Chapter 9

Externalities and Public Goods

Questions
1. Why are externalities called market failures? Are pecuniary externalities also an example of market
failure?
Answer: Externalities are called market failures because the market allocates resources without
considering the costs and benefits of externalities. Since firms and individuals do not consider
externalities when they make choices, the market fails to arrive at a socially efficient outcome.
Pecuniary externalities are not market failures because they do not result in market inefficiencies.
Pecuniary externalities exist when market transactions affect third parties, but only through the
market price. The market price will then correctly reflect the society-wide impact of market
transactions and therefore pecuniary externalities are not market failures.
2. Explain whether the following are examples of externalities.
a. Alisha did not sleep well because her neighbor was playing loud music.
b. Rochelle was late for a job interview because her alarm did not go off.
c. José, who is allergic to pollen, is sick from the flowers that grow in his garden.
Answer:
a. This is an example of a negative externality. Loud music played by her neighbor has a
spillover effect on Alisha as she is unable to sleep.
b. This is not an example of an externality. Rochelle was late because her alarm did not go off.
There is no spillover cost here that is affecting someone who is not involved in the activity.
c. This is not an example of an externality. Since José is sick from the flowers that grow in his
own garden, he is directly engaged in the activity. Note that if his neighbor got sick, then it
would qualify as an externality.

3. Education is considered as a consumer good with positive externality in that an educated person tends
to also benefit other parties in the society who are the non-consumers. Why does the invisible hand
fail to generate the social efficient outcome in the education market?

Answer: The marginal social benefit of education with positive externality is greater than its marginal
private benefit given by the market demand curve. Since buyers and sellers only consider the
marginal private benefit, the invisible hand will drive the quantity towards market equilibrium
quantity where marginal private benefit equals marginal cost which is less than the socially efficient
quantity where marginal social benefit equals marginal cost.

4. What does it mean to say that an individual or a firm has internalized an externality?
Answer: Externalities are external costs or benefits that firms or consumers do not consider when
making decisions. When incentives are altered such that an externality is taken into account, firms
and individuals are said to have internalized the externality. So, for example, suppose I raise bees
next door to your apple orchard. The bees pollinate your tress and so there is an externality. The
externality will be internalized if I buy your orchard.

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5. What is the Coase Theorem? Under what conditions will the Coase Theorem break down?
Answer: The Coase Theorem predicts that, when there are externalities, negotiation between the
individuals involved leads to the efficient outcome regardless of who has the legal property right.
This means that government intervention is not necessary to solve externality problems.
The Coase Theorem will not hold if transaction costs of negotiating are too high. This cost could
include direct expenditures like legal fees and time and also the cost of an awkward situation: it may
be difficult to bargain with neighbors and others. The number of agents on each side of the bargaining
table also matters; bargaining may not work when there are many people involved. Additionally, it’s
important for the property right to be clearly defined; in many cases, the law is not clear on who holds
the property rights.
6. How does a command-and-control policy differ from a market-based policy?
Answer: Governments sometimes use a mix of policies to encourage firms and consumers to
internalize externalities. Command-and-control is a centralized system of controlling production in
which an authority decides the allocation of resources. Here, the government directly regulates the
allocation of resources (for example, the government bans smoking in restaurants). Market-based
policies are those where the government provides incentives for private organizations to internalize
the externality. Market-based policies include Pigouvian taxes or subsidies and markets for pollution
rights.
7. What are Pigouvian taxes and subsidies? How do governments decide when to levy a tax or provide a
subsidy?
Answer: Governments address externalities through Pigouvian taxes or subsidies, named after the
economist Arthur Pigou. Taxes and subsidies are levied to ensure that firms internalize externalities.
Consider a good with negative externalities. The marginal social cost of the good is greater than its
marginal private cost. The government will levy a tax on the good, which is equal to the external cost
of the good. This tax makes firms take into account the external damage from the good when it makes
its production decisions. Similarly, for a good with positive externalities, the government provides a
subsidy to a firm or consumer that is equal to the external benefits from the good. The Pigouvian
subsidy raises the individual’s marginal benefits of consumption by an amount equal to the external
benefits its consumption causes, exactly aligning the individual’s benefits with society’s benefits.

8. To provide national security to a country, the supplier needs to hire soldiers and also acquire weapons
and other military equipments. Do you think it is possible that a private firm is able to supply
national security efficiently?

Answer: National security is non-rival and non-excludable. Even if a private firm is able to hire
professional soldiers and purchase weapons and military equipments, it will not be able to collect
sufficient revenues from the consumers. Consumers know that national security is non-
excludable and hence they will have no incentive to pay for it. The private firm will not be able to
cover its cost and hence it will not be able to provide national security efficiently.

