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1 Externalities chapter: What type of externality (positive or negative) is present in each of the following examples? Is the marginal social benefit of the activity greater than or equal to the marginal benefit to the individual? Is the marginal social cost of the activity greater than or equal to the marginal cost to the individual? Without intervention, will there be too little or too much (relative to what would be socially optimal) of this activity? a. Mr. Chau plants lots of colorful flowers in his front yard. b. Your next-door neighbor likes to build bonfires in his backyard, and sparks often drift onto your house. c. Maija, who lives next to an apple orchard, decides to keep bees to produce honey. d. Justine buys a large SUV that consumes a lot of gasoline. 1. a. This is a positive externality: since other people enjoy looking at Mr. Chau s flowers, the marginal social benefit of looking at the flowers is greater than the marginal benefit to Mr. Chau of looking at them. As a result, fewer flowers will be planted than is socially optimal. b. This is a negative externality: an external cost, the risk that your house will catch fire from the sparks from your neighbor s bonfire, is imposed on you. That is, the marginal social cost is greater than the marginal cost incurred by your neighbor. Since your neighbor does not take this external cost into account, there will be more bonfires in your neighbor s yard than is socially optimal. c. This is a positive externality: since bees pollinate her neighbor s apple trees and therefore confer an external benefit on the owner of the apple orchard, the marginal social benefit is greater than the marginal benefit to Maija. Since Maija does not take the external benefit into account, she will keep fewer bees than is socially optimal. d. This is a negative externality: the burning of gasoline produces toxic gases that impose an external cost on others. The marginal social cost is greater than the marginal cost incurred by Justine. As a result, more people will purchase SUVs than is socially optimal. S-231 KrugWellsECPS3e_Micro_CH16.indd S-231

2 S-232 CHAPTER 16 EXTERNALITIES 2. The loud music coming from the sorority next to your dorm is a negative externality that can be directly quantified. The accompanying table shows the marginal social benefit and the marginal social cost per decibel (db, a measure of volume) of music. a. Draw the marginal social benefit curve and the marginal social cost curve. Use your diagram to determine the socially optimal volume of music. b. Only the members of the sorority benefit from the music, and they bear none of the cost. Which volume of music will they choose? c. The college imposes a Pigouvian tax of \$3 per decibel of music played. From your diagram, determine the volume of music the sorority will now choose. Volume of Marginal social Marginal social music (db) benefit of db cost of db \$ a. The accompanying diagram shows the marginal social cost curve and the marginal social benefit curve of music. The socially optimal volume of music is the volume at which marginal social benefit and marginal social cost are equal (point O in the diagram). This is the case at a volume of 95 db. \$ Marginal social cost, marginal social benefit of db \$36 MSB Volume of music (db) O T MSC M KrugWellsECPS3e_Micro_CH16.indd S-232

