Microeconomics 3rd Edition Hubbard Solutions Manual 1

Solution Manual for Microeconomics 3rd Edition
Hubbard Brien 0136021972 9780136021971

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CHAPTER 5| Externalities, Environmental

Policy, and Public Goods
Brief Chapter Summary and Learning Objectives
5.1 Externalities and Economic Efficiency (pages 134–137)
Identify examples of positive and negative externalities and use graphs to show how
externalities affect economic efficiency.
▪ A negative externality is a cost that affects someone who is not directly involved in the
production or consumption of a good or service.
▪ A positive externality is a benefit that affects someone who is not directly involved in the
production or consumption of a good or service.
5.2 Private Solutions to Externalities: The Coase Theorem (pages 137–143)

Discuss the Coase theorem and explain how private bargaining can lead to economic
efficiency in a market with an externality.
▪ The Coase theorem states that if transactions costs are low, private bargaining can result in
an efficient solution to the problem of externalities.
5.3 Government Policies to Deal with Externalities (pages 143–147)

Analyze government policies to achieve economic efficiency in a market with an
externality.
▪ When private solutions to externalities are not feasible, government intervention in the
form of a tax (negative externality) or subsidy (positive externality) can bring about an
efficient level of output.
©2010 Pearson Education, Inc. Publishing as Prentice Hall

98 CHAPTER 5 | Externalities, Environmental Policy, and Public Goods
▪ Government policies to deal with negative externalities include a command and control
approach and a market-based approach.
5.4 Four Categories of Goods (pages 148–157)

Explain how goods can be categorized on the basis of whether they are rival or
excludable, and use graphs to illustrate the efficient quantities of public goods and
common resources.
▪ The four categories of goods are private, public, quasi-public, and common resources.

CHAPTER 5 | Externalities, Environmental Policy, and Public Goods 99
Key Terms
Coase theorem, p. 142. The argument of Private benefit, p. 134. The benefit received by
economist Ronald Coase that if transactions the consumer of a good or service.
costs are low, private bargaining will result in an
efficient solution to the problem of externalities. Private cost, p. 134. The cost borne by the
producer of a good or service
Command-and-control approach, p. 145. An
approach that involves the government imposing Private good, p. 148. A good that is both rival
quantitative limits on the amount of pollution and excludable.
firms are allowed to emit or requiring firms to
install specific pollution control devices. Property rights, p. 136. The rights individuals
or businesses have to the exclusive use of their
Common resource, p. 148. A good that is rival property, including the right to buy or sell it.
but not excludable.
Public good, p. 148. A good that is both
Excludability, p. 148. The situation in which nonrivalrous and nonexcludable.
anyone who does not pay for a good cannot
consume it. Rivalry, p. 148. The situation that occurs when
one person’s consuming a unit of a good means
Externality, p. 134. A benefit or cost that no one else can consume it.
affects someone who is not directly involved in
the production or consumption of a good or Social benefit, p. 134. The total benefit from
service. consuming a good or service, including both the
private benefit and any external benefit.
Free riding, p. 148. Benefiting from a good
without paying for it. Social cost, p. 134. The total cost of producing
a good or service, including both the private cost
Market failure, p. 136. A situation in which and any external cost.
the market fails to produce the efficient level of
output. Tragedy of the commons, p. 155. The
tendency for a common resource to be overused.
Pigovian taxes and subsidies, p. 145.
Government taxes and subsidies intended to Transactions costs, p. 142. The costs in time
bring about an efficient level of output in the and other resources that parties incur in the
presence of externalities. process of agreeing to and carrying out an
exchange of goods or services.
Chapter Outline
Economic Policy and the Environment

Pollution is a part of economic life. In the past, the U.S. Congress often employed policies that ordered
firms to use particular methods to reduce pollution. Many economists are critical of this approach and argue
that a more efficient way to deal with pollution is through a market-based approach. In 2009, President
Obama proposed a market-based approach known as cap-and-trade. Under this system the federal
government would auction off allowances to produce a given amount of carbon dioxide emissions. Firms
would buy and sell allowances, but must end up with allowances equal to the amount of carbon dioxide
they emit.

>>Teaching Tips
Economics in YOUR LIFE! asks students what they consider the “best” level of pollution to be. Answers
are found at the end of the chapter. An Inside Look at the end of the chapter explores the proposed cap-
and-trade policy to reduce emissions of carbon dioxide.
5.1 Externalities and Economic Efficiency (pages 134–137)

Learning Objective: Identify examples of positive and negative externalities and use
graphs to show how externalities affect economic efficiency.
An externality is a benefit or cost that affects someone who is not directly involved in the production or
consumption of a good or service. There is a positive externality in the production of college educations,
because people who do not pay for college educations will nonetheless benefit from them. There is a
negative externality in the generation of electricity because, for example, people with homes on a lake from
which fish and wildlife have disappeared because of acid rain have incurred a cost, even though they might
not have bought electricity from the polluting utility.
A. The Effect of Externalities

A competitive market achieves economic efficiency by maximizing the sum of consumer and producer
surplus. But that result holds only if there are no externalities in production or consumption. An externality
causes a difference between the private cost of production and the social cost, or the private benefit from
consumption and the social cost. The private cost is the cost borne by the producer of a good or service.
The social cost is the total cost of producing a good or service, including both the private cost and any
external cost. The private benefit is the benefit received by the consumer of a good or service. The social
benefit is the total benefit from consuming a good or service, including both the private benefit and any
external benefit. When there is a negative externality in the production of a good or service, too much of
the good or service will be produced at market equilibrium. When there is a positive externality in
consuming a good or service, too little of the good or service will be produced at market equilibrium.
B. Externalities and Market Failure

Market failure refers to a situation in which the market fails to produce the efficient level of output.
C. What Causes Externalities?

