SECTION 14 Review

Module 74

1. When pollution can be directly observed and controlled, government policies should be geared directly to producing the socially optimal quantity of pollution, the quantity at which the marginal social cost of pollution is equal to the marginal social benefit of pollution. In the absence of government intervention, a market produces too much pollution because polluters take only their benefit from polluting into account, not the costs imposed on others.

2. The cost to society of pollution from a power plant is an example of an external cost; the benefit to neighbors of beautiful flowers planted in your yard is an example of an external benefit. External costs and benefits are jointly known as externalities, with external costs called negative externalities and external benefits called positive externalities.

3. According to the Coase theorem, when externalities exist, bargaining will cause individuals to internalize the externalities, making government intervention unnecessary, as long as property rights are clearly defined and transaction costs—the costs of making a deal—are sufficiently low. However, in many cases transaction costs are too high to permit such deals.

Module 75

4. Governments often deal with pollution by imposing environmental standards, an approach, economists argue, that is usually inefficient. Two efficient (cost-minimizing) methods for reducing pollution are emissions taxes, a form of Pigouvian tax, and tradable emissions permits. The optimal Pigouvian tax on pollution causes the polluter to pay the marginal social cost at the socially optimal quantity of pollution. These methods also provide incentives for the creation and adoption of production technologies that cause less pollution.

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   When a good yields external benefits, such as technology spillovers, the marginal social benefit of the good is equal to the marginal private benefit accruing to consumers plus its marginal external benefit. Without government intervention, the market produces too little of the good. An optimal Pigouvian subsidy to producers, equal to the marginal external benefit, moves the market to the socially optimal quantity of production. This yields higher output and a higher price to producers.

6. When there are external costs from production, the marginal social cost of a good exceeds its marginal private cost to producers, the difference being the marginal external cost. Without government action, the market produces too much of the good. The optimal Pigouvian tax on production of the good is equal to its marginal external cost, yielding lower output and a higher price to consumers. A system of tradable production permits for the right to produce the good can also achieve efficiency at minimum cost.

7. Communications, transportation, and high-technology goods are frequently subject to network externalities, which arise when the value of the good to an individual is greater when more people use the good.

Module 76

8. Goods may be classified according to whether or not they are excludable, meaning that people can be prevented from consuming them, and whether or not they are rival in consumption, meaning that one person’s consumption of them affects another person’s consumption of them.

9. Free markets can deliver efficient levels of production and consumption for private goods, which are both excludable and rival in consumption. When goods are nonexcludable, nonrival in consumption, or both, free markets cannot achieve efficient outcomes.

10. When goods are nonexcludable, there is a free-rider problem: consumers will not pay for the good, leading to inefficiently low production. When goods are nonrival in consumption, any positive price leads to inefficiently low consumption.

11. A public good is nonexcludable and nonrival in consumption. In most cases a public good must be supplied by the government. The marginal social benefit of a public good is equal to the sum of the marginal private benefits to each consumer. The efficient quantity of a public good is the quantity at which the marginal social benefit equals the marginal social cost of providing the good. As with a positive externality, the marginal social benefit is greater than any one individual’s marginal private benefit, so no individual is willing to provide the efficient quantity.

12. One rationale for the presence of government is that it allows citizens to tax themselves in order to provide public goods. Governments use cost-benefit analysis to determine the efficient provision of a public good. Such analysis is difficult, however, because individuals have an incentive to overstate the good’s value to them.

13. A common resource is rival in consumption but nonexcludable. It is subject to overuse, because an individual does not take into account the fact that his or her use depletes the amount available for others. This is similar to the problem with a negative externality: the marginal social cost of an individual’s use of a common resource is always higher than his or her marginal private cost. Pigouvian taxes, the creation of a system of tradable licenses, and the assignment of property rights are possible solutions.

14. Artificially scarce goods are excludable but nonrival in consumption. Because no marginal cost arises from allowing another individual to consume the good, the efficient price is zero. A positive price compensates the producer for the cost of production but leads to inefficiently low consumption.

Module 77

15. Antitrust laws and regulation are used to promote competition. When the industry in question is a natural monopoly, price regulation is used.

16. The Sherman Act, the Clayton Act, and the Federal Trade Commission Act were the first major antitrust laws.

17. Marginal cost pricing and average cost pricing are examples of price regulation used in the case of natural monopoly to allow efficiencies from large scale production without allowing the deadweight loss that results from unregulated monopoly.

Module 78

18. Despite the fact that the poverty threshold is adjusted according to the cost of living but not according to the standard of living, and that the average income in the United States has risen substantially over the last 30 years, the poverty rate, the percentage of the population with an income below the poverty threshold, is no lower than it was 30 years ago. There are various causes of poverty: lack of education, the legacy of discrimination, and bad luck. The consequences of poverty are particularly harmful for children.

19. Median household income, the income of a family at the center of the income distribution, is a better indicator of the income of the typical household than mean household income because it is not distorted by the inclusion of a small number of very wealthy households. The Lorenz curve indicates the percentage of all income received by the poorest members of the population, starting with the poorest 0% and ending with the poorest 100%. The Gini coefficient, a number that summarizes a country’s level of income inequality, is used to compare income inequality across countries.

20. Means-tested programs target aid to people whose income falls below a certain level. The major in-kind benefits programs are Medicare and Medicaid, which pay for medical care. Due to concerns about the effects on incentives to work and on family cohesion, aid to poor families has become significantly less generous even as the negative income tax has become more generous. Social Security, the largest U.S. welfare program, has significantly reduced poverty among the elderly. Unemployment insurance is another key social insurance program.