9. Compare and contrast between a private good and a club good.

Answer: A private good is both rival and excludable. This means that the consumption of a private
good by one consumer reduced the quantity available to others. Also, the purchaser, who is the
rightful owner of the private good, can prevent or exclude others from consuming the good. In
contrast, a club good is non-rival but excludable. This means the consumption of a club good by one
consumer will not reduce the quantity available to others.

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10. Why is it difficult for the market to deliver socially efficient quantities of goods like clean air or street
lighting?
Answer: Goods like clean air and street lighting are public goods. This means that individuals can
consume these goods even without paying for them as they are non-rival and non-excludable. Such
goods present particular problems for markets to provide because consumers have an incentive to act
as free-riders; they can consume public goods even if they do not pay for them. Therefore, the
problem with efficiently providing public goods is that consumers aren’t willing to pay for them
because no one can be excluded from consuming them once they are provided.
11. When does the free-rider problem arise?
Answer: The free-rider problem arises when a person has no incentive to pay for a good because
failure to pay does not prevent consumption. For example, even if an individual does not pay for
national defense, the military protects him nonetheless. This implies that a single individual does not
have an incentive to pay for a service that he can consume, as long as others are paying for it.

12. How does the market demand curve for a private good differ from that of a public good?

Answer: Public goods are non-rival and non-excludable. Everyone consumes the same quantity of a
public good. Therefore, the market demand for public goods is derived by summing individual
demand curves vertically. On the other hand, for a public good, individual demand curves need to be
summed vertically because this shows the amount of money consumers are willing to pay for each
level of the public good.
13. What is meant by the tragedy of the commons? Use an example to explain your answer.
Answer: The tragedy of the commons refers to the depletion of a common pool resource due to open
access. When deciding how much to use, everyone using the common pool resource considers only
his or her own costs of use. But this use depletes the resource for everyone accessing it. Since this
extra cost is external, individuals end up using too much of the resource. Congested roads without
tolls are a good example of the tragedy of the commons. People who use the road consider their
benefits but ignore the costs they impose on other drivers by forcing them to drive more slowly.

Problems
1. The European Union has banned certain pesticides for two years after studies found links between the
use of these insecticides and a decline in the bee population. In particular, research has shown that the
use of imidacloprid, clothianidin, and thiamethoxam on flowering crops have adversely affected the
honeybee population in North America and Europe.
a. Consider the private market for these pesticides. Use supply and demand curves to show the
equilibrium level of pesticides that will be produced and consumed.
b. How might the impact of the insecticide on honeybees be modeled as a marginal external cost?
Show the deadweight loss from this externality in the graph you drew for the first part of this
question.
c. Is the private market outcome socially efficient?
Answer:
a. The equilibrium quantity in the market is Q1.

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b. At each level of production, the private cost of producing the pesticide plus the external cost
of the effect of the pesticide on bees equals marginal social cost (MSC). The MSC curve
includes both the private marginal cost and the external marginal cost. The efficient quantity
is the quantity where MSC intersects demand, Q2. The deadweight loss is the shaded area in
the diagram below. It is equal to the difference between demand and MSC between Q 1 and
Q 2.

c. The equilibrium quantity Q1 is greater than the efficient quantity Q2.

See http://www.independent.co.uk/environment/nature/victory-for-bees-as-european-union-bans-
neonicotinoid-pesticides-blamed-for-destroying-bee-population-8595408.html
2. Suppose that you put an invisible tracking device on your computer that will instantly lead police to it
if your computer is ever stolen. Does your purchase of the tracking device provide a positive or
negative externality? What kind of externality do you provide when you purchase a visible computer
lock in order to prevent theft?
Answer: Buying an invisible tracking device provides a positive externality. If your computer is
stolen, the tracking device will ensure that the thief gets caught or at least that the computer will be

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found. By increasing the chances of getting caught, the tracking device makes stealing less lucrative
and more risky.
The situation is very different if the lock is visible. A thief who realizes he cannot steal your
computer may decide to steal your friend’s computer. Therefore a visible lock leads to a negative
externality.

3. To improve the public transportation in Singapore, the government has decided to construct the Circle
Line (CCL), amass rapid transit (MRT) project which comprises many stations in the central region
of the country. This is a huge infrastructure project where digging and pounding occurred in the
residential areas, creating noise, dust and causing traffic congestions in the vicinity. Many residents
have complained to the construction company that the project has created noise and air pollution and
had created a lot of inconvenience to them. Explain what type of externality has occurred and why
Coase Theorem is unable to rectify this issue.