3 CHAPTER 16 EXTERNALITIES S-233 b. Since the members of the sorority do not bear any of the social cost of playing loud music, they will play music up to the volume where the marginal social benefit is zero (point M in the diagram). This is at a volume of 96.5 db. c. If the college imposes a Pigouvian tax of \$3 per decibel, the sorority now faces a marginal cost of playing music of \$3. So they will play music up to the volume where the marginal social benefit is just equal to \$3 (point T in the diagram). This is at a volume of 96 db. This is not the optimal quantity of music, so this is not an optimal Pigouvian tax. 3. Many dairy farmers in California are adopting a new technology that allows them to produce their own electricity from methane gas captured from animal wastes. (One cow can produce up to 2 kilowatts a day.) This practice reduces the amount of methane gas released into the atmosphere. In addition to reducing their own utility bills, the farmers are allowed to sell any electricity they produce at favorable rates. a. Explain how the ability to earn money from capturing and transforming methane gas behaves like a Pigouvian tax on methane gas pollution and can lead dairy farmers to emit the efficient amount of methane gas pollution. b. Suppose some dairy farmers have lower costs of transforming methane into electricity than others. Explain how this system leads to an efficient allocation of emissions reduction among farmers. 3. a. Without the new technology, dairy farmers will release methane gas until the marginal social benefit of emissions is zero. With the new technology, there is now an opportunity cost to the farmer from releasing methane gas because there now exists a profitable alternative turning it into electricity. The financial reward forgone if a farmer emits the methane gas acts like a Pigouvian tax on emissions. If the financial reward is set at the right level equal to the marginal social cost of a unit of methane gas pollution it will lead dairy farmers to emit the efficient amount of methane gas pollution. b. Farmers who have a lower cost of capturing methane will generate more profit from transformation of their methane than farmers who have a higher cost. So farmers with lower costs will transform more units of methane gas into electricity than will farmers with higher costs. As a result, emissions reduction will be allocated efficiently among dairy farmers. 4. Voluntary environmental programs were extremely popular in the United States, Europe, and Japan in the 1990s. Part of their popularity stems from the fact that these programs do not require legislative authority, which is often hard to obtain. The 33/50 program started by the Environmental Protection Agency (EPA) is an example of such a program. With this program, the EPA attempted to reduce industrial emissions of 17 toxic chemicals by providing information on relatively inexpensive methods of pollution control. Companies were asked to voluntarily commit to reducing emissions from their 1988 levels by 33% by 1992 and by 50% by The program actually met its second target by a. As in Figure 16-3, draw marginal benefit curves for pollution generated by two plants, A and B, in Assume that without government intervention, each plant emits the same amount of pollution, but that at all levels of pollution less than this amount, plant A s marginal benefit of polluting is less than that of plant B. Label the vertical axis Marginal benefit to individual polluter and the horizontal axis Quantity of pollution emissions. Mark the quantity of pollution each plant produces without government action. KrugWellsECPS3e_Micro_CH16.indd S-233

4 S-234 CHAPTER 16 EXTERNALITIES b. Do you expect the total quantity of pollution before the program was put in place to have been less than or more than the optimal quantity of pollution? Why? c. Suppose the plants whose marginal benefit curves you depicted in part a were participants in the 33/50 program. In a replica of your graph from part a, mark targeted levels of pollution in 1995 for the two plants. Which plant was required to reduce emissions more? Was this solution necessarily efficient? d. What kind of environmental policy does the 33/50 program most closely resemble? What is the main shortcoming of such a policy? Compare it to two other types of environmental policy discussed in this chapter. 4. a. The accompanying diagram shows the marginal benefit curve for plant A, MB A, and the marginal benefit curve for plant B, MB B. Without government intervention, both plants produce Q MKT pollution. Marginal benefit to individual polluter MB B MB A Q MKT Quantity of pollution emissions b. We should expect that the total quantity of pollution before the plan was adopted was above the optimal quantity because pollution generates a negative externality. When the negative externality is not internalized or regulated, it results in higher market activity than is optimal. c. The accompanying diagram shows the targeted level of emissions in 1995, Q Both firms had to reduce their emissions by the same amount. This was not necessarily efficient: since at the quantity Q 1995, plant B had a higher marginal benefit of pollution, the situation could have been more efficient by allowing plant B to pollute a little more and asking plant A to reduce its emissions more. Marginal benefit to individual polluter MB B MB A S B(1995) S A(1995) Q 1995 Q MKT Quantity of pollution emissions KrugWellsECPS3e_Micro_CH16.indd S-234

6 S-236 CHAPTER 16 EXTERNALITIES b. The accompanying diagram shows the marginal social benefit (MSB) and the marginal social cost (MSC) of trees. The marginal social benefit is decreasing: the first trees are planted in the most ideal locations (close to frequently traveled streets, etc.), but subsequent trees must increasingly be planted in less ideal locations. The marginal social cost is increasing: as homeowners have more trees planted, arborists are likely to raise their rates in response to the increased demand for their services. The diagram shows the market equilibrium quantity, Q MKT, the socially optimal quantity, Q OPT, and the optimal Pigouvian subsidy. Marginal social cost, marginal social benefit MSC of trees Optimal Pigouvian subsidy on trees O Q MKT Q OPT MSB of trees Quantity of trees 7. Fishing for sablefish has been so intensive that sablefish were threatened with extinction. After several years of banning such fishing, the government is now proposing to introduce tradable vouchers, each of which entitles its holder to a catch of a certain size. Explain how fishing generates a negative externality and how the voucher scheme may overcome the inefficiency created by this externality. 7. An individual fisherman makes decisions about how much fish to catch based on his or her marginal benefit and marginal cost. However, the marginal social cost of fishing is greater than the fishing industry s marginal cost, since catching fish reduces the number of fish that can reproduce and so imposes an external cost on other fishermen. Since an individual fisherman does not take this external cost into account in deciding how much to fish, there will be too much fishing compared to what would be socially optimal. Assuming that the number of vouchers allocated to all fishermen corresponds to the socially optimal quantity of fish caught, the voucher scheme could achieve efficiency: it will limit the size of the total catch to the socially optimal quantity. And since the vouchers are tradable, fishermen who are more efficient (can operate at a lower cost) will buy vouchers from less efficient ones, so only the most efficient fishermen will operate. KrugWellsECPS3e_Micro_CH16.indd S-236