Governments need to guarantee property rights for a market system to function well. Property rights refer
to the rights individuals or businesses have to the exclusive use of their property, including the right to buy
or sell it. In certain situations, property rights do not exist or cannot be legally enforced. Externalities and
market failures result from incomplete property rights or from the difficulty of enforcing property rights in
certain situations.
>>Teaching Tips
Industrial pollution is often cited as an example of a negative externality, but you can also use smoking as
a classroom example. Most college students grew up in an era where smoking was much less socially
acceptable than when their parents and grandparents were young. Students are often stunned to learn that
smoking—by both students and instructors—was allowed in many college classrooms as late as the 1970s.
Although few, if any, colleges allow smoking in classroom buildings now, many bars and restaurants have
smoking sections. Ask your students (a) if they would be willing to pay smokers to not smoke while they
are in the same restaurant or (b) if they have ever chosen to sit in a restaurant’s smoking section to avoid a
longer wait for a table in a non-smoking section.
Figures 5-1 and 5-2 illustrate the impact of externalities on market equilibrium.

Extra Solved Problem 5-1

Smoking at Ike’s Bar-B-Q Pit
Supports Learning Objective 5.1: Identify examples of positive and negative externalities and
use graphs to show how externalities affect economic efficiency.
By 2009, 23 states, including California, Florida, Massachusetts, and New York, had enacted laws to
prohibit smoking in workplaces. But Ike’s Bar-B-Q Pit is not located in any of these states. Some of Ike’s
non-smoking customers, including some who suffer from asthma, have petitioned Ike to adopt a no-
smoking rule for his restaurant. Upon hearing of the petition, some of Ike’s other customers complained
that they have smoked in Ike’s restaurant for years and would not patronize the restaurant if the no-smoking
rule were adopted. Ike is greatly concerned because he does not wish to lose business from either his
smoking or non-smoking customers.
Draw a graph illustrating the externality associated with Ike’s Bar-B-Q Pit and explain how this externality
causes a deviation from economic efficiency in this market.
Source: Americans for Nonsmokers’ Rights, http://www.no-smoke.org
SOLVING THE PROBLEM:

Step 1: Review the chapter material.
This problem is about externalities, so you may want to review the section “Externalities and
Economic Efficiency,” which begins on page 134 of the textbook.
Step 2: Draw a graph to illustrate the externality at Ike’s Bar-B-Q Pit.
This is a negative externality because there are external costs imposed on Ike’s non-smoking
customers as a result of breathing in second-hand smoke. These are costs that neither Ike nor
his smoking customers have to pay.
Step 3: Describe how the externality causes a deviation from economic efficiency.
The economically efficient outcome is for the quantity of meals served at Ike’s restaurant to be
Q2 and the price of the meals to be P2. (Ike’s, no doubt, has a varied menu with different meals
with different prices. To simplify this problem, assume P2 is an average meal price.) This is

where the equilibrium point would be if the market supply curve that represents social costs,
including the negative health effects on non-smokers, crosses the demand curve. At this point,
the marginal benefit from Ike’s meals would equal the marginal social cost. However, because
neither Ike nor his smoking patrons have to pay for the negative externality, the market supply
curve represents only private costs. As a result, the equilibrium market price and quantity are
P1 and Q1. At this point, the marginal social cost from Ike’s meals exceeds the marginal benefit.
Extra Making The Mystery of the Missing Bees

the
Connection
In over two dozen states, beekeepers scratched their heads over the disappearance of significant numbers
of their bees. In addition to providing honey, bees are used to pollinate more than $14 billion worth of seeds
and crops in the Untied States annually, mostly fruits, vegetables, and nuts. By early 2007, bee losses
ranged from 30 to 60 percent on the West Coast. Experts searched for explanations of the crisis—called
“colony collapse disorder”—as growers of almonds, avocados, and kiwis worried about the ability of the
remaining bee colonies to pollinate their crops. The symbiotic relationship between beekeepers and farmers
is a classic example of positive externalities: The production activities of each group benefit the other. Jeff
Pettis, researcher at the U.S. Department of Agriculture, believes that there may be more than one factor
that caused the problem: “I think there are interactions going on, like low-level pesticide exposure and poor
nutrition weakening the host honeybees and then the pathogens doing the killing.” But in 2009 there were
signs that the bees may be staging a comeback. Tim Schuler, an agriculture official in New Jersey, claimed
that “We have healthy bees here…Things are improving. Two winters ago, we had a 40 percent winter die
off. Last year, it was 17 percent. But it’s too early to know what will happen this year.” Anticipating the
worst, researchers have tried to develop “self-compatible” almond trees that require fewer bees. One
company is attempting to commercialize a “blue orchard bee” that is stingless and works at colder
temperatures than the honeybee.
Sources: Alexi Barrionuevo, “Mystery of the Vanishing Bees” International Herald Tribune, February 27, 2007. Wendy Lyons
Sunshine, “Is Life Too Hard for Honeybees?” Scientific American, March 31, 2009. “N.J. honey bees are recovering from
mysterious population drop,” www.nj.com, March 24, 2009.
5.2 Private Solutions to Externalities: The Coase Theorem (pages 137–143)

Learning Objective: Discuss the Coase theorem and explain how private bargaining can
lead to economic efficiency in a market with an externality.
Although government intervention may increase economic efficiency in markets where externalities are
present, it is possible for people to find private solutions to the problem of externalities. Ronald Coase made
this argument in a 1960 article. To understand Coase’s argument, it is important to understand that
completely eliminating an externality is usually not economically efficient.

