Lesson 10

Refer to the Table. What is the socially-optimal level of output in this market?

4 units; The socially-optimal quantity of output is the quantity at which the social value equals the supply (private cost).

Refer to the Figure. Which policy would lead to the socially-optimal level of output?

A subsidy of $16 per unit; The vertical distance between the demand curve and social value curve is $16 ($28 - $12). A subsidy of $16 per unit would shift the demand curve upward to coincide with the social value curve. The supply and (shifted) demand curve would intersect at the socially-optimal quantity (Q = 10).

Refer to the figure. Which of the following would internalize the externality shown in this graph?

A tax of about $0.35 per unit; This figure depicts a market with a negative externality, which we can deduce because the sum of the private and external costs exceeds the private cost. A tax in the amount of the external cost will cause the market to internalize the externality. The external cost is the vertical distance between the two supply curves, which is about ($1.80 − $1.45 =) $0.35 per unit.

A corrective tax distorts market incentives and moves the allocation of resources away from the social optimum.

False; Corrective taxes are unlike most other taxes. 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.

When a market experiences a positive externality, the government can internalize the externality by imposing a tax on the product.

False; The government can internalize a positive externality by providing a subsidy for the product.

Suppose that Company A's railroad cars pass through Farmer B's wheat fields. The railroad causes an externality to the farmer because the railroad cars emit sparks that cause $2,000 in damage to the farmer's crops. There is a special soy-based grease that the railroad could purchase that would eliminate the damaging sparks. The grease costs $1,800. Suppose that the railroad is not liable for any damages to the farmer's crops. Assume that there are no transaction costs. Which of the following characterizes the efficient outcome?

The farmer will pay the railroad $1,800 to purchase and apply the grease so that no crop damage will occur; Because the railroad has the legal right to emit sparks without liability, any negotiation would begin with the farmer. The farmer would offer the railroad the $1,800 to buy and apply the grease because the cost of the grease is less than the cost of the crop damage ($2,000).

If the government subsidizes a good, the market demand curve shifts up.

True; A subsidy shifts the market demand curve upward by the size of the subsidy.

An ideal corrective subsidy equals the external ____________ from an activity with a _____________.

benefit, positive externality; An ideal corrective subsidy would equal the external benefit from an activity with a positive externality. An ideal corrective tax would equal the external cost from an activity with a negative externality.

An ideal corrective tax equals the external ____________ from an activity with a _____________.

cost, negative externality; An ideal corrective tax would equal the external cost from an activity with a negative externality. An ideal corrective subsidy would equal the external benefit from an activity with a positive externality.

Refer to the Table. This market

creates positive externalities; Positive externalities exist when the social value of the good exceeds the private value

Which of the following is an example of a private solution to the problem of externalities? (i) Charities (ii) Taxes (iii) Social Norms of moral behavior (iv) Subsidies

i and iii only; Charities and Social Norms of moral behavior are private solutions. Charities encourage donations because our tax system allows an income tax deduction. Social Norms of moral behavior encourages people to internalize their externalities. Taxes and subsidies are public, not private, solutions.

Refer to the Figure. This graph represents the oil industry. The industry creates

negative externalities; Negative externalities exists when the social cost of the good exceed the private cost.

This graph represents the market for cigarettes. This market has a ________ and would benefit from a ________.

negative externality, tax; A negative externality exists when the social cost of the good exceeds the private cost. In the presence of a negative externality, a tax gives buyers and sellers an incentive to take into account the negative external effects of their actions.

Refer to the figure. The ____________ externalities in this market are evident because the private value is ____________.

positive, less than the social value of the good; Positive externalities exist when the private value of the good is less than the social value of the good. Market participants do not account for the benefits to society.

Olivia owns a dog whose barking annoys her neighbor, Eric. Suppose that the benefit of owning a dog is worth $500 to Olivia and that Eric bears a cost of $400 from the barking. Assuming that Olivia has the legal right to keep a dog, a private market solution to this problem is that

situation is efficient; Because Olivia has the legal right to keep the dog, any negotiation would begin with Eric. Eric would offer Olivia up to $400 to relocate the dog. Olivia will not accept any amount less than $500. The present solution is efficient because there are no trades that will make both parties better off.

Consider the market for vaccines. When one person is vaccinated, other people are protected from illness because the vaccinated person will not transmit the illness. We would expect that in this market, the

social value curve lies above the private value curve; When bystanders receive a benefit without paying for that benefit, a positive externality exists. When the benefit to the bystanders (external benefit) is added to the private value, the result is the social value, which lies above the private value curve.

A tax on a producer of a polluting product would shift the private cost curve

upward by the size of the tax and cause the industry to decrease the quantity it supplies to the market; An industry will supply the quantity at which the private cost curve intersects the demand curve. A tax shifts the private cost curve upward by the size of the tax and decreases the equilibrium quantity.

Refer to the Figure. This graph represents the market for cigarettes. This market

would benefit from a tax; This market has a negative externality. A tax gives buyers and sellers an incentive to take into account the negative external effects of their actions.