Index

Ch1
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Ch2
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Ch3
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Ch4
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Ch5
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Ch6
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Ch7
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Ch8
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Ch9
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Ch10
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Review Questions Chapter 1

Review Questions
Review Questions
Review Questions
Review Questions

Review Questions
Review Questions
Review Questions
Review Questions
Review Questions

Review Questions
9. Externalities
Question 1
Louis and Dewey live in adjacent houses and are part-time private tutors, who give
lessons from home. Louis is a maths tutor, and Dewey is a rock-and-roll music tutor.
(If you think the latter sounds weird, there is a real-life School of Rock in
Philadelphia. Look it up!) Unfortunately, Louis has trouble getting students because
they cannot concentrate while Deweys students play loud music. Suppose that
Dewey earns $10,000 from tutoring, but would earn $0 if he were forced to keep the
house quiet. Louis earns $2,000 if it is noisy, but would earn $11,000 if it were quiet.
A. Is it socially efficient for Dewey to be loud or keep quiet?
B. Suppose that there is a law saying that residents are not allowed to make noise
that is disturbing to their neighbors. Based on the Coase theorem, will Dewey be
loud or keep quiet? Explain.

C. Suppose that there is no law limiting loud noise. How will the outcome be
different?
D. Again, suppose there is no law, and also suppose that it is possible for Dewey to
soundproof his house for $5,000. How can the socially efficient outcome be
achieved?

Answer
A.
It is efficient for Dewey to be loud, because his surplus if he can make noise is
$10,000, while Louiss surplus if Dewey is quiet is $9,000.
B.
Even though Louis has a legal right to quiet, he values this right less than Dewey
values being able to make noise. Therefore, Louis could sell his right to Dewey for an
amount between $9,000 and $10,000, and both would be better off.
C.
If there is no law limiting Deweys noise, then Louis would not be willing to buy
Deweys right to make noise because it values it less than Dewey does. Thus, the end
result is the same. Dewey will be loud, which is the efficient outcome.
(Note that Louis obviously prefers the case where he has a right to quiet, while
Dewey prefers the other case. However, in both cases the outcome is efficient
because the action with greater benefits than costs Dewey making noise is taken.)
D.
In this case, the most efficient outcome if for Dewey to soundproof his house and
make noise. Given that Dewey is making noise, soundproofing decreases his surplus
by $5,000 but increases Louiss surplus by $9,000. So, Louis would be willing to pay
the cost of the soundproofing, and the efficient outcome will be achieved.

Hint

Check out Chapter 9.2.

Question 2
Education is heavily subsidized (or publicly provided) in most countries. Can you
provide an economic argument for why this is a good policy?

Answer
There are many positive externalities associated with individuals becoming more
educated. For example, in a democracy, an educated population may choose better
leaders. Also, in a country with progressive taxation (those with higher incomes pay a
higher percentage of their income in taxes) and social programs, those with higher
education tend to earn more income and contribute more to government revenues.
Individuals with more education are also more likely to develop a new product,
process, or technology that will make others more productive, and they tend to be
less likely to commit crimes. Keep in mind, though, that most of the benefits of
education, such as higher future salary and social connections, are private benefits
and not externalities.
Another argument for subsidized education is that it is an effective way to promote a
more equal distribution of income because it allows the children of both wealthy and
poorer parents to have access to the same career opportunities. This is a positive
externality to the extent that individuals value the economic equality of the society
they live in.
Question 3
Fertilizer runoff from farms can cause ocean dead zones near the mouths of rivers.
Among other things, the existence of these zones reduces the catch of fishermen in
the area. Suppose that corn farms are one source of fertilizer runoff. Using a graph,
demonstrate the deadweight loss associated with the competitive market
equilibrium for corn.

Answer

Because corn production entails a negative externality, the social supply curve
(which is equal to the marginal cost of production plus the marginal external cost) is
above the private supply curve, and the efficient quantity of corn (Q*) is below the
market equilibrium quantity (QM). Thus, the deadweight loss associated with the
competitive market equilibrium is equal to the area of the shared, below the social
supply curve and above the demand curve for the quantity above the efficient level.

Hint
Figure 9.4 is an example of the deadweight loss from a negative externality. Also,
check out Chapter 9.3.
Question 4
Explain how cigarette smoking is likely to produce an externality. Is this externality
likely to be corrected by private bargaining? Using a graph, discuss the relative
merits of a ban on cigarette smoking compared to a tax on cigarettes.