A. The Economically Efficient Level of Pollution Reduction

The optimal decision is to continue any activity up to the point where the marginal benefit equals the
marginal cost. This applies to reducing pollution just as much as other activities. As pollution declines
society benefits, but the marginal benefit from eliminating another unit of pollution declines as emissions
are reduced. As pollution declines, the marginal cost of further reductions rises. The net benefit to society
from reducing pollution is equal to the difference between the benefit of reducing pollution and the cost.
To maximize the net benefit to society, any type of pollution should be reduced to the point where the
marginal benefit from another ton of reduction is equal to the cost.
B. The Basis for Private Solutions to Externalities

If arguing that private solutions to the problem of externalities were possible, Ronald Coase emphasized
that when more than the optimal level of pollution is occurring, the benefits from reducing the pollution to
the optimal level are greater than the costs.
C. Do Property Rights Matter?

Ronald Coase pointed out that the amount of pollution reduction will be the same whether polluters or
the victims of pollution are legally liable for damages. Bargaining between the parties will result in the
same reduction in pollution, where the marginal benefit of the last unit of reduction is equal to the
marginal cost.
D. The Problem of Transactions Costs

There are frequently practical difficulties in the way of a private solution to the problem of externalities.
For example, if many people suffer from the negative effects of pollution, bringing all the victims together
with all the producers of the pollution and negotiating an agreement often fails due to high transactions
costs. Transactions costs are the costs in time and other resources that parties incur in the process of
agreeing to and carrying out an exchange of goods or services.
E. The Coase Theorem

The Coase Theorem is the argument of economist Ronald Coase that if transactions costs are low, private
bargaining will result in an efficient solution to the problem of externalities. Private bargaining is most
likely to reach an efficient outcome when the number of bargaining parties is small and all parties are
willing to accept a reasonable agreement.
>>Teaching Tips
The first Making the Connection in this section presents evidence that the Clean Air Act has helped reduce
air pollution and reduce infant mortality. See related problem 2.8. The second Making the Connection
describes how beekeepers and apple growers reach private agreements to internalize positive externalities,
an example of the application of the Coase Theorem. See related problem 2.9.
Don’t Let This Happen To YOU! explains why completely eliminating pollution would not result
in the greatest net benefit to society; Figure 5-4 provides a graphical explanation of this important point. See
related problem 2.6.

Extra Solved Problem 5-2

Ike’s Bar-B-Q Pit Reaches A Coase Solution
Supports Learning Objective 5.2: Discuss the Coase Theorem and explain how private bargaining
can lead to economic efficiency in a market with an externality.
Refer to Extra Solved Problem 5-1 in this Instructor’s Manual. Because Ike’s restaurant is not in a state that
regulates smoking in public places, Ike decides to meet with his smoking and non-smoking customers to
accommodate both of their wishes regarding his smoking policy. Suggest a solution that would be consistent
with the Coase Theorem.
SOLVING THE PROBLEM:

Step 1: Review the chapter material.
This problem is about the Coase theorem, so you may want to review the section “Private
Solutions to Externalities: The Coase Theorem,” which begins on page 137.
Step 2: Describe the type of solution that would bring about an efficient outcome and be
consistent with the Coase Theorem.
Private bargaining between those who are the source of the externality and those who are
affected by the externality could result in a solution that is satisfactory to both parties.
Step 3: Suggest a solution that would enhance the well-being of Ike’s customers and
increase economic efficiency.
One possible solution is to construct a wall separating Ike’s restaurant into smoking and non-
smoking sections. This would raise the cost of providing meals at Ike’s and, in effect, shift the
supply curve that represents private costs from the graph in Extra Solved Problem 5-1 to the
left. The costs of doing this could be passed on to either or both groups of customers. It would
not matter if the costs were paid for by the smokers or non-smokers, as long as the economically
efficient rate of output were achieved where the marginal social cost equals the marginal benefit
from the meals served at Ike’s.

5.3 Government Policies to Deal with Externalities (pages 143–147)

Learning Objective: Analyze government policies to achieve economic efficiency in a
market with an externality.
When private solutions to externalities are not feasible, government can intervene to increase economic
efficiency. A.C. Pigou argued that to deal with a negative externality in production, the government should
impose a tax equal to the cost of the externality. Pigou argued that the government should deal with a positive
externality in consumption by giving consumers a subsidy equal to the value of the externality. Pigovian taxes
and subsidies are government taxes and subsidies intended to bring about an efficient level of output in the
presence of externalities. These taxes and subsidies internalize the externalities.
A. Command and Control versus Market-Based Approaches

A command and control approach is an approach that involves the government imposing quantitative
limits on the amount of pollution firms are allowed to emit or requiring firms to install specific pollution
control devices. Instead of a command and control approach, Congress decided to use a market-based
approach to deal with the problem of acid rain. The objective was to reduce emissions of sulfur dioxide to
8.5 million tons annually by 2010. A system of tradable emissions allowances was set up. The federal
government gave electric utilities, the major sources of sulfur dioxide emissions that cause acid rain,
allowances equal to the total amount of allowable emissions. The utilities were then free to buy and sell
the allowances. Utilities that could reduce their emissions at a low cost did so and sold some or all of their
allowances to utilities that could reduce their emissions only at a high cost. The program has so far been
successful not only in reducing emissions but in doing so at a much lower cost than had been expected.
B. Are Tradable Emissions Allowances Licenses to Pollute?

