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.