Chapter 18 - Externalities and public goods

Question 1

What are externalities?

Answer 1

Externalities are effects of production and consumption activities not directly reflected in the market.

It is basically events that have some impact of other people, but this impact is not balanced in market.

We have both positive and negative externalities.

Question 2

What are public goods?

Answer 2

Public goods are goods that benefit all consumers but that the market undersupplies or doesnt supply at all.

Question 3

Why are we interested in externalities and public goods?

Answer 3

we are interested in externalities and public goods because of what they can do to market failure.

Since they can lead to market failure, they raise important policy questions.

Question 4

Discuss social value vs price of a good when externalities are present

Answer 4

When externalities are present, the price of the good need not reflect the social value of the good. This measn, tthe price can be lower or higher than the social value.

As a result, firms may produce too little OR too much of the good.

Question 5

Define negative externalities

Answer 5

negative externalities refer to cases where some action of one party impose a COST on the other party

Question 6

Define positive externalities

Answer 6

Postive externalities refer to cases where the action of one party impose a benefit on another party.

Question 7

Are externalities reflected in prices?

Answer 7

No

Question 8

What is Marginal Social Cost, MSC?

Answer 8

Marginal Cost + Marginal External Cost (from externalities)

Question 9

According to the “social point of view”, what is the optimal production level?

What happens with price for the individual firm and for the industry, if competitive?

Answer 9

Society wants the point where MSC = MR = P (if competitive)

the individual firm considers price as given, not much to do.

The industry will se a change in qantity demanded and therefore the price will change. If society wants lower production due to negative externalities, the price will increase and vice versa.

So, if there are negative externalities, social perspective wants the firms to produce less. Therefore, there are too much output when there are negative externalities.

Question 10

What is required for efficient level of output in regards to externalities?

Answer 10

Marginal Revenue must be equal to marginal social cost. Recall the MSC is the sum of MC and MEC.

At the point where MR = MSC, any change would not be beneficial as it would damage either the firm or the rest more than the gain.

Question 11

Graphically, define the inefficiency of externalities.

Answer 11

It is the area above the demand curve, and between MSC and MC from the point where we have competitive output and the point where we have social- competitive output.

Question 12

What is MEB?

Answer 12

Marginal External Benefits

the same as MEC, but when the effect is positive rather than negative.

Question 13

What is MSB?

Answer 13

Marginal Social Benefit.

The same as MSC, but opposite.

MSB = D + MEB

Question 14

Elaborate on standards vs fees

Answer 14

A standard is a legal limit on how much a firm is allowed to produce, or a consumer allowed to consume. By using standards, you will limit the amount of action.

A fee is usually per-unit cost

Question 15

Define externalities and public goods

Answer 15

Externalities re effects that are not directly refelcted in the market.

Public goods are goods that are in benefit of all consumers, but the market either undersupplies or does not supply at all.

We are interested in externalities and public goods because they are important sources to market failure.

the classical example is waste dumping problem. It is not reflected in the market, but people will get affected by it.

Question 16

Elaborate on what we mean by externalities not being reflected in the market

Answer 16

We mean that the price of some good or sercive does not match its social value. We say that the market becomes inefficient since people’s utility is not maximized.

For instance, if a firm is dumping waste in a local fishing lake. The firm does not take social welfare into account when calcualting maximized profits. Since these social costs are not represented in the market, they become a source of inefficiency. We get excess production.

Question 17

What is marginal external cost?

Answer 17

MEC, marginal external cost, is the cost received by negative externalities. For instance, if the fishing firm is impacted by someone dumping waste, the effect of this is measured as marginal external cost.

Question 18

From society’s point of view, what is marginal benefit? Say in the case of waste dumping. There is clearly a need for the firm to do their job, however there comes a point where the waste becomes more problematic than the firm’s contribution. What level is that?

Answer 18

Marginal benefit of society is given by the demand function.

The cost to society is given as the difference between marginal social cost and the marginal benefit. Society wants the demand function to intersect with a point on the curve that gives output level equal to Marginal social cost. However, the firms will not use social cost, but rather marginal cost.

Question 19

What can cause firms to stay in the market even though it would be efficient for them to leave?

Answer 19

If there are negative externalities, efficiency does not mean profits. The efficency is a measure of whether there are externalities or not. If there are negative externalities, we know the market is inefficent. Therefore, it could indicate that firms should move, but they might stay.

Question 20

Say we have an inefficiency that is the result of externality. How can we correct this? Consider the case with fixed proportions production function.

What happens if we use too much emmissions?

Answer 20

If Leontief: The only way to reduce input factors is to reduce production. We therefore want to encourage the firm to produce less. This can be done with a tax.

Most firms are more flexible, and can find other input combinaitons.

In the case of emissions, there will be 2 curves of interest:
1) Marginal external cost of emissions
2) Marginal cost of abating emissions

This is essentially MR = MC, Marginal benefit = marginal cost.