Some environmentalists have labeled tradable emissions allowances “licenses to pollute.” But this criticism
ignores a central economics lesson: resources are scarce and trade-offs exist. Resources spent reducing
pollution are not available for any other use. Because reducing acid rain using allowances cost utilities $870
million, rather than $7.4 billion as originally estimated, society saved more than $6.5 billion.
>>Teaching Tips
Solved Problem 5-3 explains how a tax can bring about an efficient level of production when a market has
a negative externality. See related problem 3.7. The Making the Connection feature in this section
discusses a proposal to use tradable emission permits to reduce greenhouse gases that contribute to global
warming. Problem 3.11 is related to this feature.
Economists working for the private research group, Resources for the Future (RFF), are among the
strongest supporters of a system of tradable emissions allowances to reduce the problem of acid rain. In
formulating environmental policy, it is often difficult to put a dollar value on environmental damage. For
example, what is the dollar value of the breathing difficulty that people with asthma experience due to sulfur
dioxide pollution? Economists at RFF have pioneered techniques for measuring the value of things for
which no market price exists. You can refer students interested in environmental economic issues to the
RFF web site: www.rff.org. RFF, located in Washington D.C., has a summer internship program that
provides opportunities for undergraduates to do research with environmental economists.

5.4 Four Categories of Goods (pages 148–157)

Learning Objective: Explain how goods can be categorized on the basis of whether they
are rival or excludable, and use graphs to illustrate the efficient quantities of public goods
and common resources.
Goods differ on the basis of whether their consumption is rival and excludable. Rivalry is the situation that
occurs when one person’s consuming a unit of a good means no one else can consume it. Excludability is
the situation in which anyone who does not pay for a good cannot consume it. There are four categories of
goods. A private good is a good that is both rival and excludable. Food, clothing, and many other goods
and services fall into this category. A public good is a good that is both nonrivalrous and nonexcludable.
Public goods are often, but not always, supplied by a government rather than by private firms. The classic
example of a public good is national defense. Your consuming national defense does not interfere with
your neighbor’s consuming it, so consumption is nonrivalrous. You cannot be excluded from consuming
it, whether you pay for it or not. The behavior of consumers in this situation is referred to as free riding.
Free riding is benefiting from a good without paying for it. Quasi-public goods are goods that are
excludable but not rival. For example, people who do not pay for cable television do not receive it, but one
person’s watching it doesn’t affect other people’s watching it. A common resource is a good that is rival
but not excludable. Forest land in many poor countries is a common resource. If one person cuts down a
tree, no one else can use the tree. But if no one has a property right to the forest, no one can be excluded
from using it.
A. The Demand for a Public Good

We can determine the market demand curve for a private good or service by adding horizontally the quantity
of the good demanded at each price by each consumer. To arrive at a demand curve or marginal social
benefit curve for a public good, we don’t add quantities at each price; instead, we add the price each
consumer is willing to pay for each quantity of the public good. This value represents the total dollar amount
consumers as a group would be willing to pay for that quantity of the public good.
B. The Optimal Quantity of a Public Good

The optimal quantity of any public good will occur where the marginal social benefit curve intersects the
supply curve. One difficulty with the market providing the economically efficient quantity of a public good
is that the individual preferences of consumers are not revealed in this market. Because no consumer can
be excluded from consuming the services provided by the good, no one has an incentive to reveal his or her
preferences. Governments sometimes use cost-benefit analysis to determine the quantity of a public good
that should be supplied. However, for many public goods, including national defense, the quantity supplied
is determined by a political process involving Congress and the president.
C. Common Resources
In England during the Middle Ages, each village had an area of pasture, known as a commons, on which
any family in the village was allowed to graze its cows or sheep without charge. Because the grass that one
cow ate was not available to another cow, consumption was rival. But every family in the village had the
right to use the commons, so it was nonexcludable. Without some type of restraint on usage, the commons
would end up being overgrazed. The tendency for a common resource to be overused is called the tragedy
of the commons. The source of the tragedy of the commons is the same as the source of negative
externalities: a lack of clearly defined and enforced property rights. Over the years, most of the commons
in England were converted to private property. In some situations, though, enforcing property rights is not
feasible. An example is the oceans. Because no country owns the oceans beyond its own coastal waters,
the fish and other resources of the ocean remain a common resource. In such situations, two types of
solutions to the tragedy of the commons are possible. If the geographic area involved is limited and the

number of people involved is small, access to the commons can be restricted through community norms
and laws. If the geographic area or the number of people is large, legal restrictions on access to the
commons are required.
>>Teaching Tips
This section’s Making the Connection feature provides an overview of the economics of the health care
system in the United States. Some of your students are likely to have their own views on health care and
what the government’s role should be. But they are unlikely to understand the incentives the current system
provides to consumers and health care providers. This feature describes some of the important aspects of
what will be an important public policy issue for years to come. See related problem 4.9. Solved Problem
5-4 describes how to construct a demand curve for a public good with two consumers. See related problem
4.4. According to the U.S. Department of Agriculture, the average American consumes 223 pounds of
beef, pork, and chicken annually. Despite the large and continuing demand for this meat, we do not see
news reports of shortages of cows, pigs, and chickens. In contrast, there are occasional media reports of
over-fishing and the possible extinction of some animal species. When resources are privately owned,
owners have incentives to conserve their use; producers have strong incentives to maintain the stocks of
cows, pigs, and chickens to ensure future supplies. Property rights to some parts of oceans, rivers, lakes,
and habitat areas of endangered species are non-existent or are poorly enforced.
Extra Making Paying for Speed

