MICRO ECONOMICS (Chapters 10-11, 21 & 13)

Market Efficiency and Negative externalities:

Negative externality: the cost of production to society is larger than the cost to producers.

Suppose citizens living around Metropolitan Airport value peace and quiet at a value of $3 billion. If it costs the airlines $4 billion to make their planes quieter (the airlines value noise at $4 billion), is it efficient for the government to require that the planes be muffled? Why or why not?

No, because the cost of correcting the externality exceeds the value placed on it by the affected parties.

Common resources are _____, but they are _____.

not excludable, rival in consumption

3. Charities:

-Environmental Working Group (pollution) -Alumni associations (education)

Market inefficiency and positive externality example:

-Education -The benefit of education is private -Externalities of education include lower crime rates, higher productivity and wages, etc.

Basic research:

-General knowledge -Subsidize by government -The public sector fails to pay for the right amount and the right kinds

How can the government potentially solve the problem of failing to allocate resources efficiently?

-Help define property rights -Regulate private behavior -Use tax revenue to supply a good that the market fails to supply

Why might private solutions NOT work?

-High transaction costs (costs that parties incur in the process of agreeing to and following through on a bargain) -Bargaining simply breaks down -Large number of interested parties; coordinating everyone is costly

Why is gasoline taxed so heavily?

-The gas tax is a corrective tax -Reduces deadweight loss instead of causing deadweight losses -Makes the economy work better (less traffic congestion, safer roads, and cleaner environment)

COMMON property gives owners the incentive to what?

-To neglect (not provide the necessary upkeep to maintain the usability of the resource) -To overuse, since no one has authority to define limits to use. Conservation is irrelevant because owners know if they do not use the resource then others will; and, joint ownership makes it difficult to coordinate acceptable levels of use.

National defense:

-Very expensive public good -$579 billion in 2015 (World Bank)

Market-Based Policy 2-Tradable Pollution Permits:

-Voluntary transfer of the right to pollute from one firm to another -New scarce resource: pollution permits -Market to trade permits -A firm's willingness to pay for permits depends on its cost of reducing pollution

Excludable vs. Rival in consumption:

-Whether goods are excludable or rival in consumption is sometimes a matter of degree. -A good is excludable if people can be prevented from using it. -A good is rival in consumption if one person's use of the good diminishes other people's use of it.

PUBLIC policies/solutions to correct market failure:

1. Command-and-control policies 2. Market-based policies

1. Suppose an individual enjoys lawn care and gardening a great deal. He uses pesticides to control insects and the harmful residue drifts across the neighborhood. He values the use of the pesticides at $10,000, and the neighborhood values clean air at $15,000. What does the Coase theorem suggest will take place? 2. How large would the transaction costs need to be in order to ensure that no private solution to the problem can be found?

1. No pesticides will be used, and the air will be clean, regardless of whether the individual owns the right to use pesticides or the neighborhood residents own the right to clean air. Either the individual will fail to buy the right to pollute or the neighborhood residents will pay the individual not to pollute. 2. There are $15,000-$10,000 = $5,000 of potential benefits. If transaction costs exceed this amount, there will be no private solution.

PRIVATE policies/solutions to correct market failure:

1. The Coase Theorem 2. Moral codes and social sanctions 3. Charities 4. Agreements/contracts

How high should the tax on gasoline be?

2007 Journal of Economic Literature: -Optimal corrective tax on gasoline -$2.28 per gallon in 2005 dollars -$2.70 per gallon in 2012 dollars Actual tax in the U.S. in 2017: -46 cents per gallon on average -39 cents in Lousiana

Free rider:

A person who receives the benefit of a good but avoids paying for it.

Market failure:

A term used to describe a situation in which a market fails to allocate resources efficiently; the market fails to maximize economic well-being.

Which of the following would likely produce negative externalities? A. Exhaust from automobiles B. Restored historic buildings C. Green spaces/community gardens D. Technology research E. Barking dogs

A. Exhaust from automobiles E. Barking dogs Explanation: A. The exhaust from automobiles is a negative externality because it creates smog that other people have to breathe. Because drivers may ignore this externality when deciding what cars to buy and how much to use them, they tend to pollute too much. The federal government addresses this problem by setting emission standards for cars. It also taxes gasoline to reduce the amount that people drive. E. Barking dogs create a negative externality because neighbors are disturbed by the noise. Dog owners do not bear the full cost of the noise and, therefore, tend to take too few precautions to prevent their dogs from barking. Local governments address this problem by making it illegal to "disturb the peace."