7 CHAPTER 16 EXTERNALITIES S The two dry-cleaning companies in Collegetown, College Cleaners and Big Green Cleaners, are a major source of air pollution. Together they currently produce 350 units of air pollution, which the town wants to reduce to 200 units. The accompanying table shows the current pollution level produced by each company and each company s marginal cost of reducing its pollution. The marginal cost is constant. Marginal cost of Initial pollution reducing pollution Companies level (units) (per unit) College Cleaners 230 \$5 Big Green Cleaners 120 \$2 a. Suppose that Collegetown passes an environmental standards law that limits each company to 100 units of pollution. What would be the total cost to the two companies of each reducing its pollution emissions to 100 units? Suppose instead that Collegetown issues 100 pollution vouchers to each company, each entitling the company to one unit of pollution, and that these vouchers can be traded. b. How much is each pollution voucher worth to College Cleaners? To Big Green Cleaners? (That is, how much would each company, at most, be willing to pay for one more voucher?) c. Who will sell vouchers and who will buy them? How many vouchers will be traded? d. What is the total cost to the two companies of the pollution controls under this voucher system? 8. a. College Cleaners would have to reduce its pollution level by 130 units, costing it 130 \$5 = \$650. Big Green Cleaners would have to reduce its pollution level by 20 units, costing it 20 \$2 = \$40. So the total cost of reducing pollution to a total of 200 units would be \$650 + \$40 = \$690. b. One pollution voucher is worth \$5 to College Cleaners and \$2 to Big Green Cleaners. To see why, consider this: if College Cleaners can obtain one more voucher entitling it to one more unit of pollution, it saves \$5 (the cost it would have had to incur to reduce pollution by one unit). c. Each voucher is worth more to College Cleaners than to Big Green Cleaners, so Big Green Cleaners will sell all of its 100 vouchers to College Cleaners (for a price between \$2 and \$5). d. Big Green Cleaners will reduce its output of pollution to zero, which will cost it 120 \$2 = \$240. College Cleaners will now have 200 vouchers and can emit 200 units of pollution, 30 fewer than before. This will cost College Cleaners 30 \$5 = \$150. So the total cost of pollution control under this system is \$240 + \$150 = \$390. The prices paid by College Cleaners and received by Big Green Cleaners in trading vouchers cancel each other out they are pure transfers between the two companies. KrugWellsECPS3e_Micro_CH16.indd S-237

9 CHAPTER 16 EXTERNALITIES S a. This choice is characterized by a network externality: you want to use the standard that is more widely adopted by other people. That s because the greater the use of a given electricity standard, the greater the availability of appliances and other electrical items using that standard. b. This choice is not characterized by a network externality because there are millions of Fords and Toyotas already on the road. Consequently, you will easily find a Toyota or Ford repair shop whenever you need one. There would be a network externality present in the choice of buying a new make of car in which you could not be assured of finding a mechanic for it. c. This choice is characterized by a network externality because you want to be assured of finding a cartridge for your printer in the future. If few people use your type of printer, you may be unable to find a cartridge; if many people use the printer, you are much more likely to find a cartridge for it. d. This choice is not characterized by a network externality because an ipod Touch and an ipod Nano use the same operating system. Any song that you could download using an ipod Touch you could also download using an ipod Nano. Any repair shop that can repair an ipod Touch can also repair an ipod Nano. KrugWellsECPS3e_Micro_CH16.indd S-239

10 KrugWellsECPS3e_Micro_CH16.indd S-240

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