Chapter 3

Question 1

What are externalities in the context of market transactions?

Answer 1

Externalities are costs or benefits of market transactions to third parties that are not reflected in prices.

Question 2

Who are the third parties affected by externalities in market transactions?

Answer 2

Third parties are individuals other than the buyer or the seller who are affected by the production or consumption of certain goods or services.

Question 3

How do externalities impact the accuracy of market prices in reflecting MSB and MSC?

Answer 3

Externalities result in market prices that do not accurately reflect either all the marginal social benefit (MSB) or all the marginal social cost (MSC) of traded items.

Question 4

What are negative externalities in the context of market transactions?

Answer 4

Negative externalities refer to costs imposed on third parties that are not reflected in the market price.

Question 5

Can you provide examples of negative externalities?

Answer 5

Examples of negative externalities include industrial pollution, noise from low-flying aircraft near residential areas, and health problems for those living near high voltage power lines.

Question 6

What are positive externalities in market transactions?

Answer 6

Positive externalities represent benefits to third parties that are not reflected in market prices.

Question 7

Can you provide an example of a positive externality?

Answer 7

An example of a positive externality is the purchase of smoke alarms leading to fire prevention or vaccination campaigns benefiting public health.

Question 8

Do externalities impact resource allocation in a market system?

Answer 8

Yes, externalities can pose problems for resource allocation in a market system.

Question 9

In competitive markets, what do prices typically equate?

Answer 9

Prices in competitive markets typically equate the marginal private cost (MPC) incurred by sellers and the marginal private benefit (MPB) enjoyed by buyers.

Question 10

How do externalities affect the relationship between MPC/MPB and MSC/MSB?

Answer 10

Externalities cause a divergence between the MPC and MPB from the MSC and MSB.

Question 11

What is a negative externality, and how does it relate to environmental damage?

Answer 11

A negative externality occurs when business firms producing a polluting product do not pay for the damage done to the environment.

Question 12

How do externalities hinder competitive markets from achieving efficient outcomes?

Answer 12

Externalities hinder competitive markets from achieving efficiency because they disrupt the balance between marginal social costs (MSC) and marginal social benefits (MSB).

Question 13

What approach will be discussed to correct resource allocation problems resulting from externalities?

Answer 13

Alternative government policies to correct resource allocation problems caused by externalities will be explored.

Question 14

What is a negative externality in a market, and how does it affect the price of a good or service?

Answer 14

A negative externality occurs when the price of a good or service does not reflect the full marginal social cost (MSC) of its production

Question 15

Give an example of external costs related to the production of paper

Answer 15

External costs associated with paper production could include industrial pollution of rivers and lakes, which may decrease the catch of commercial fishers and reduce the benefits that recreational users of lakes get from activities like swimming and boating

Question 16

What is the concept of “Marginal External Cost” (MEC)?

Answer 16

Marginal External Cost (MEC) represents the extra cost to third parties resulting from the production of an additional unit of a good or service. It is a part of the Marginal Social Cost (MSC) of making the good available

Question 17

How do producers make decisions about production in the presence of negative externalities?

Answer 17

Producers make decisions based on their Marginal Private Cost (MPC), which does not account for the MEC or the full MSC caused by externalities.

Question 18

In a perfectly competitive paper industry, what is the equilibrium price (P) and quantity (Q) if no external costs are considered?

Answer 18

In a perfectly competitive paper industry without considering external costs, the equilibrium is at point A, with P=$100 per ton, and Q=5 million tons

Question 19

What is the demand curve in the paper industry based on, and what does it represent?

Answer 19

The demand curve in the paper industry is based on the marginal private benefit that buyers receive from each ton of paper. It represents the marginal social benefit of paper.

Question 20

Why do producers’ marginal private cost curves not include all costs in the presence of externalities?

Answer 20

Producers’ marginal private cost curves do not include all costs because they do not account for the marginal external cost (MEC) associated with each ton of paper produced

Question 21

How is the marginal social cost (MSC) calculated in the presence of external costs in the paper industry?

Answer 21

To calculate the marginal social cost (MSC) in the presence of external costs, you need to add the marginal external cost (MEC) to the marginal private cost (MPC): 𝑀𝑃𝐶 + 𝑀𝐸𝐶 = 𝑀𝑆𝐶.

Question 22

Is the competitive output level at point A considered efficient? Why or why not?

Answer 22

No, the competitive output level at point A is not efficient. At A, 𝑀𝑃𝐶 is not equal to 𝑀𝑆𝐵, and 𝑀𝑆𝐶 exceeds the MSB. Therefore, the market equilibrium output of 5 million tons of paper per year is inefficient.

Question 23

What happens when the marginal social cost (MSC) exceeds the marginal social benefit (MSB) in a competitive market?

Answer 23

When the MSC exceeds the MSB in a competitive market, it means too much of the good is being sold relative to the efficient amount. This results in an inefficient allocation of resources.