When wealthy alumni provide charitable contributions to their alma mater to reduce the tuition payments of current students, it is an example of A. an attempt to internalize a positive externality. B. an attempt to internalize a negative externality. C. a corrective tax. D. a command-and-control policy.

A. an attempt to internalize a positive externality.

Which of the following is not considered a transaction cost incurred by parties in the process of contracting to eliminate a pollution externality? A. costs incurred to reduce the pollution B. costs incurred due to lawyers' fees C. costs incurred to enforce the agreement D. costs incurred due to a large number of parties affected by the externality E. all of the above are considered transaction costs.

A. costs incurred to reduce the pollution

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. increases, more Explanation: 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.

Internalizing the externality:

Altering incentives so people take account of the external effects of their actions.

At any given quantity, what does the height of the demand curve show?

At any given quantity, the height of the demand curve shows the willingness to pay of the marginal buyer; it shows the value to the consumer of the last unit of the product bought.

At any given quantity, what does the height of the supply curve show?

At any given quantity, the height of the supply curve shows the cost to the marginal seller; it shows the cost to the producer of the last unit of the product sold.

Taxes on sellers creates a _____ in supply:

Decrease

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. $50 Explanation: 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.

Bob and Tom live in a university dorm. Bob values playing loud music at a value of $100. Tom values peace and quiet at a value of $150. Which of the following statements is true about an efficient solution to this externality problem if Bob has the right to play loud music and if there are no transaction costs? A. Bob will pay Tom $100, and Bob will stop playing loud music. B. Tom will pay Bob between $100 and $150, and Bob will stop playing loud music. C. Bob will pay Tom $150, and Bob will continue to play loud music. D. Tom will pay Bob between $100 and $150, and Bob will continue to play loud music.

B. Tom will pay Bob between $100 and $150, and Bob will stop playing loud music.

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. above, less

The government engages in an industrial policy A. to internalize the negative externality associated with industrial pollution. B. to internalize the positive externality associated with technology-enhancing industries. C. to help stimulate private solutions to the technology externality. D. by allocating tradable technology permits to high technology industry.

B. to internalize the positive externality associated with technology-enhancing industries.

Why might markets fail to allocate resources efficiently?

Because property rights are not well established

Public goods vs. Common resources:

Both public goods and common resources are not excludable; they have no price. They differ in internal effects: -Positive externalities (public goods) -Negative externalities (common resources) Private decisions about consumption and production can lead to inefficient allocations.

Like negative externalities, how can the government correct the market failure with positive externalities?

By inducing market participants to internalize the externality. The appropriate response in the case of positive externalities is exactly the opposite to the case of negative externalities. To move the market equilibrium closer to the social optimum, a positive externality requires a subsidy.

How can the government correct the market failure with negative externalities?

By taxing goods that have negative externalities.

Which of the following is an example of a positive externality? A. Dev mows Hillary's lawn and is paid $100 for performing the service. B. While mowing the lawn, Dev'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. Hillary's newly cut lawn makes her neighborhood more attractive.

Which of the following statements about corrective taxes is generally 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. They cause deadweight losses. Explanation: 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.

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. transaction costs make negotiating difficult.

Examples of common resources:

Clean air and water; roads

Club goods:

Club goods are excludable but not rival in consumption. Example: consider fire protection in a small town. It is easy to exclude someone from using this good; the fire department can just let her house burn down. But fire protection is not rival in consumption; once a town has paid for the fire department, the additional cost of protecting one more house is small.

What are the two types of public policies toward externalities? Describe them. Which one do economists prefer? Why?

Command-and-control policies are regulations that prohibit certain behaviors. Market-based policies align private incentives with social efficiency. Economists prefer market-based policies because they are more efficient and they provide incentives for even further reduction in, say, pollution through advances in technology.

Common resources:

Common resources are rival in consumption but not excludable. Example: fish in the ocean are rival in consumption. When one person catches fish, there are fewer fish for the next person to catch. But these fish are not an excludable good because it is difficult to stop fishermen from taking fish out of a vast ocean.

The Equivalence of Corrective Taxes and Pollution Permits:

Corrective taxes and pollution permits lead to the same price and quantity of pollution.

Bob and Tom live in a university dorm. Bob values playing loud music at a value of $100. Tom values peace and quiet at a value of $150. Which of the following statements is true? A. It is efficient for Bob to continue to play loud music. B. It is efficient for Bob to stop playing loud music only if Tom has the property right to peace and quiet. C. It is efficient for Bob to stop playing loud music only if Bob has the property right to play loud music. D. It is efficient for Bob to stop playing loud music regardless of who has the property right to the level of sound.

