Economic Applications Midterm, 1 Material

When there are negative externalities in the market for some product, the market outcome leads to welfare loss relative to the social optimum because**

*an amount is produced where the social cost exceeds the social benefit. The social cost (private cost + external cost) is above the supply curve (private cost). In the presence of a negative externality, the social cost of the good exceeds the private cost. When there are negative externalities, social costs exceed the private costs by the amount of the externality. When firms decide how much to produce, however, they only take into account their private costs even though social costs are greater. Too much will be produced by the free market and some products will be sold where the social costs exceed the social benefits.

Determine whether the following goods are public goods, private goods, common resources, or produced by a natural monopoly: 1) Fish in a Private Pond 2) Fish in the Ocean 3) Broadcast Television Signals 4) Cable Television Signals 5) Basic research 6) Specific research that can be patented

1) A private good. Rival and Excludable. If I catch the fish you can't (rival) and will call police if trespass (excludable) 2) Common resource. Rival but not excludable. Ocean not privately owned. Me catching lots of fish diminishes you. 3) Public Good. Not rival or excludable. Anyone who can get a connection. 4) Natural Monopoly. Not rival but exludable. Non-payers don't get it but additional customers doesn't detract. 5) Public Good. If in public domain 6) Natural Monopoly. Not rival but excludable. People using the knowledge does not detract but patent can limit it.

Survey to value how people monetary value a proposed public good? Effective method? What other ways do you think the Council could use to gauge the public's valuation of the tram line?

1) This may or may not be effective (depending on how honest you think people are). Individuals who value the tram, even if very slightly so, may have an incentive to exaggerate their valuation in order to increase the probability it will be built. The survey would likely result in an overestimated valuation of the tram. What's more, the citizens of Edinburgh will be quite uncertain how much they want a tram (perhaps they can't foresee it will take so long to build). 2) Could measure how valuable a shorter commute time could be.

Assess the following statement: "Plastic grocery bags lead to huge negative externalities. They are not biodegradable and contaminant the environment. Furthermore, their production creates pollution. Therefore, we should ban plastic bags to maximise efficiency." Draw two diagrams illustrating private cost, private benefit, social cost and social benefit.

: If the social cost of every plastic bag produced exceeds the social benefit, plastic bags should be banned in order to maximise efficiency. As can be seen in the following figure, social cost of plastic bag production is always higher than the social benefit, and the efficient level of output is 0. This statement is not always correct, however. Consider the case presented in the diagram below. For the first few plastic bags produced, the social benefit is greater than the social cost. It is efficient for plastic bags to be produced so long as the social benefit is greater than the social cost. The government should reduce plastic bag usage in this case, but it should not ban it. Answer: In the second diagram, the socially optimal level of output of plastic bags is positive. If plastic bags are banned, that means that the use of plastic bags where the social benefit exceeds to the social cost will also be banned. This will lead to a loss of welfare equal to the area below the social benefit curve and above the social cost curve.

A positive externality generates

A positive externality exists when the action of one individual yields a benefit to somebody else not involved in the action. When there are positive externalities, the social value of an action exceeds the private value of an action. so, *a social value curve that is above the demand curve (private value curve) for a good.*

Public Policies Toward Externalities?

Command and Control: Regulation. Example: limiting the number of anitbiotics that can be sold. Pigovian Tax.

Carla must pay £100 because of Ronald (pollutants). Ronald could build a new fence on his farm which prevents his cattle's waste from entering the river. The cost of this fence is £90. Efficient outcome? What if they could costlessly communicate?

Efficient outcome would be for Ronald to build a fence and stop polluting. 2) Carla would offer b/w 90 to 100, Ronald takes it because he earns a profit. Both benefit. (Coase theorem--private parties can bargain w/out cost they can solve problem of externalities.) Likewise if bargaining or communicating is too costly, a deal won't be made. *Initial distribution of rights does not matter for the market's ability to reach the efficient outcome.