the
Connection
Economists often have used public highways as examples of a common resource. Highways are
nonexcludable because all automobile drivers have access to them, and rival because as more drivers
enter a highway, the amount of congestion increases. For busy interstate highways near large cities,
congestion can become severe. For example, during rush hour Minneapolis commuters can spend over
an hour on Interstate 394 for a drive that can take as little as 12 minutes without traffic. In 2005,
Minnesota began using a market-based approach to its common resource problem: commuters on I-394
were allowed to pay tolls to use carpool lanes. The most interesting part of this solution is that technology
has allowed the toll to vary based on the amount of congestion, from 25 cents to $8. The goal is to regulate
traffic so that those willing to pay the toll can maintain a speed close to 55 miles per hour. Although
charging drivers to avoid traffic is not a new idea, it has become increasingly popular among
municipalities. Additional revenue is raised, but only from those drivers who are willing to pay to save
time. “The congestion problem is bad and getting worse, and we aren’t in the position where we can
dismiss possible solutions that involve changing the way we pay for travel,” notes Tim Lomax, a research
engineer from Texas A&M University. Charging extra to use special lanes “is democracy in
transportation. You get to vote every day with your pocketbook.” Sensors in highway pavement keep
track of the number of cars and their speed. When traffic slows, computers increase the toll, which
discourages drivers from entering the toll lanes. Toll amounts are displayed on signs visible to drivers
and are deducted from an electronic card placed inside a driver’s vehicle. Some critics of this program
are concerned that the toll lanes cater to the needs of wealthy drivers, but the toll lanes appeal to other
drivers as well. The program has another benefit: Drivers who use the lanes report using less gasoline
than when they spend more time fighting traffic.
Source: Daniel Machalaba, “Paying for VIP Treatment in a Traffic Jam,” Wall Street Journal, June 21, 2007.

Extra Economics in YOUR LIFE!

Can You Do Anything to Reduce Acid Rain?
The tradable emissions allowances program that has been used to reduce sulfur dioxide emissions has been
targeted at electric utilities. Utilities buy allowances when the cost of reducing their emissions exceeds the
cost of the allowances. Each allowance represents one ton of sulfur dioxide.
Question: Why are utilities the only ones that can trade allowances? Why can’t college students or
individuals help to reduce sulfur dioxide emissions that cause acid rain?
Answer: In fact, although utilities have the greatest interest in trading allowances, anyone can purchase
them. Trades can take place through brokers or through environmental groups such as the Clean Air
Conservancy Trust and the Acid Rain Retirement Fund. Another option is to participate in an annual auction
conducted by the Environmental Protection Agency (EPA). Once a year at the end of March, the EPA
auctions off a certain number of sulfur dioxide emissions allowances to the highest bidders. Successful
bidders in past auctions include students from Environmental Economics classes from several universities.
Although allowances can be resold, student groups and environmental groups typically hold onto
allowances to prevent them from being used by utilities to cover their emissions. For more information
about the auctions, go the EPA web site (http://www.epa.gov/).
Extra INSIDE LOOK News Article to Use in Class

Visit www.myeconlab.com for current Inside Look news articles.
SOLUTIONS TO END-OF-CHAPTER EXERCISES

Answers to Thinking Critically Questions
1. A carbon tax faces the same difficulty as a permit scheme. With a permit scheme the government could
issue too many permits, thus causing the price of the permits to be too low and little carbon reduction to
take place. Likewise, if the carbon tax is set at a low enough level, it may be cheaper for electricity
producers to continue burning coal and pay the tax rather than to switch production to a less carbon-
emitting fuel.
2. A carbon tax would generate revenue. Tradable carbon permits would generate no revenue if they are
given away to electricity producers. However, if the permits are auctioned, then the government could
raise as much revenue as a carbon tax.
5.1 Externalities and Economic Efficiency

Learning Objective: Identify examples of positive and negative externalities and use
graphs to show how externalities affect economic efficiency.
Review Questions
1.1 An externality is a benefit or cost that affects someone who is not directly involved in the
production or consumption of a good or service. Examples of positive externalities include a) the benefits
received by a passerby who enjoys a beautiful garden and b) the benefits from a college education that go

to one’s children, grandchildren, co-workers, or complete strangers. Examples of negative externalities

include a) the noise from a loud party or from a jetliner, and b) the pollution emitted from a factory.
1.2 The private cost of producing a good will differ from the social cost when there is a negative
externality. For example, the private cost of producing electricity includes the costs of the fuel and running
the power plant, but the social cost also adds the costs of the pollution emitted—which can reduce visibility
and cause health problems. The private benefit of consuming a good differs from the social benefit when
there is a positive externality. For example, the private benefits from your college education include your
enjoyment of the experience and the increase in income you’ll receive, but the social benefits add the
benefits to third parties, such as your potential co-workers’ improved productivity because you know more,
or the gains to people who receive more services from the government because you earn more and pay more
taxes.
1.3 Economic efficiency occurs when the marginal benefit to consumers of the last unit produced is
equal to its marginal cost of production, and where the sum of consumer surplus and producer surplus is
maximized. Externalities generally reduce economic efficiency because buyers and firms ignore the
external cost or benefit, which leads firms to either overproduce the good if there is an external cost, or
underproduce the good if there is an external benefit.
1.4 Market failure is the failure of the market to produce the efficient level of output. Externalities,
public goods, and common resources all cause market failure (as does monopoly, which will be covered in
a later chapter).
1.5 Externalities generally arise because of incomplete property rights or from the difficulty in
enforcing property rights.
Problems and Applications

1.6 Under these circumstances, consumption of Big Macs causes a negative externality. These types of
externalities exist in the consumption of many products. There has recently been a debate over whether the
health effects of high-fat fast food justify government intervention. Ironically, the person with health
problems due to a lifetime of burger consumption didn’t cause taxpayers to suffer an externality until the
government created Medicare. In some sense, the government created the externality by taking the cost
upon itself.
1.7 Yes, it is possible for consumption to generate negative externalities and for production to generate
positive externalities. Drinking excessive amounts of alcohol is an example of consumption generating a
negative externality. One example of production generating a positive externality is the production of
honey, as described in the Making the Connection feature on page 141.