Answer: The construction company's marginal private cost of constructing the project did not account
for the noise, dust and inconvenience imposed on the residents in the vicinity of the project.
This is an example of negative externality where the marginal social cost exceeds the marginal
private cost by the amount of external cost. The external cost represents the inconvenience to
residents due to the noise and dust caused by the construction project. Coase Theorem is unable to
rectify this issue since it involves many parties and the negotiation cost between the construction
companies and the affected residents are likely to be high. In addition, there is no clearly defined
property right in this case since the project is approved by the government.

4. Serene is a dance instructor who tends to switch on music very loudly at home to practice dancing.
Her neighbor, Jennifer, is a teacher who needs a quiet environment to mark her student's assignment.
The dance gives benefits to Serene which she considered equivalent to $120 daily. But Jennifer's
marking progress is affected and it costs her $50 daily.

a. Is it efficient to for Serene to stop dancing with loud music since it creates noise pollution to
Jennifer?

b. If Serene has the right to do whatever she prefer but both parties can negotiate with no cost, will
Jennifer be able to mark assignments in a quiet environment?

b. If Jennifer has the right to a quiet environment and Serene can only switch on the music loudly
with Jennifer's approval. Assume both parties can negotiate with no cost. Will Jennifer be able to
mark assignment in a quiet environment?

Answer:

a. Since the benefit to Serene is $120 and the cost to Jennifer is $50, the net benefit to the society is
$70. Thus it is not efficient for Serene to stop dancing to loud music.

b. If both parties can negotiate with no cost, Serene would require a compensation of $120 to allow
a quiet environment for Jennifer to mark assignments. However, Jennifer would be willing to
compensate Serene for a maximum of $50. Therefore, private bargaining will not lead to an
efficient outcome.

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c. Jennifer is still unable to mark assignments in a quiet environment. This is because Serene will
compensate Jennifer at least $50 daily to seek Jennifer's permission to endure the loud music.
Serene is still able to earn a benefit of up to $70 after compensating Jennifer.

5. The government of Country Alpha imposes an entry charge of $3 for each vehicle using the
expressway to control traffic volume but still there are congestions. Explain why the government did
not raise the charge further to reduce more traffic volume?

Answer: The objective of imposing a charge for vehicle is to regulate the traffic volume to the
efficient quantity where marginal social benefit of congestion equals marginal social cost. There
are social benefits to have some congestion on the expressway and hence the government did not
raise the charge further once the optimal traffic volume on the expressway is reached.
6. Malaria is spread by mosquitos. That is, a mosquito spreads malaria by biting an infected person and
later infusing malaria into a different person. A study by Jeffrey Sachs et al shows a strong correlation
between the incidence of malaria in a country and poverty. While malaria is known to exist in poor
countries, it has also been found that the incidence of malaria exacerbates poverty. One of the
simplest and effective ways of preventing the occurrence of malaria is by using Insecticide Treated
Nets (ITNs).
a. Consider the private market for ITNs. Use supply and demand curves to show the equilibrium
level of nets that will be produced. Is this outcome socially efficient?
b. In the graph, how would you account for the ITNs’ effect on poverty? What happens to the level
of output in the market?
c. How could the government encourage the production of the efficient number of ITNs?
Answer:
a. The outcome is not socially efficient because the private market does not consider all of the
social benefits associated from the ITNs. The equilibrium price and quantity in the market is
P1 and Q1 respectively.

b. At each level of production, the private benefit from producing ITNs plus the external benefit
of the ITNs on poverty equals the marginal social (MSB). Consequently, the MSB curve for
ITNs lies above the demand curve. The MSB curve includes both the private marginal benefit
and the external marginal social benefit.

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The efficient quantity of ITNs equates marginal social benefit and marginal social cost and is
therefore equal to Q2.
c. The government needs to provide incentives for consumers to internalize the externality. In
the case of goods with a positive externality, it can provide a corrective subsidy that is equal
to the difference between the private benefit and the social benefit of the ITNs. This will shift
the demand curve outward and increase the production of ITNs to the efficient level.
See “The Malaria Gap,” Pia Malaney, Andrew Spielman, and Jeffrey Sachs, American Journal of
Tropical Medicien and Hygiene, August 2004 vol. 71 no. 2 suppl 141-146 and
http://www.cdc.gov/malaria/malaria_worldwide/reduction/itn.html

7. Certain diseases, such as chicken pox, are highly contagious. When a person is affected by chicken
pox, his family members, colleagues and people whom they regularly interact with stand a high risk
of catching the disease. The disease can be prevented by taking an injection of vaccine in local
hospitals. The decision to take injection is purely voluntarily and some people choose not to have it
due to the high cost involved.

a. What type of externality occurs for vaccines against contagious diseases?

b. Use a suitable diagram to show the market equilibrium quantity of vaccines. Is the quantity also
socially efficient?

b. Suggest one method to achieve the social efficient outcome.