Answer
Second-hand smoke from cigarettes has been shown to cause cancer, and many
people find the odor unpleasant. This is an external cost, which is not borne by the
person choosing to smoke. In addition, if health care is provided by the government

or subsidised by insurance schemes, then the costs of the negative health effects on
the smoker are also borne to some extent by others.
The externality may be corrected by private bargaining in small groups. For example,
a smoker is not likely to smoke in a non-smokers house due to social pressure.
However, in public places and large venues such as restaurants and stores, it may be
difficult for all affected parties to negotiate in order to reach an efficient outcome.
The graph below depicts the market for cigarettes. The social supply curve is drawn
above the private supply curve to reflect the external costs of cigarette smoking.

We can see that the optimal quantity (Q*), which maximises total surplus, is less than
the market equilibrium quantity (QM). However, it is greater than zero. A tax equal to
the marginal external cost of cigarette smoking will lead to the optimal quantity
being consumed and total surplus equal to the area of the shaded region. On the
other hand, an effective ban will cause quantity to be equal to zero, which results in
zero surplus.
So, a tax is more effective at creating an efficient outcome than a total ban on
smoking. This is because cigarette smoking has some benefits, the enjoyment people
get from smoking. As a result, even though the costs (both to smokers and nonsmokers) are very large, some smoking generates surplus for society.

(Note: This is not to say that banning cigarettes in some locations, such as bars and
restaurants, is not optimal. In confined spaces, it may be that the costs of even one
cigarette being smoked outweigh all the benefits to the smoker.)
Question 5
Suppose that in the Sydney suburbs the demand for flowering plants is given by P =
60 Q, and supply is given by P = 0.2Q, where Q represents thousands of a plants.
Because people enjoy seeing flowers as they pass by others houses, these plants
produce a positive externality. Suppose that each plant produces a marginal external
benefit equal to $6.
A. What will be the market price and the quantity supplied of flowering plants?
B. What is the socially optimal number of plants?
C. Calculate the deadweight loss associated with the competitive market outcome.
D. How would you suggest that the government correct the inefficiency caused by
this externality?

Answer
A.
P = $10; Q = 50
B.
To find the socially optimal quantity, we have to add the marginal external benefit to
the demand curve. (Remember that P must be isolated on the left-hand side so that
we are adding the extra benefit to consumers reservation price, i.e. adding
vertically.) So, MSB = 66 Q, so the socially optimal quantity is 55,000.
C.
To calculate the deadweight loss, it is helpful to draw the graph.

The deadweight loss is equal to the area of the shaded region, which represents lost
surplus from not consumer goods for which the marginal social benefit is above the
marginal cost.
The deadweight loss is equal to ($16 $10)x(55,000-50,000)/2 = $15,000
D.
The simplest way for the government to correct the inefficiency caused by this
externality would be to provide a subsidy for flowering plants equal to $6 per plant.
This would increase private demand so that it would coincide with social demand,
and the socially optimal quantity will be produced.

Review Questions
10. Public Goods
Question 1

Explain why a public good will typically be under-provided by the private market.

Hint
Review Chapter 10.1 and Chapter 10.3 of the text.
Question 2
A family of four Dawn, Michael, Stephanie, and Ian are thinking of installing a
swimming pool in their home. Suppose that each will get greater enjoyment from a
longer pool. Their individual demand curves for pool length are
Dawn:

P = 6,000 200Q

Michael:

P = 3,000 100Q

Stephanie:

P = 1,800 60Q

Ian:

P = 1,200 40Q

Q represents the length of the pool in meters. Suppose that the marginal cost of
building a pool one meter longer is $2,000. (You may assume that each family
members enjoyment of the pool is not affected by whether the other family
members are using it at the same time.)
A. Draw the aggregate demand curve for pool length for the family.
B. What is the optimal pool length for the family?
C. Suppose that each family member had to individually and independently decide
how many meters of the pool to pay for. How long would the pool that they would
choose be?

Hint
Review the example in Chapter 10.2 and Chapter 10.3 of the text.
Question 3

Fred and Ted have the following demand curves for hectares of urban parkland:
Fred:

P = 10 Q

Ted:

P = 1 0.1Q

A. Assuming parkland is a public good, find the aggregate demand curve for urban
parkland.
B. Suppose that the marginal cost of maintaining urban parkland is $5/hectare.
Calculate the quantity demanded individually by Fred and Ted.
C. Now, calculate the socially optimal quantity of urban parkland. Explain why this
amount is different from the individually demanded quantities.
Question 4
Suppose that David and Danny are neighbors in adjoined houses that share a lawn.
Both want to hire a gardener to tend to their lawn, and they have identical demand
functions for the numbers of hours of gardening services to hire per week, which is
given by P = 24 2Q.
A. If a gardener costs $20 per hour, what is the efficient number of hours for which
to hire the gardener? B. Suppose that David and Danny cannot come to an
agreement to share the cost of the gardener. What will be the deadweight loss
associated with competitive market outcome?