What are excludable goods? What are rival goods? How are private good, public goods, common resources, and club goods divided?

Excludable: can people who do not pay for the use of a good be prevented from using the good Prevented if you don't pay. You can prevent people. Rival: Does one person's use of the good diminish another person's ability to use it? One person using it diminishes someone else. Private goods: exludable and rival. Most goods in the economy are this way i.e. a chocolate bar Public goods: neither excludable nor rival. People can't be prevented and one using it doesn't hurt another. ex: national defense Common resources: are rival but not exludable. ex: fishing Club goods: exlcludable but not rival. like paying for a small town fire coverage. One more house doesn't hurt.

The Optimal Provision of a Public Good?

Govt. will use cost-benefit analysis to determine. Difficult to determine how people value a public good because there are no price signals. May use contingent valuation methods: survey with willingness to pay and willingness to accept. Ultimately optimal provision: where the marginal cost of providing the public good intersects the marginal social benefit curve.

Roberto and Thomas live in a university hall of residence. Roberto values playing loud music at a value of £100. Thomas values peace and quiet at a value of £150. Which of the following statements is true?

It is efficient for Roberto to stop playing loud music regardless of who has the property right to the level of sound. The total benefit of playing loud music is £100. The total cost of playing music is £150. It is therefore efficient for Roberto to stop playing music, regardless of whether or not he has the right to. If the Coase theorem holds true (and negotiations are easy), Thomas would pay Roberto some sum between £100 and £150 to get Roberto to stop playing music if Roberto has the right to play loud music.

What are merit goods? De-merit goods?

Merit goods arise because consumers may have imperfect information about the benefits of these goods and are not able to value them appropriately as a result. Merit goods can be provided by the market but may be underconsumed as a result. Examples are education, health care, pensions, and insurance. Govts. can encourage saving and subsidize education. De-merit goods: goods that are over-consumed if left to the market mechanism and which generate both private and social costs which are not taken into account by decision maker ex: alcohol, tobacco. Govts. can tax these.

Why might fire extinguishers exhibit positive externalities? What would a graph of the fire extinguisher market look like?

Positive Externality- the benefits to a third party of a decision. Fire extinguishers exhibit positive externalities because even though people buy them for their own use (to protect their own property), they may prevent fire from damaging the property of others. The graph would show the social value curve is above the demand curve because there are positive externalities. The social cost curve is the same as the supply curve because there are no negative externalities. The quantity optimum socially is above what the market produces. The quantities differ because in deciding to buy fire extinguishers, people don't account for the benefits they provide to other people.

If one person's consumption of a good diminishes other people's use of the good, the good is said to be

Rival. A good is rival if the consumption of it by one individual decreases the ability of other people to use it. A park bench, for example, would be rival.

Where/what is the welfare loss from a positive externality? What government policy could result in an efficient outcome?

Suppose the benefit to society of one more fire extinguisher is £100 and the cost is £60. If this fire extinguisher is not sold, there will be a loss in welfare equal to £40. The welfare loss from the positive externality occurs where the social value exceeds the social cost. The distance between the Qmarket and Qoptimum between the demand and the social value. 2) A government policy that would result in the efficient outcome would be to subsidize people £10 for every fire extinguisher they buy. This would shift the demand curve up to the social value curve, and the market quantity would increase to the optimum quantity. And the opposite of a subsidy to incentivize a positive externality is a Pigovian tax to correct a negative externality.

There has been substantial overfishing in the Mediterranean, and some species of fish are near extinct there. Ignoring the increase in population and the improvement in fishing technology, do you think overfishing was a problem for the Roman Empire, whose borders completely encircled the Mediterranean?

