Ans homework

EE 311
1. What is the difference between a positive externality and a negative externality? Describe an
example of each.

With a negative externality, the marginal private cost of a good is less than the marginal
social cost of a good. For example, the private costs associated with driving to work on the
highway include personal time, gasoline, wear and tear on the vehicle, etc. In addition, by
entering the highway, a vehicle creates congestion that increases the time it takes all other
drivers to get where they are going. Thus, the social cost exceeds the private cost and
entering the highway creates a negative externality.
With a positive externality, the marginal private benefit is less than the marginal social benefit. For
example, when parents immunize a child they reduce the risks of the child contracting a disease. In
addition, by immunizing the child, the child is less likely to pass on certain diseases to other people.
Thus, the social benefits from immunizing exceed the private benefits and immunization creates a
positive externality.

2. Why does an otherwise competitive market with a negative externality produce more output
than would be economically efficient?

A competitive market with a negative externality produces more output than is socially
optimal. This occurs because the firms in the industry do not take into account the external
costs associated with production; they only take into account their private costs. Because
they view the cost as lower than it actually is, they produce more than would be produced if
they were forced to take into account the external costs.

3. What is a public good? How can one determine the optimal level of provision of a public good?

A public good is any good that is nonexclusive and nonrival. To determine the optimal level
of provision of a public good, one should determine the marginal social benefits from the
public good, which is equal to the sum of the marginal private benefits for the individual
consumers, and equate that to the marginal cost of providing the public good. Units of the
good should be provided as long as the marginal social benefit exceeds the marginal cost.
This will occur up to the point where the marginal social benefit equals the marginal cost.

4. Why does the free-rider problem make it difficult or impossible for markets to provide public
goods efficiently?

It is difficult to provide public goods efficiently when free riders exist. Free riders will
consume the good, but will pay nothing for the good, anticipating that others will pay. It may
therefore prove difficult to raise funds to finance a project with a public good, leading to an
under-production of the good, or possibly even no provision of a good with positive net
benefits.

5. a) Explain why cigarette smoking is often described as a good with negative externalities.
b) Why might a tax on cigarettes induce the market for cigarettes to perform more efficiently?

c) How would you evaluate a proposal to ban cigarette smoking? Would a ban on smoking
necessarily be economically efficient?

a) For one, by smoking in public, smokers force other individuals to breathe air with smoke,
known as second-hand smoke. In addition, the health problems associated with smoking
force society to pay higher health care costs to pay for smoking related illnesses, both for
smokers and for those who breathe second-hand smoke, than if no one in society smoked.

b) By imposing a tax on cigarettes the government increases the marginal private cost of
smoking and forces the individual to take into account (at least some of) the negative
externality associated with smoking. This would likely reduce the level of smoking in
society, pushing the equilibrium toward the socially efficient level of smoking.

c) A ban on smoking entirely is probably not socially efficient. To evaluate such a ban, one
would need to compare the marginal benefits with the marginal social costs. The ban would
only be socially efficient if the marginal social costs exceed the marginal benefits at a level of
zero. This would not necessarily be socially efficient because it is possible that the marginal
benefit of smoking exceeds the marginal social cost for low levels of smoking.

6. The accompanying graph shows the demand curve for gasoline and the supply curve for
gasoline. The use of gasoline creates negative externalities, including CO2, which is an important
source of global warming. Using the graph and the table below, identify:

• The equilibrium price and quantity of gasoline

• The producer and consumer surplus at the market equilibrium

• The cost of the externality at the free-market equilibrium

• The net social benefits arising at the free-market equilibrium

• The socially optimal price of gasoline

• The consumer and producer surplus at the social optimum

• The cost of the externality at the social optimum

• The net social benefits arising at the social optimum

• The deadweight loss due to the externality

 Equilibrium price Social optimum Difference
and quantity = P2 price and quantity between social
and Q2 = P1 and Q1 optimum and
equilibrium

Consumer surplus A+B+G+K A -B-G-K

Private producer surplus E+F+R+H+N B+E+F+R+H+G B+G-N

- Cost of externality -R-H-N-G-K-M -R-H-G M+N+K

Net social benefits A+B+E+F-M A+B+E+F M

Deadweight loss M Zero M

7. A competitive refining industry produces one unit of waste for each unit of refined product. The
industry disposes of the waste by releasing it into the atmosphere. The inverse demand curve for
the refined product (which is also the marginal benefit curve) is Pd = 24 - Q, where Q is the
quantity consumed when the price consumers pay is Pd. The inverse supply curve (also the
marginal private cost curve) for refining is MPC = 2 + Q, where MPC is the marginal private cost
when the industry produces Q units. The marginal external cost curve is MEC = 0.5Q, where MEC is
the marginal external cost when the industry releases Q units of waste.

a) What are the equilibrium price and quantity for the refined product when there is no correction
for the externality?

b) How much of the chemical should the market supply at the social optimum?

c) How large is the deadweight loss from the externality?

d) Suppose the government imposes an emissions fee of $T per unit of emissions. How large
should the emissions fee be if the market is to produce the economically efficient amount of the
refined product?

a) If there is no correction for the externality, the equilibrium will occur at the point
where the marginal benefit curve, P d  24  Q , intersects the marginal private cost curve,
MPC  2  Q . This occurs at
24  Q  2  Q
Q  11
At Q  11 , price is P  13 .

b) At the social optimum marginal benefit, P d  24  Q , will equal marginal social cost,
MSC  MPC  MEC . This occurs where
24  Q  (2  Q)  0.5Q
Q  8.80
Thus, the social optimum is to produce Q  8.80 .

c) At the uncorrected equilibrium, the marginal social cost is MSC  2  1.5(11)  18.5 .
Thus, the deadweight loss will be 0.5(11  8.80)(18.5 13)  6.05 .

d) The emissions fee of $T should be set to shift the MPC curve so that it intersects the
marginal benefit curve at Q  8.80 , the socially optimal quantity. At Q  8.80 the marginal
benefit is P  15.2 and the marginal private cost is MPC  2  8.80  10.80 . Therefore, the
optimal tax is T  15.2 10.8  4.4 .

8. The demand for energy-efficient appliances is given by P = 100/Q, while the inverse supply (and
marginal private cost) curve is MPC = Q. By reducing demand on the electricity network, energy-
efficient appliances generate an external marginal benefit according to MEB = eQ.

a) What is the equilibrium amount of energy-efficient appliances traded in the private market?

b) If the socially efficient number of energy-efficient appliances is Q = 20, what is the value of e?

c) If the government subsidized production of energy efficient appliances by $S per unit, what
level of the subsidy would induce the socially efficient level of production?

a) Equilibrium occurs where P = MPC, or 100/Q = Q. Thus Q = 10.

b) If the socially efficient number of appliances is Q = 20, then P + MEB = MPC at Q =

20, or 100/20 + e*20 = 20. Solving, we get e = 0.75.

c) With the subsidy, equilibrium occurs where P + S = MPC, or 100/Q + S = Q. Since

the efficient amount of appliances is Q = 20, the proper subsidy would solve 100/20 + S = 20
or S = 15.