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 positive or negative externalities:
a. Thomas drives an old car and his neighbor’s complaint of air pollution.
b. Sonya is a good student and she works as a volunteer at a local childcare center.
c. Diana use pesticides to improve the yield of her apple trees.
Answer:
a. This is an example of a negative externality, as the car Thomas drives is old and creates air
pollution, which is an external cost imposed on other people who live in the city.
b. This is an example of a positive externality, as Sonya receives a good education and she is able to
offer this to other people by volunteering at the local nursery.
c. This is an example of a negative externality, as the pesticides are imbedded in the apple products,
thus harming the health of consumers.
3. Education is considered as a consumer good with positive externality, in which other non-consuming
parties in the society also tend to benefit from it. Why does the invisible hand fail to generate socially
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 yo--ur orchard.

©2018 Pearson Education Ltd.

 Chapter 9 | Externalities and Public Goods 98

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 defense to a country, the supplier needs to hire soldiers and acquire weapons and
other military equipment. Do you think it is possible that a private firm is able to supply national
defense efficiently?
Answers:
National security is non-rival and non-excludable. Even if a private firm is able to hire professional
soldiers, purchase weapons and military equipment, 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 a private good with 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. In addition, 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.

©2018 Pearson Education Ltd.

 Chapter 9 | Externalities and Public Goods 99

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 private 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?
Answers:
a. The equilibrium quantity in the market is Q1.

©2018 Pearson Education Ltd.

 Chapter 9 | Externalities and Public Goods 100

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 Q2.

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. A company decides to expand its business activities and build a new factory close to the existing one.
Thus, it buys the land next to its property and builds a link roadway. Based on the ideas from this
chapter, how can this be a positive externality?
Answer: This is clearly a case of negative externality, as the construction of the road is associated with
external costs in losing the landscape, which people can no longer enjoy, pollution and noise. This can be
transformed into a positive externality if the company decide to build the factory outside the city and not
harm the third parties.

©2018 Pearson Education Ltd.

 Chapter 9 | Externalities and Public Goods 101

3. To improve the public transportation in Singapore, the government has decided to construct the Circle
Line (CCL), a mass rapid transit (MRT) project that comprises many stations in the central region of
the country. This is a huge infrastructural project and involves digging and pounding in the residential
areas, resulting in noise, dust, and traffic congestions in the vicinity. Many residents have complained
to the construction company that the project has led to pollution and inconvenienced them. Explain
what type of externality has occurred and why the 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 play music very loudly at home while practicing. Her
neighbor, Jennifer, is a teacher who needs a quiet environment to mark her students’ assignments.
Dancing gives benefits to Serene worth $120 daily. But Jennifer’s marking progress is affected and it
costs her $50 everyday.
a. Is it efficient for Serene to stop dancing with loud music on since it inconveniences Jennifer?
b. If Serene has the right to do whatever she prefers but both parties can negotiate with no cost
involved, will Jennifer be able to mark assignments in a quiet environment?
c. Jennifer has the right to a quiet environment and Serene can only play 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.
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 on each vehicle using the
expressway to control the traffic volume but still there are congestions. Explain why the government
did not raise the charge to reduce the number of vehicles on the expressway.
Answers:
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.

©2018 Pearson Education Ltd.

 Chapter 9 | Externalities and Public Goods 102

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 and others shows a strong
correlation between the incidence of malaria in a country and poverty. 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.
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 insecticide-treated nets’ 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 nets?
Answer:
a. The outcome is not socially efficient because the private market does not consider all of the social
benefits associated from the insecticide-treated nets. The equilibrium price and quantity in the
market is P1 and Q1 respectively.

b. At each level of production, the private benefit from producing insecticide-treated nets plus the
external benefit of the nets 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.

©2018 Pearson Education Ltd.

 Chapter 9 | Externalities and Public Goods 103

The efficient quantity of insecticide-treated nets 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 insecticide-treated nets. This
will shift the demand curve outward and increase the production of nets 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, their family members, work 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 the vaccine is purely voluntary and some people choose not to go
ahead with it due to the high cost.
a. What type of externality occurs for injection against contagious diseases?
b. Use a suitable diagram to show the market equilibrium quantity of the injection. Is the quantity
also socially efficient?
c. Suggest one method to achieve a socially efficient outcome.
Answers:
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
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.

©2018 Pearson Education Ltd.

 Chapter 9 | Externalities and Public Goods 104

8. China’s economic growth has been powered by an increasing, coal-dominated fossil fuel
consumption. The coal production required to match such demand generates both carbon dioxide and
all particulate matters, along with arsenic, mercury, chromium and cadmium. This has resulted in
extremely high emission levels of carbon dioxide and all particulate matters. The number of annual
premature deaths attributable to this pollution is also high in China. Draw a diagram and explain your
answers to the following questions:
a. Will these high social costs imply a higher or a lower efficient quantity of coal?
b. If the Chinese government imposes taxes on air pollution, will the high social costs imply a high
or low level of tax required, to lead to the efficient level of coal production?
Answers:
a. This is an example of negative externality. The estimated damages from the coal production have
increased, as the annual premature deaths attributable to these gases remain at high levels. The
difference between the marginal cost of fuel consumption and the supply of coal must have
increased. In the graph below, marginal social costs shift up from MSC1 to MSC2, which means
that the efficient quantity of steel falls from Q1 to Q2.
b. If the government imposes a tax on coal equal to the external damage of the coal production, this
means that increases from AB to CE.

See: “Air Pollution Control Policies in China: A Retrospective and Prospects”, International Journal of
Environmental Research and Public Health, 2016 Dec; 13(12): 1219,
https://www.ncbi.nlm.nih.gov/pmc/articles/PMC5201360/

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 101st 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?

©2018 Pearson Education Ltd.

 Chapter 9 | Externalities and Public Goods 105

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:
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. Each year, a university organizes a students’ laser show at the beginning of the summer. Ana and
Jenna are willing to pay $40 to participate, Tom and Gerard are willing to pay $50, and Laura and
Sam are willing to pay $70. The cost of this laser show is $300.
a. In terms of efficiency, should the university organize the laser show?
b. Explain whether the students decide to organize the laser show on their own.
c. Suppose the students decide to put the matter to vote. If at least 4 of them vote in favor of the
laser show, each student will be taxed $60 and the laser show will be organized. How many
students will vote in favor?
Answer:
a. Yes. The total benefit is $320, while the costs are $300.
b. No. The maximum a pair of students can pay is $140 in case of Laura and Sam, which is less than
the cost of $300, so no one is willing to fund the laser show on their own.
c. Students will vote only if their private benefit is at least $60, so Ana and Jenna will not vote. The
other four will vote in favor of it.
11.

12. Suppose demand is QD = 16 - P supply is QS = P. There is a constant positive externality of $4 per

unit (Marginal External Benefit, MEB = $4). Find the maximum possible social surplus.
Answer: Marginal private benefit is MPB = 16 - Q, thus marginal social benefit is this marginal private
benefit plus the external benefit: MSB = MPB + MEB = 16 - Q + 4 = 20 - Q. This intersects the marginal
cost (both private and social as there are no negative externalities) at Q = 10. The maximum surplus is
thus the area of the triangle below MSB and above MSC, which is (1/2)*($20)*(10) = $100.

©2018 Pearson Education Ltd.

 Chapter 9 | Externalities and Public Goods 106

©2018 Pearson Education Ltd.