We can encourage a firm to reduce production/emissions in 3 ways:

1) Standards
2) Fees
3) Transferrable emmisions permits

Question 21

What is a standard?

Answer 21

A standard is a legal limit of production/emmisions. We cannot breach this.

Question 22

What is a fee?

Answer 22

A fee is typically per unit of emission. A charge per item. By setting an appropriate fee, we can restrict the output level.

Question 23

Elaborate on standards vs fees, and their impact on for instance emissions. Graphically as well

Answer 23

Consider the MEC curve and the MCA curve. They will intersect at some point. at this point, society gets the efficient optimal level of production. Therefore, we need to add a fee or standard that enforce this.

A standard would be a vertical line through the itnersection point. This line stands at a quantity, which is the level we want.

A fee would be a per-item charge.

Regarding externalities. Consider fees for something like emissions. The socially optimal level of production is at the point where Marginal external cost intersects with marginal cost of abating. However, since firms dont usually care about MEC, we can, as the government, add a fee. The fee can be viewed as a price line that could replace the MEC curve. By adding a fee of x USD so that x is equal to the price we get from the intersection between MCA and MEC, the firm will automatically consider the fee as a part of its costs, which will result in the same effect as if the firm originally cared about the external cost.

Question 24

Define the characteristics of public goods

Answer 24

Public goods are characterized by 2 feats:

1) Nonrival
2) Nonexclusive

A good is non-rival if the cost of “making it” or “allowing” another consumer to consume it. Meaning, the marginal cost of it is 0. Once it is there, MC is zero for all consumers.

A good is nonexclusive if it doesnt disallow anyone to use it. everyone is free from using it.

So, public goods are goods that combine the feats of nonrival and nonexclusive.

Roads are examples of public goods.

Question 25

name examples of public goods

Answer 25

National defense.

Television broadcasts IF made free for anyone, like NRK.

lighthouse

Question 26

Elaborate on efficient level of provision of a public good VS private good

Answer 26

The efficient level for a private good is given at the point where marginal benefit is equal to marginal cost. This also applies to public goods, but the analysis is different.

With private goods, marginal benefit is measured by the benefit that the consumer receives. With public goods however, we must ask “how much each person values an additional unit of output”. The marginal benefit is obtained by adding these “values” by all people who enjoy the good. Then we must equate this sum to the marginal cost of production.

SO, what we do is that we add the price each consumer is willing to pay for the public good together. This sum of prices represent the marginal benefit. Then we can look at marginal costo f produciton. When these two sums are equal, we have achieved an efficient level of public good output for that specific public good.

Question 27

Elaborate on how the graph of public goods look like

Answer 27

We will have a marginal cost line/curve.

We will have the demand curve from EACH consumer.

Then we will have the aggregated demand curve for all the consumers.

Now, if the amount of consumers is relatively small, the market demand curve for the public good is going to be kinked at multiple places. This reflects the points where new consumers enter the demand. Recall that different demand curves of consumers reflect willingness to buy different quanta. If no one wants to buy 100 units regardless of price, then the market demand curve will never reach this far on the graph.

Question 28

Elaborate on public goods and free riders and market failure

Answer 28

There will likely be free riders when considering public goods.

Free riders are people who dont pay for the public good, but still receive benefit from it. A free rider assumes that other people will, which eliminates his need to do so.

F

Question 29

Elaborate on fees. Why do we need them? what purpose do they serve?

Answer 29

If we consider a firm that is polluting by some form of emissions, this pollution will have an effect on society that we call “negative externality”. We can measure this “cost” with the MEC, marginal external cost curve. This tries to capture how people in society would place a monetary cost on different levels of pollution. Some level of pollution is generally accepted as efficient, because it leads to lower prices in markets etc. So, the problem is that if the MEC is great enough, it will cause inefficiency because the firm is not taking this cost into account when calculating its profit maximizing price and quanta. The firm ends up producing too much. Therefore, if we want an efficient market, we need to regulate the pollution in some way. Ideally, we want to limit production to the point where MEC is equal to MCA. MCA is marginal cost of abatement. This means, the cost of reducing emissions. So, efficiency is achieved when the marginal cost of reducing one more emission is equal to the marginal cost of adding one more unit of emissions. However, this is not something that firms tend to do on their own. Therefore, as the government, we can add a fee. We want to add a fee of X amount of bucks per unit of emission so that the cost of adding antother unit of emission is equal to the cost of reducing another unit. By adding a fee, the firm has to do measures that limit emissions. This is because, initially, the cost of the emissions are likely to be far greater than the cost of reducing them. With the appropriate emission fee, we will force the firm to limit emissions to the point where it will not produce more emissions because the fee-cost will outweigh the cost of reducing it. Likewise, the cost of reducing even more emissions would be greater than paying the fee. At this balance point, we have efficiency.