1.8
The efficient amount of alcohol consumption is Q2, but because the negative externality is ignored, actual
consumption is Q1. The deadweight loss is area A.
1.9 a. A positive externality arises from studying.

b.
Tom’s demand for studying is D2, the marginal social benefit curve, which adds together his marginal
private benefit and the marginal external benefit to his future children. He studies QT hours, which is the
efficient amount. Jacob’s demand for studying is D1, the marginal private benefit curve. Jacob studies
only QJ, which is inefficient because the marginal social benefits from studying more exceed the marginal
costs.

1.10 It is a positive externality in production. Because of the way the cable provider packages
channels, popular programs on one channel will increase sales of other channels. It is possible to think of
a private agreement in which other cable channels assume some of the production costs of popular shows,
but negotiating such an agreement would be difficult.
1.11 By market failures, he means that an unregulated market will result in more than the economically
efficient amount of development of farmland. Inefficient land allocation refers to the conversion of
farmland into developed land. Because the market fails to take into account the external cost of lost
farmland, an inefficiently large quantity of land (Q1) is developed. The efficient level of land development
is Q2, which is determined by the intersection of demand and S2.
5.2 Private Solutions to Externalities: The Coase Theorem

Learning Objective: Discuss the Coase theorem and explain how private bargaining can
lead to economic efficiency in a market with an externality.
Review Questions
2.1 The economically efficient amount of pollution is the quantity at which the marginal cost of
eliminating another unit just equals the marginal benefit from eliminating it. The economically efficient
quantity of pollution isn’t zero in most cases. Eliminating all pollution would incur costs that are greater
than the benefits.
2.2 The Coase theorem argues that if transactions costs are low, private bargaining will result in an
efficient solution to the problem of externalities—for example, in the efficient quantity of pollution
emissions. Transactions costs are the costs in time and other resources that parties incur in the process of
agreeing to and carrying out an exchange of goods or services. Private solutions to the problem of
externalities are most likely when it is easy to define and enforce property rights and when the costs of
making a deal are low.


2.3 An increase in pollution could make society better off if the current level of pollution is below the
efficient quantity. For example, government restrictions could be so strict that they require pollution
reductions to level A in the figure. The marginal costs of the last unit of pollution reduction exceed the
marginal benefit, so society would be better off if pollution reduction was only level B—the efficient
quantity.
2.4 Yes, assuming that the marginal benefit does not drop to zero before all of that type of pollution is
eliminated.
2.5 The marginal cost of reducing crime would include resources devoted to police, courts, and prisons.
The marginal benefit to reducing crime would include the reduction in losses to crime victims, including
losses due to personal injury and anxiety. Just as with pollution, it would not be economically efficient to
reduce the amount of crime to zero.
2.6 You should disagree because in deciding on the optimal amount of pollution reduction, we must
take into account the costs as well as the benefits. Because the marginal benefit of reducing sulfur dioxide
emissions all the way to zero will be very low, while the marginal cost will be very high, it would not be
economically efficient to completely eliminate sulfur dioxide emissions.
2.7 As the level of pollution falls, further cleanup becomes increasingly costly. In developing countries
with significant air pollution, existing technology can be used. Proven pollution reduction methods can be
implemented at the beginning of the cleanup process, so air pollution resulting from automobile use or
factory production could be addressed. Because significant technological advances have already been made
in these areas, the cost of implementation would be relatively low. Cleaning up the last 10 percent would
be considerably more expensive because a viable method to completely eliminate air pollution in populated,
urban areas has yet to be developed. An important trade-off involves spending resources to develop a
method to completely eliminate air pollution versus using those resources for other purposes.
2.8 Although there would be health benefits of reducing pollution further, it is not clear that the
government should take action to do so. Remember that if the marginal benefit of reducing air pollution is
greater than the marginal cost, further reductions will make society better off. But if the marginal cost of

reducing air pollution is greater than the marginal benefit, reducing air pollution will actually make society
worse off. The government needs to quantify the marginal cost and the marginal benefit of a further
reduction in air pollution, and take steps to reduce air pollution further only if the marginal benefit exceeds
the marginal cost.
2.9 It seems likely that private agreements will result in something close to the efficient quantities of
apple trees and beehives. We know that private agreements are detailed and enforceable so it is likely that
the externalities can be internalized successfully. The transactions costs involved in negotiating the
agreements may result in the efficient quantities of apple trees and beehives not being attained exactly.
5.3 Government Policies to Deal with Externalities

Learning Objective: Analyze government policies to achieve economic efficiency in a
market with an externality.
Review Questions
3.1 A Pigovian tax aims to bring about an efficient level of output by setting the tax equal to the
marginal external cost, which is the difference between the marginal social cost and the marginal private
cost.
3.2 Most economists prefer tradable emissions allowances because they allow pollution to be reduced
at the lowest cost. The firm that can reduce pollution cheaply will do so and sell its right to emit pollution
to another firm whose costs of reducing pollution are high. The command and control approach is generally
much costlier, because it often forces firms to adopt expensive methods of pollution control.

