Review Questions

1. Contrast negative and positive externalities. Provide an example of each type of externality.

   Negative externalities, like pollution, impose costs on third parties not directly involved in the economic transaction. Positive externalities confer benefits on third parties. Factors such as education and increased immunizations provide benefits to people beyond those directly involved.

2. Why does an unregulated market overproduce goods with negative externalities?

   In an unregulated market, firms pay only the private cost of the good. For a good with a negative externality, this private cost does not equal the social cost of the good, since the external marginal cost of the good is positive. As a result, firms face lower costs than the social cost and overproduce the good.

3. How can the external marginal benefit and external marginal cost curves be used to find the efficient level of an externality?

   The efficient production level of an externality occurs at the intersection between the social marginal cost curve (equal to the private marginal costs plus external marginal costs) and the social demand curve (equal to the private marginal benefits plus external marginal benefits).

4. Why are the marginal benefit and marginal abatement cost of pollution considered equivalent?

   The marginal benefit of pollution curve allows us to consider how much it would cost a firm to reduce the level of pollution it creates and therefore is equivalent to the marginal cost of cutting pollution, also known as the marginal abatement cost.

5. How do regulators use Pigouvian taxes to produce efficient outcomes?

   A Pigouvian tax is a tax that equals the external marginal cost imposed by an externality. This tax rate shifts marginal costs up to the social marginal cost, resulting in efficient production on the market.

6. Describe how tradable pollution permits can be used to address pollution.

   The holder of a government-issued tradable permit has two options: The firm may emit a certain level of pollution allowed by the permit, or the firm may trade its permit to another firm in the industry. By restricting the number of tradable permits issued, the government puts a cap on the amount of pollution that a given industry can produce. At the same time, since permits may be traded, the policy allows pollution across individual firms to vary and effectively creates a market for pollution.

7. Compare and contrast Pigouvian taxes and quantity-based solutions to externalities. What are some of the advantages and disadvantages of each?

   In a market in which the optimal level of the externality is known, a price-based mechanism such as a Pigouvian tax or a quantity-based mechanism such as a quota or tradable permits market will produce the same efficient result. But when the optimal level is unknown, a deadweight loss is produced. Depending on market characteristics, a Pigouvian tax or a quantity-based mechanism will prove more optimal. In particular, the deadweight loss from regulation is minimized in a market with a relatively flat marginal abatement cost curve when a quantity regulation is imposed. A Pigouvian tax is more optimal in a market with a relatively steep marginal abatement cost curve.

8. What is the main prediction of the Coase theorem?

   The Coase theorem predicts that economic parties will reach the optimal level of an externality if they can costlessly negotiate with one another, regardless of who holds the property rights.

9. What are the two defining properties of public goods?

   Public goods are nonexcludable and nonrival. This means that anyone can access and use the good (nonexcludable), and that any one person’s consumption of the good does not diminish another consumer’s enjoyment of it (nonrival).

10. When is a public good being produced efficiently?

    When produced efficiently, a public good’s total marginal benefit—the vertically combined marginal benefit curves of all its individual consumers—equals its marginal cost.

11. Why does the free-rider problem arise?

    A free-rider is an individual who uses a good or service without paying for it. Since a public good is nonexcludable and nonrival, the free-rider problem arises.

12. What types of solutions can address the tragedy of the commons?

    The tragedy of the commons is the phenomenon whereby anyone can use a common resource without restraint. As a result, that common resource is used more intensely than it would if it were privately held. As with other negative externalities, Pigouvian taxes or quantity-based mechanisms are one set of solutions to the tragedy of the commons. Another solution is to grant property rights to an individual, transforming the resource from one that is commonly held to one that is privately held.