Answer:

a. Vaccinating against contagious diseases is an activity with positive externalities in consumption.

A vaccinated person can avoid the discomfort of catching these diseases. In the process, other
people in his surroundings will also face a lower chance of catching the diseases. Thus, there is
external benefit in addition to the marginal private benefit.

b. Refer to the diagram below. Since a vaccine has positive externality in consumption, the marginal
social benefit (MSB) is larger than the willingness to pay represented by the market demand

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curve. The market equilibrium quantity is Q1 but the socially efficient quantity is Q2. Thus the
market equilibrium quantity is less than the socially optimal quantity.

c. The government can provide a subsidy equal to the amount of external benefit to encourage
consumers to go for the injection. This amount is equivalent to the vertical distance AE. This
would make the demand curve coincide with the MSB curve, thereby making the market
equilibrium quantity equal to the socially efficient quantity.

8. The US government recently raised its estimate of the social damage from greenhouse gases such as
carbon dioxide. Steel production generates a great deal of carbon dioxide. Present and discuss a
diagram to help explain your answers to the following two questions.
a. Will the new higher estimate of social cost imply a higher or lower efficient quantity of steel?
b. Will the new higher estimate of social cost imply a higher or lower level of the Pigouvian tax
required to lead to the efficient level of steel?
Answer:

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a. This is an example of a negative externality in production. The externality is the difference

between supply and marginal social cost. If the estimated damages from greenhouse gases
have increased, then the difference between the marginal social cost of electricity and the
supply of steel must have increased. In the diagram below, marginal social cost shifts up from
MSC1 to MSC2. This implies that the efficient quantity of steel falls from Q 1 to Q2.
b. The required Pigouvian tax on steel equals the external damages from steel production. The
increase in those damages means that the Pigouvian tax has increased from AB to CE.

See “New Effort to Quantify ‘Social Cost’ of Pollution,” New York Times, June 19, 2013
(http://www.nytimes.com/2013/06/19/us/politics/new-effort-to-quantify-social-cost-of-
pollution.html?_r=0)
9. There is a road between the suburbs and downtown. The road is congested at rush hour. If 100 people
use the road at rush hour, the trip takes 30 minutes. If the 101 st person enters the road, everyone has to
slow down and the trip now takes 31 minutes. People value their time at $6 per hour (i.e., $0.10 per
minute). For simplicity, ignore all of the costs of using the road other than the cost of time.
a. What is the total social cost of 100 people using the road at rush hour?
b. What is the marginal social cost of the 101st person?
c. The governor of this state (who has taken a Principles of Economics course) would like to
institute a toll that would equal the costs the last driver who uses the road imposes on the other
drivers. How high should the toll be on this road during rush hour?
d. Suppose at noon 50 people are using the road. The road is not congested and the trip takes just 20
minutes. If the 51st driver enters uses the road, no one has to slow down and the trip continues to
take 20 minutes. How high should the toll be at noon?
Answer:

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a. The total social cost of 100 drivers is 100 drivers x 30 minutes per driver x $0.10 per minute
= $300.
b. The total social cost of 101 drivers is 101 drivers x 31 minutes per driver x $.10 per minute =
$313.10. The marginal social cost is the increase in total cost and therefore equals $313.10 -
$300.00 = $13.10.
c. The 101st driver makes the commute one minute longer for each of the other 100 drivers. He
therefore imposes a cost of 100 drivers x 1 minute per driver x $.10 per minute = $10.00. The
rush-hour toll should therefore equal $10.00. Each driver would “pay” 31 minutes per driver
x $.10 per minute = $3.10 and the $10.00 toll, for a total of $13.10. And for efficiency that is
exactly what we (and the governor) want: the price of using the road will equal the marginal
social cost of using the road.
d. At noon, the last driver does not impose additional costs on other drivers because the road is
not congested. The toll should therefore be zero at noon.

10. John, Jack, and James are neighbors and each of them has children in the families. They are keen to
have a playground in the vacant land in front of their house. The playground, with simple facilities
such as swing and see saw, may need $6,000 to build. The playground is worth $5,000 to John,
$2,500 to Jack and $1,500 to James.

a. Is it efficient to build the playground?

b. Will any of the three parties build the playground on their own?

a. The town council suggests that each of them pay one-third of the price to build the
playground. It put the matter to a vote and requires majority to vote in favor to
implement it. Will the playground be built?