3.3 Unlike hamburgers, college educations are believed to generate sizeable positive externalities, thus
justifying subsidies, which will increase output toward the efficient amount.
3.4 Yes, subsidizing something that generates external benefits can help increase the quantity produced
toward the efficient level. (Although, output of new technology may become too high if the subsidy is too
big, or the funds may be wasted if the government subsidizes new technologies that don’t generate external
benefits.) The U.S. government does subsidize the production of new technology by providing grants to
researchers through the National Science Foundation and other agencies. Distinguishing between “good”
new technologies and mediocre new technologies is a very difficult task.
3.5 a. The efficient amount of crime is where the marginal benefit (from increased safety, reduced
property losses, increased peace of mind, and so forth) of reducing crime equals the marginal
cost (from the salaries of additional police officers, the cost of additional squad cars, and so
forth) of reducing crime.
b. The tax is a Pigovian tax because it attempts to push the quantity of crime toward its efficient
level. Assuming that the marginal benefit of reducing crime is currently greater than the
marginal cost—so that the current level of crime is inefficiently high—Governor Patrick’s
proposal would increase economic efficiency.
3.6 A normal good is a product that consumers demand more of as income rises. Environmental
protection is a normal good. The developed nations of the West already had higher incomes than third world
countries do today when they first began to take significant steps to protect the environment. Because third

world countries have low incomes, they do not demand nearly as much environmental protection as
developed countries do. As an economy develops and people get richer and can afford to pay more for a
clean environment, their willingness to pay for a clean environment rises—so the marginal benefit curve
for pollution reduction rises. Economic development also brings new technologies that reduce the marginal
cost of reducing pollution.
3.7 a. The tax should be the amount necessary to shift up the supply curve from S1 to S2. That amount
is $7.50 – $7.15 = $0.35 per item dry-cleaned.
b. The deadweight loss from excessive dry cleaning arises because the efficient amount of items
to dry clean is 600,000 per week, but the market outcome is 750,000 per week. The deadweight
loss equals the amount by which the marginal social cost (S2) of cleaning the last 150,000 items
exceeds the marginal benefit (which equals the demand curve). This is shown by area A of the
figure: 0.5 × $0.35 × 150,000 = $26,250. (Note: We know that the base of the deadweight loss
triangle must be $0.35 because S2 is parallel to S1, so the distance between them is constant.)
3.8 a. Marginal external cost is the difference between the marginal social cost and the marginal
private cost curve. Because marginal external cost rises as output rises, the gap between the
marginal private cost curve and the marginal social cost curve gets larger as output rises.
b. The optimal Pigovian tax can be found by first finding the efficient level of output, which is
found at the intersection of the demand curve and the marginal social cost curve. At this output,
the optimal tax equals the gap between the social cost and the private cost curves—that is, it
equals the amount of the marginal external cost. Therefore, in the large city the optimal tax is
$6.60 − $5.40 = $1.20, but in the small city the optimal tax is only $5.60 – $5.00 = $0.60. The
efficient tax is larger in the large city because demand is greater and marginal social cost
increases as the quantity of items cleaned per week increases.

3.9 a.
b. The government would most likely require the firms producing soft drinks to pay the tax. If the
government can collect the tax as easily from consumers as from firms, it would not matter
which group pays the tax. If firms are required to pay the tax, the supply curve will shift from
S1 to S2. If consumers pay the tax, the demand curve will shift from D1 to D2. Either way, the
price will end up at P2 and the quantity at Q2. In both cases, the tax is represented by the distance
from P3 to P2, with the consumers’ burden represented by the distance from P1 to P2, and the
firms’ burden represented by the distance from P3 to P1. Review Chapter 4, Section 4.4 for a
discussion on tax incidence.

3.10 a. The cap-and-trade system used to reduce sulfur dioxide emissions has been very successful and
has resulted in utilities meeting the emissions goal at a much lower cost than expected. A cap-
and-trade system to reduce CO2 emissions may also result in lower costs to meet goals than
initially expected. Electric utility rates rising because of the cap-and-trade system is a legitimate
argument against such a system, as this would significantly affect many U.S. residents, but it
may end up being a less-costly way of reducing CO2 emissions than alternative methods.
b. If the proceeds from auctioning off the permits would be used to finance tax cuts for low- and
middle-income people, this would reduce the burden of the increase in electric utility rates for
these people. This may make for a better argument for using the cap-and-trade system, but
much would depend on the amount of tax savings compared to the amount of the electric utility
price increase, as well as the actual number of taxpayers that would receive the tax cuts.
3.11 The success of using tradable permits to reduce sulfur dioxide emissions has led many economists to
believe that they may be similarly successful in reducing emissions of carbon dioxide. Tradable permits are
likely to reduce carbon dioxide emissions more efficiently than would command and control proposals that
would mandate certain reductions in emissions. Some economists, though, favor using a Pigovian tax on
carbon-based fuels, sometimes referred to as a “carbon tax,” as an alternative to tradable permits. Because
there are many more sources of carbon dioxide emissions than there are sources of sulfur dioxide emissions,
some economists do not believe tradable permits will be as effective in reducing carbon dioxide emissions.
5.4 Four Categories of Goods

Learning Objective: Explain how goods can be categorized on the basis of whether they
are rival or excludable, and use graphs to illustrate the efficient quantities of public goods
and common resources.
Review Questions
4.1 Rivalry occurs when one person’s consuming a unit of a good means that no one else can consume
it. Excludability occurs when anyone who doesn’t pay for a good cannot consume it. Goods that are both
rival and excludable are called private goods, which comprise most of the goods we consume. Goods that
are rival, but nonexcludable, are called common resources—such as fish in the sea. Goods that are both

nonrival and nonexcludable are called public goods. Goods that are nonrival, but excludable, are called
quasi-public goods.
4.2 A public good is nonrival and nonexcludable. Because anyone can get it without paying for it once
it has been produced—attempting to “free ride” in this manner—there is often little incentive for firms to
supply the good, because they can’t make a profit if people don’t pay for the good. Free riding will lead to
market failure, as less than the economically efficient amount of a public good will be produced.
4.3 The tragedy of the commons is the tendency of a common resource to be overused. It can be
avoided if there is a way to block overuse. One method is to give someone a property right to the resource,
which would give the person the incentive to use it efficiently. However, this won’t work well if the person
cannot enforce his or her property right easily.