D. It is efficient for Bob to stop playing loud music regardless of who has the property right to the level of sound.

CHAPTER 10:

EXTERNALITIES

2. Moral codes and social sanctions:

Ex. littering

In the presence of a NEGATIVE externality, such as pollution, the social cost of the good _____ the private cost.

Exceeds

In the presence of a POSITIVE externality, the social value of the good _____ the private value.

Exceeds

One source of market failure:

Externalities

Corrective Taxes vs. Pollution Permits:

FIRMS PAY FOR THEIR POLLUTION -Corrective taxes: pay to the government -Pollution permits: pay to buy permits FIRMS INTERNALIZE THE EXTERNAL COSTS OF POLLUTION

The role of the government:

Government action can sometimes improve market outcomes.

Command-and-Control Policies-Regulation:

Governments have the option to regulate behavior directly.

The social value of education is _____ than the private value.

Greater

1. The Coase Theorem:

If private parties can bargain without cost over the allocation of resources, then they can solve the problem of externalities on their own. Regardless of the initial distribution of property rights, interested parties can reach a bargain in which everyone is better off and the outcome is efficient.

Taxes on sellers creates a decrease in supply:

If the tax equals the external cost, than the DWL from the negative externality would be eliminated. The tax would shift the supply curve by the size of the external cost, and we would arrive at the optimum quantity.

In terms of public goods, how can the government remedy the free-rider problem?

If total benefits of a public good exceeds its costs: -Provide the public good -Pay for it with tax revenue Examples: fireworks display, flood control, mosquito control

Negative externality:

Impact on the bystander is adverse (harmful).

Postive externality:

Impact on the bystander is beneficial.

Externalities and Market Efficiency:

In a competitive market, the outcome is efficient in the absence of externalities.

Pollution and the social optimum DWL:

Negative externalities create a deadweight loss (DWL) in the market. A corrective tax can reduce/eliminate this inefficiency.

Summary of negative and positive externalities:

Negative externalities lead markets to produce a LARGER quantity than is socially desirable. Positive externalities lead markets to produce a SMALLER quantity than is socially desirable. To remedy the problem, the government can internalize the externality by taxing goods that have negative externalities and subsidizing goods that have positive externalities.

Corrective taxes:

Induce private decision makers to take into account the external costs that arise from a negative externality. -Place a price on the right to pollute -Reduce pollution at a lower cost to society -Raise revenue for the government -Enhance economic efficiency

PROS of free market for pollution permits:

Initial allocation doesn't matter. If the cost reducing pollution is relatively low compared to permit costs, firms sell whatever permits they get. If the cost of reducing pollution is relatively high compared to permit costs, firms buy whatever permits they need. ---> Efficient final allocation.

The government can help correct market failure through policies aimed at what?

Internalizing the externality

When there is an under-allocation of goods in the market, the optimum quantity (Q OPTIMAL) is _____ than the market equilibrium quantity (Q MARKET). The optimum quantity will _____ total welfare.

Larger, maximize

PRIVATE property rights provide incentives to what?

Maintain, protect, and conserve property as well as to transfer property if someone else values it more (you can gain from trade).

The equilibrium quantity:

Maximizes the total value to buyers minus the total costs of sellers. In the absence of externalities, therefore, the market equilibrium is efficient.

Market-Based Policy 1- Corrective Taxes and Subsidies:

NEGATIVE EXTERNALITIES: -Markets produce a LARGER quantity than is socially desirable -Government: TAX POSITIVE EXTERNALTIES: -Markets produce a SMALLER quantity than is socially desirable -Government: SUBSIDY

What are two important public goods?

National defense and basic research.

With NEGATIVE externalities, there is an _____ of goods in the market.