Question 24

How can a gain in net social benefit be achieved in the presence of an externality like industrial pollution?

Answer 24

A gain in net social benefit can be achieved by reducing the annual output of the polluting good to a more efficient level, which typically involves decreasing output. In the case mentioned, reducing annual paper output from 5 million tons to 4.5 million tons resulted in such a gain in net social benefit.

Question 25

What is the necessary price adjustment to induce consumers to cut back consumption from 5 million tons to 4.5 million tons per year?

Answer 25

To induce consumers to cut back consumption from 5 million tons to 4.5 million tons per year, the price of paper would have to increase to $105 per ton.

Question 26

What is the condition for the efficient equilibrium in the presence of a negative externality?

Answer 26

The efficient equilibrium occurs when 𝑀𝑆𝐶 (Marginal Social Cost) is equal to 𝑀𝑃𝐶 (Marginal Private Cost) plus 𝑀𝐸𝐶 (Marginal External Cost), which is also equal to 𝑀𝑆𝐵 (Marginal Social Benefit).

Question 27

Why does too much output occur in a competitive market when a negative externality exists?

Answer 27

Too much output occurs in a competitive market with a negative externality because producers are not taking into consideration the external cost imposed on other parties, and they are not penalized for it. As a result, they produce more of the good than the efficient level, causing inefficiency

Question 28

What is a positive externality, and can you provide an example?

Answer 28

A positive externality is a benefit received by third parties that is not reflected in the market price of a good or service. An example is vaccination against influenza, where those who are vaccinated benefit by reducing their own risk of catching the flu and also provide benefits to others by reducing the spread of the disease.

Question 29

Why does the sale of vaccines in a competitive market result in less than the efficient annual number when a positive externality exists?

Answer 29

In a competitive market with a positive externality, the sale of vaccines results in less than the efficient annual number because the market price does not reflect the full Marginal Social Benefit (MSB), which includes the external benefit to third parties. As a result, too few vaccines are consumed, leading to inefficiency.

Question 30

What is the market equilibrium point in a competitive market for vaccinations, and what are the quantities and prices at that point?

Answer 30

The market equilibrium in a competitive market for vaccinations occurs at point U, with a quantity of 10 million vaccinations and a price of $25 per vaccine.

Question 31

What is the basis for consumers’ decisions in a competitive market for vaccinations, and what condition does the market equilibrium satisfy?

Answer 31

Consumers base their decisions on the marginal private benefit (MPB), and the market equilibrium satisfies the condition that MPB equals the Marginal Social Cost (MSC).

Question 32

If the marginal external benefit (MEB) of vaccinations is $20, what impact does it have on the market equilibrium?

Answer 32

The marginal external benefit (MEB) of $20 creates a positive externality. It means that for every vaccine, there is an additional benefit to society of $20. This positive externality is not considered in the market equilibrium, leading to an under-consumption of vaccinations from an efficiency standpoint.

Question 33

What happens to the marginal social benefit (MSB) when a positive externality exists in a market, such as vaccinations?

Answer 33

When a positive externality exists, the MSB will exceed the marginal private benefit (MPB).

Question 34

What is the result of the MSB exceeding the price in a market with a positive externality?

Answer 34

When the MSB exceeds the price, it leads to less than the efficient output, meaning that the market does not produce enough of the good or service to maximize societal benefit

Question 35

Where is efficiency achieved in a market with a positive externality?

Answer 35

Efficiency is achieved when the MSB equals the Marginal Social Cost (MSC). In such a scenario, the market produces the efficient level of output that maximizes overall societal benefit.

Question 36

Where is efficiency achieved in a market with a positive externality, such as vaccination?

Answer 36

Efficiency is achieved when the Marginal Social Benefit (MSB) equals the Marginal Social Cost (MSC). In this case, the market produces the efficient level of output

Question 37

What is the result of reaching efficiency in a market with a positive externality?

Answer 37

When efficiency is reached, the quantity demanded by consumers aligns with the efficient number, maximizing net benefits

Question 38

What concept does the government need to consider to reach efficiency in a market with positive externalities?

Answer 38

To reach efficiency in a market with positive externalities, the government may consider internalizing the externality, which involves interventions to align market outcomes with the social optimum.

Question 39

What is the Coase theorem?

Answer 39

The theorem states that governments can internalize externalities, by merely establishing rights to use resources, when transactions costs of bargaining
are zero.

Question 40

What are the transactions costs of bargaining?

Answer 40

The transactions costs of bargaining include the **costs of locating a trading partner **and agreeing on the value of the traded right

These costs tend to be low when the parties involved are few in number

Question 41

What are small-number externalities?

Answer 41

The kinds of externalities for which the Coase theorem is relevant are called small-number externalities

Question 42

How does the Coase theorem achieve efficiency?

