Check Your Understanding

1. Question

   Wastewater runoff from large poultry farms adversely affects residents in neighboring homes. Explain the following:

   1. why this is considered an externality problem

      This is an externality problem because the cost of wastewater runoff is imposed on the farms’ neighbors with no compensation and no other way for the farms to internalize the cost.

   2. the efficiency of the outcome with neither government intervention nor a private deal

      Since the large poultry farmers do not take the external cost of their actions into account when making decisions about how much wastewater to generate, they will create more runoff than is socially optimal. They will produce runoff up to the point at which the marginal social benefit of an additional unit of runoff is zero; however, their neighbors experience a high, positive level of marginal social cost of runoff from this output level. So, the quantity of wastewater runoff is inefficient: reducing runoff by 1 unit would reduce total social benefit by less than it would reduce total social cost.

   3. how the socially optimal outcome is determined and how it compares with the no-intervention, no-deal outcome

      At the socially optimal quantity of wastewater runoff, the marginal social benefit is equal to the marginal social cost. This quantity is lower than the quantity of wastewater runoff that would be created in the absence of government intervention or a private deal.

2. Question

   According to Yasmin, any student who borrows a book from the university library and fails to return it on time imposes a negative externality on other students. She claims that rather than charging a modest fine for late returns, the library should charge a huge fine, so that borrowers will never return a book late. Is Yasmin’s economic reasoning correct?

   Yasmin’s reasoning is not correct:
   Allowing some late returns of books is likely to be socially optimal. Although a marginal social cost is imposed on others every day they are late in returning a book, there is some positive marginal social benefit to returning a book late—one gets a longer period during which to use it for education and pleasure. If one needs it for a book report, the additional benefit from another day might be large indeed. The socially optimal number of days that a book is returned late is the number at which the marginal social benefit equals the marginal social cost. A fine so stiff that it prevents any late returns is likely to result in a situation in which people return books although the marginal social benefit of keeping them another day is greater than the marginal social cost—an inefficient outcome. In that case, allowing an overdue patron another day would increase total social benefit more than it would increase total social cost. Thus, it is appropriate to charge a moderate fine, one that leads to a reduction in the number of days books are returned late so that it is the same as the socially optimal number of days.