinguishers. D Give out fire extinguishers for free.
Demand Curve shifts to the right (Social Value) Because fire extinguishers exhibit a positive externality, the demand curve does not reflect the value to society of the good. Therefore, the social-value curve lies above the demand curve, and the social-cost curve is equal to the supply curve. See Section: Positive Externalities. The market equilibrium level of output occurs where quantity demanded equals quantity supplied, or where the demand and supply curves intersect. However, the efficient level of output occurs where the social-value curve and the social-cost curve (which is supply in this case) intersect. Therefore, the socially optimal quantity is greater than the quantity that the private market would naturally reach on its own. See Section: Positive Externalities. -A The government can correct the market failure by inducing market participants to internalize the externality. The appropriate response in the case of positive externalities is to subsidize consumers in order to entice them to purchase more of the good. In this case, a subsidy of $10 per fire extinguisher would yield the efficient outcome given the external benefit of $10 per fire extinguisher. See Section: Positive Externalities.