Answer:

a. Since the total benefit derived from the playground is $5,000 + $2,500 + $1,500 = $9,000
which is higher than the cost of $6,000, it is efficient to build the playground.

b. No. The playground costs $6,000 which is higher than any individual’s maximum willingness
to pay ($5,000 for John, $2,500for Jack and $1,500for James). None of the individuals have
the incentive to build the playground on their own.

c. The playground will not be built since each individual would be required to pay $3,000 and
only John would be willing to pay the amount since he values it at $5,000. Jack and James
would not be willing to pay since they value it at $2,500 and $1,500 respectively. Hence, Jack
and James will vote against the plan and would constitute the majority.

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11. Three roommates Tinker, Evers, and Chance share an apartment. It is really cold outside and they are
considering turning up the thermostat in the apartment up by 1, 2, 3, or 4 degrees. Their individual
marginal benefits from making it warmer in the apartment are as follows:
Tinker Evers Chance
1 degree $5 $4 $3
2 degrees $4 $3 $2
3 degrees $3 $2 $1
4 degrees $2 $1 $0
They know that each time they raise the temperature by one degree, their heating bill goes up by $8.
a. Find the marginal social benefit from making it 1, 2, 3, or 4 degrees warmer.
b. By how many degrees should they raise the temperature?
Answer:
a. Heat in the apartment is a public good; all three enjoy the benefits from turning up the
thermostat. The marginal social benefit is therefore the sum of their individual marginal
benefits.
Marginal
Tinker Evers Chance Social Benefit
1 degree $5 $4 $3 $12
2 degrees $4 $3 $2 $9
3 degrees $3 $2 $1 $6
4 degrees $2 $1 $0 $3

b. They should continue to turn up the thermostat as the long as the marginal social benefit from
making it warmer is at least as great as the marginal cost of making it warmer (which we are
told is $8). They should therefore raise the temperature by two degrees. The marginal social
benefit of raising the temperature a third degree is $6, which is less than marginal cost.
12. Rhino poaching is a serious problem in South Africa, where a large proportion of Africa’s rhino
population is found. The demand for rhino horns, used in traditional Chinese medicine, has increased
the prices of rhino horns substantially. This has fueled an illegal market for rhino horns. What
economic tools can be used to solve this problem? (Hint: Look up Elinor Ostrom’s Nobel Lecture
"Beyond Markets and States: Polycentric Governance of Complex Economic Systems")
Answer: The government can strengthen its command-and-control policies to crackdown on
poaching. An example would be to ban poaching and enforce the ban strictly. Since the market for
rhino horns is illegal, it would be difficult for the government to use market-based policies here.
Some of the other solutions to problems involving common pool resources such as this would be to
introduce private property rights. If the areas where rhinos live are privatized, the owners would have
an incentive to protect their property from poachers. Elinor Ostrom’s work finds that common pool
resources avoid the tragedy of the commons if local communities are allowed to organize themselves
to govern the resource. If the community that benefits from the resource is allowed to manage access
and usage, it is less likely that the resource will be used indiscriminately.

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13. In Horton Hears a Who by Dr. Seuss, Horton the Elephant hears voices coming from a speck of dust.
He soon learns that the speck is actually a tiny planet where the Whos live. None of the other animals
in the jungle can hear the Whos and they threaten to boil the speck in Beezelnut Oil. The only way
the Whos can save themselves is by making so much noise that the other animals in the jungle can
hear them. Horton and the Mayor of Whoville have trouble convincing all of the Whos to contribute
to the noise making effort. Finally, “a very small shirker named JoJo” joins in and together all of the
Whos make enough noise to avoid disaster.
Dr. Seuss (whose real name was Theodor Seuss Geisel) took two economics classes at Dartmouth
College while he was an undergraduate. Do you think he did well in those classes?
Answer: Probably so. Horton Hears a Who is wonderful illustration of the free rider problem. Recall
that a free-riding problem occurs when an individual who has no incentive to pay for a good does not
pay for that good because non-payment does not prevent consumption. Each of the Whos had an
incentive to be a free rider. Each hoped to avoid the cost of making noise but still enjoy the benefits
of not being boiled in Beezelnut Oil. But if all of the Whos acted as free riders then the Whos efforts
were doomed. Fortunately, Horton, the Mayor, and the other Whos were able to persuade JoJo to join
in.
See “Oh, the Economics You'll Find in Dr. Seuss!” (http://papers.ssrn.com/sol3/papers.cfm?
abstract_id=1364412)

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