Over-allocation

CHAPTER 11:

PUBLIC GOODS AND COMMON RESOURCES

The tragedy of the commons:

Parable that shows why common resources are used more than desirable: social and private incentives differ The tragedy of the commons arises because of a negative externality (one person's use diminishes another's enjoyment of the resource). Common resources, like public goods, are not excludable: They are available free of charge to anyone who wants to use them. Common resources are, however, rival in consumption: One person's use of the common resource reduces other people's ability to use it. Thus, common resources give rise to a new problem: Once the good is provided, policymakers need to be concerned about how much it is used. This problem is best understood from the classic parable called the Tragedy of the Commons

Subsidies:

Payments made by the government to a producer or consumer. -Induce private decision makers to internalize external benefits -Causes an increase in production/consumption (the opposite of taxes) -Causes DWL if the market itself is efficient, but can be used to correct inefficiencies of positive externalities

Private goods:

Private goods are both excludable AND rival in consumption. Example: consider an ice-cream cone, for example. An ice-cream cone is excludable because it is possible to prevent someone from eating one—you just don't give it to her. An ice-cream cone is rival in consumption because if one person eats an ice-cream cone, another person cannot eat the same cone. Most goods in the economy are private goods like ice-cream cones: You don't get one unless you pay for it, and once you have it, you are the only person who benefits.

Externalities may be due to _____ OR _____.

Production, consumption

Excludability:

Property of a good whereby a person can be prevented from using it.

Rivalry in consumption:

Property of a good whereby one person's use diminishes other people's use.

2. Market-based policies:

Provide incentives so that private decision makers will choose to solve the problem on their own; modify incentives

Public goods:

Public goods are NEITHER excludable nor rival in consumption; people cannot be prevented from using a public good, and one person's use of a public good does not reduce another person's ability to use it.

The Free-Rider Problem:

Public goods are not excludable, which prevents the private market from supplying the goods.

1. Command-and-control policies:

REGULATE behavior directly

When there is an over allocation of goods in the market, the optimum quantity (Q OPTIMAL) is _____ than the market equilibrium quantity (Q MARKET). The optimum quantity will _____ total welfare.

Smaller, maximize

Social cost:

Social cost= Private costs of the producers (supply) + the cost to the bystanders affected adversely by the externality

What is an example of a public policy using regulation?

The Environmental Protection Agency: -Develop and enforce regulation -Dictates maximum level of pollution -Requires that firms adopt a particular technology to reduce emissions

Suppose there are no transaction costs and suppose that airlines have the right to make as much noise as they please. If it costs the airlines $2 billion to make their planes quieter, what is the private solution to the problem?

The affected citizens must pay at least $2 billion and are willing to pay up to $3 billion to the airlines to have the planes made quieter.

Suppose there are no transaction costs and suppose that people have the right to peace and quiet. If it costs the airlines $2 billion to make their planes quieter, what is the private solution to the problem?

The airlines could spend $2 billion and make their planes quieter or buy the right to make noise for $3 billion, so they will choose to make the planes quieter for $2 billion.

What does the demand curve for a product reflect?

The demand curve reflects the value to buyers. D=MWTP It reflects the value of the product to consumers, as measured by the prices they are willing to pay.

The difficult job of cost-benefit analysis:

The government aims to decide what public goods to provide and in what quantities. Cost-benefit analysis: -Compare the costs and benefits to society of providing a public good -Doesn't have any price signals to observe -Government findings are rough approximations at best

Compare your answers to c and d above. What are the similarities, and what are the differences? What general rule can you make from the comparison?

The planes will be made quieter regardless of the original property rights because it is efficient. Differences: If the citizens have the right to quiet, citizens gain and airlines lose. If the airlines have the right to make noise, airlines gain and citizens lose.

Why are tradable pollution permits considered superior to corrective taxes at reducing pollution?

The regulator doesn't need to know anything about the demand to pollute in order to arrive at the targeted amount of pollution. The initial allocation of pollution permits will not have an impact on the efficient solution.

What does the supply curve reflect?

The supply curve reflects the costs of sellers. S=MC It reflects the costs of producing the product.

Externality:

The uncompensated impact of one person's action's on the well-being of a bystander/third party.

4. Agreements/contracts:

To correct the externality

True or False: The equilibrium of supply and demand is typically an efficient allocation of resources.

True

True or false: If a market generates a negative externality, the social cost curve is above the supply curve (private cost curve).

True.

True or false: If a market generates a positive externality, the social value curve is above the demand curve (private value curve).

True.

With POSITIVE externalities, there is an _____ of goods in the market.

Under-allocation

Suppose citizens living around Metropolitan Airport value peace and quiet at a value of $3 billion. If it costs the airlines $2 billion to make their planes quieter (the airlines value noise at $4 billion), is it efficient for the government to require that the planes be muffled? Why or why not?

Yes, because the value placed on peace and quiet exceeds the cost of muffling the planes.

If the cost of reducing pollution is relatively high compared to permit costs:

firms buy whatever permits they need.

If the cost reducing pollution is relatively low compared to permit costs:

firms sell whatever permits they get.