The fish in the Mediterranean represent a common pool resource. There is no excludability from catching fish, but there is rivalry. That is, if Italy decided to catch a lot of fish, then there would be less fish for Greece. When Italy regulates its fishing industry and decides how much Italian fishermen should be allowed to catch, they ignore, to some extent, the impact they have on Greece. This is why the Mediterranean has few fish left. During the Roman Empire, externalities were internalised. In other words, the Roman Empire had the "big picture" in mind because they owned all of the fish in the Mediterranean. The emperor would take into account the effect of fishers in one region on the fish stock of those in another.

Public goods are difficult for a private market to provide due to

The free-rider problem. Free rider- a person who receives the benefit of a good but avoids paying for it. Because public goods are not excludable, the free rider problem prevents the private market from supplying them. If govt. decides total benefit is greater than cost, through tax revenue, they can pay for it and make everyone better off. big examples: national defense, basic research Public goods are not excludable. This means that individuals, even if they had not contributed anything to its existence, can still fully enjoy it. People will have an incentive to free ride with the attitude "let somebody else pay for it."

Suppose that requiring motorcycle riders to wear helmets reduces the probability of a motorcycle fatality from 0.3 per cent to 0.2 per cent over the lifetime of a motorcycle rider and that the cost of a lifetime supply of helmets is £500. It is efficient for the government to require riders to wear helmets if human life is valued at

The probability of death before the helmet law is 0.003 and the probability of death after the helmet law would be 0.002. The probability of death falls by 0.001 by implementing a helmet law. If we valued human life at say £10,000, the benefit of imposing the helmet law is 0.001 x £10,000 = £10. For each of the possible answers, check whether the benefit of imposing the helmet law outweighs the cost (which is £500). The correct answer is D. If human life is valued at £500,000, the benefit of imposing a helmet law is 0.001 x £500,000 = £500. Any lower value on human life would imply the cost to society of the helmet law is greater than the benefit.

Why do private solutions not always work?

Transaction costs- the costs that parties incur in the process of agreeing and following through on a bargain. Bargaining Problems, Coordinating Interested Parties, Asymmetric Information and Assumption of Rational Behavior

Suppose each of 20 neighbours on a street values street repairs at £3,000. The cost of the street repair is £40,000. Which of the following statements is true?

a It is efficient for the government to tax the residents £2,000 each and repair the road.*** b.It is efficient for each neighbour to pay £3,000 to repair the section of street in front of his/her home. c.It is not efficient to have the street repaired. d.None of these answers is true. The total value to the neighbourhood from repairing the street is 20 x £3,000 = £60,000. The total cost of repairing the street is £40,000. Because the benefit to society outweighs the cost, this project should be undertaken for the sake of efficiency. The government could tax everybody £2,000 and the street would be repaired.

When there are no negative externalities and no positive externalities

a Social benefits are equal to private benefits (demand) and social costs are equal to private costs (supply). b.Taxation by the government leads to deadweight loss. c.The free market outcome is socially optimal. d.All of the above are true. When there are no externalities (positive or negative) social costs are equal to private costs and social benefits are equal to private benefits. The free market outcome will be optimal because only products will be produced where the social benefit exceeds the social cost and any intervention by the government which reduces the quantity sold will result in deadweight loss. All of the above are true.

Which of the following would not be considered a common resource?

a.Strawberries grown in a garden where there is free community access. b.Food at a free buffet paid for by the City of Edinburgh. c.Radio signal broadcast over the airwaves.*** d.A bench in a public park. A common resource is a good which is both non-excludable (non-payers cannot be stopped from using it) and rival (one person's use of it dimishes the ability of others to use it). All of the above are common resources except for the radio signal broadcast over the airwaves. The radio signal is non-excludable, but it is also not rival.

To internalise a negative externality, an appropriate public policy response would be to

tax the good. One way to prevent overproduction due to negative externalities is to internalise externalities. For this to occur, the external effect created by an action needs to be paid by the person taking the action. The government could impose a tax equal to the cost of the externality in order to prevent the social cost from being greater than the private cost.

What is the Coase Theorem?

the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.