4.4 a. The optimal level of a public good occurs at the quantity where the public’s marginal benefit
from the good—as represented by the demand curve—is equal to the marginal cost of providing
the good. To solve the problem, we need to know the demand curve for the city park and the
marginal cost of providing the park. To calculate their overall demand, we need to add the
dollar amounts that Jill and Joe are willing to pay at each quantity:
The graph shows that the optimal size park—where marginal social cost equals marginal social
benefit—is 4 acres.
b. The marginal cost of supplying the second acre is $13. But the demand curve tells us that the
marginal benefit Jill and Joe receive from the second acre is $21. Because the marginal benefit
to society is well above the marginal cost, 2 acres cannot be the optimal size city park.
4.5 The tragedy of the commons is the tendency for a common resource to be overused. Because
whales are a common resource, in the absence of agreements among governments to control whaling,
several species have been hunted toward extinction.
4.6 Clean air and the pasture are both common resources: they are rival and not excludable. Just as one
farmer using the pasture leaves less grazing space for the other farmers, one person polluting the air leaves
less clean air for other people. Because they are not private goods, neither the pasture land nor the air can
be excluded from use.

4.7 The tragedy of the commons arises because each person using the commons neglects the effects
his use has on other users. This is similar to each person neglecting to take into account the effects on
others—in the form of speeding the development of drug-resistant microbes—from using antibiotics.
4.8 Private goods include mail delivery (you’ll be excluded if you don’t use a stamp), education in a
private school, and an apple. A TV broadcast and hiking in a park without a fence are public goods. Hiking
in a park surrounded by a fence is a quasi-public good, because this is excludable but not rival. Education
in a public school is a common resource good—at least for people within the school district who won’t be
excluded. It is rival because as more students crowd into a classroom, the amount of attention the teacher
gives to each student declines. In cases where it isn’t rival, it would be a public good for those who are
eligible.
4.9 A few aspects of health care indeed do generate large positive externalities that are not excludable
and in these cases it is likely that a private system will not provide the efficient amount. But these cases
(such as vaccines) are a relatively small share of the total health care market. Most services (such as an
appendectomy or open heart surgery) are private because they are rival and excludable, and the reason for
the government to provide them cannot be due to their being public goods. There may be other reasons the
market does not provide the efficient quantity of these services, such as patients, medical care providers,
and insurance companies not all having access to the same information, distortions due to individuals not
being taxed on the medical insurance provided by their employers, and the overuse of health care by the
insured.

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CHAPTER 5| Externalities, Environmental

5.2 Private Solutions to Externalities: The Coase Theorem (pages 137–143)

5.3 Government Policies to Deal with Externalities (pages 143–147)

©2010 Pearson Education, Inc. Publishing as Prentice Hall

5.4 Four Categories of Goods (pages 148–157)

©2010 Pearson Education, Inc. Publishing as Prentice Hall

Economic Policy and the Environment

©2010 Pearson Education, Inc. Publishing as Prentice Hall

5.1 Externalities and Economic Efficiency (pages 134–137)

A. The Effect of Externalities

B. Externalities and Market Failure

C. What Causes Externalities?

©2010 Pearson Education, Inc. Publishing as Prentice Hall

Extra Solved Problem 5-1

Source: Americans for Nonsmokers’ Rights, http://www.no-smoke.org

SOLVING THE PROBLEM:

©2010 Pearson Education, Inc. Publishing as Prentice Hall

Extra Making The Mystery of the Missing Bees

5.2 Private Solutions to Externalities: The Coase Theorem (pages 137–143)

©2010 Pearson Education, Inc. Publishing as Prentice Hall

A. The Economically Efficient Level of Pollution Reduction

B. The Basis for Private Solutions to Externalities

C. Do Property Rights Matter?

D. The Problem of Transactions Costs

E. The Coase Theorem

©2010 Pearson Education, Inc. Publishing as Prentice Hall

Extra Solved Problem 5-2

SOLVING THE PROBLEM:

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5.3 Government Policies to Deal with Externalities (pages 143–147)

A. Command and Control versus Market-Based Approaches

B. Are Tradable Emissions Allowances Licenses to Pollute?

©2010 Pearson Education, Inc. Publishing as Prentice Hall

5.4 Four Categories of Goods (pages 148–157)

A. The Demand for a Public Good

B. The Optimal Quantity of a Public Good

©2010 Pearson Education, Inc. Publishing as Prentice Hall

Extra Making Paying for Speed

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Extra Economics in YOUR LIFE!

Extra INSIDE LOOK News Article to Use in Class

SOLUTIONS TO END-OF-CHAPTER EXERCISES

5.1 Externalities and Economic Efficiency

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to one’s children, grandchildren, co-workers, or complete strangers. Examples of negative externalities

Problems and Applications

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1.9 a. A positive externality arises from studying.

©2010 Pearson Education, Inc. Publishing as Prentice Hall

5.2 Private Solutions to Externalities: The Coase Theorem

©2010 Pearson Education, Inc. Publishing as Prentice Hall

Problems and Applications

©2010 Pearson Education, Inc. Publishing as Prentice Hall

5.3 Government Policies to Deal with Externalities

Problems and Applications

©2010 Pearson Education, Inc. Publishing as Prentice Hall

©2010 Pearson Education, Inc. Publishing as Prentice Hall

©2010 Pearson Education, Inc. Publishing as Prentice Hall

5.4 Four Categories of Goods

©2010 Pearson Education, Inc. Publishing as Prentice Hall

Problems and Applications