Answer 42

Once these property rights to resource use are assigned, the Coase theorem holds that free exchange of these rights for cash payments among the affected parties will achieve efficiency. It makes no difference which party is assigned the right to use a resource

Question 43

The negative externality in the cattle rancher and wheat farmer example?

What could the government do to internalize this negative externality?

Assume the government grants the wheat farmer the right to cattle-free land.

Answer 43

The government could force the cattle rancher to pay the wheat farmer for damages incurred by the cattle, which would force the rancher to take into account the external cost caused by the herd. This would internalize the externality in such a way as to increase/adjust the cattle rancher’s MPC to the point where it is equal to MSC.

Question 44

What is the Coase theorem?

What is the profit-maximizing output of beef in Case I of the Coase theorem?

Assume that the rancher is not liable for damages to the farmer.

Answer 44

The profit-maximizing output of beef in Case I of the Coase theorem is 𝑄𝐵1, where P=MPC. However, 𝑄𝐵1 is inefficient because at that output, the MSC exceeds the MPC by the MEC. The price of beef reflects only the MPC. The MEC to the wheat farmer is the loss in wheat output multiplied by the market price of wheat: 𝑀𝐸𝐶 = 𝑃𝑊𝑄𝑊.

Question 45

What is the Coase theorem?

What is the efficient output level in Case II of the Coase theorem?

Assume that the rancher is liable for damages to the farmer.

Answer 45

The efficient output level in Case II of the Coase theorem is 𝑄𝐵∗, where 𝑃𝐵 = 𝑀𝑆𝐶. The rancher must consider MEC as part of his marginal costs. In other words, he has to consider the MSC of beef (where MSC=MPC+MEC). This is done by being liable for the damage caused through the payment of a penalty. This will result in a leftward shift in his supply curve, which means a higher cost of production. He produces the output 𝑄𝐵∗ (where 𝑃𝐵 = 𝑀𝑆𝐶). This output level is the efficient output because 𝑃𝐵 also equals the MSB of beef in a competitive market. Recall that 𝑃𝐵 is the demand curve facing a producer (MSB) in a perfectly competitive market.

Question 46

What are the three options that the cattle rancher has to deal with the negative externality caused by his herd?

Answer 46

Go out of business, build a fence, or purchase the wheat farmer’s land.

If the maximum revenues he can earn at the efficient output level of Q* is less than the opportunity cost of production, he will go out of business and the land will be converted to other uses

Question 47

How does building a fence affect the average and marginal costs of production for the cattle rancher?

Answer 47

Building a fence increases the average cost of production but does not affect the marginal cost of production.

After building the fence, the rancher will produce output 𝑄𝐵1 per year because MEC will be zero after the fence is constructed.

Question 48

What is the output level of beef that the cattle rancher will produce after building a fence or purchasing the land, and why?

Answer 48

The rancher will produce output 𝑄𝐵1, because at this level, the marginal private cost (MPC) equals the marginal social benefit (MSB) of beef. The marginal external cost (MEC) is zero after building a fence or purchasing the land.

Only if buying the land allows greater annual profits than available by producing output Q* and paying damages, or by building a fence.

Question 49

What is an alternative assignment of property rights that can be used to internalize negative externalities?

Answer 49

If the rancher is granted the right to use unfenced land for grazing and thus is NOT liable for damages to the farmer, the farmer can bargain to purchase any portion of this rancher’s right of unlimited grazing. Both parties can reach a deal, according to which the rancher accepts a payment from the farmer to reduce his annual output of beef to the efficient level 𝑄𝐵∗. The rancher will accept this payment if it allows an increase in its profits. The farmer will be no worse off by making a payment up to the marginal external cost of the damages that cattle cause to the wheat crop.

Question 50

In conclusion:

What is the Coase theorem?

Answer 50

The Coase theorem states that the efficient mix of output among competing uses of a resource will result simply as a consequence of the establishment of exchangeable property rights, provided the transactions costs of exchanging the right are zero2. It makes no difference which party is assigned the right to use a resource. Therefore, when transactions costs of exchanging the right to resource use are low and the number of parties involved is few, a government need do no more than assign property rights. Bargaining among the interested parties will do the rest to achieve efficiency.

Question 51

What is incomplete information, and how does it lead to market failure?

Answer 51

Incomplete information refers to a situation where buyers or sellers do not have access to all the relevant information about a product or service. This can lead to market failure because it can result in the production or consumption of goods that are harmful to society. For example, if consumers do not have access to information about the risks of using a certain product, they may continue to use it even if it is harmful to their health.

Question 52

What is economic stabilization, and how does it relate to market failure?

Answer 52

Economic stabilization refers to the use of monetary and fiscal policies by governments to stabilize the economy in response to market imperfections such as downwardly rigid wages. This is done in an effort to correct for market failures and ensure full employment. Governments also seek to avoid excessive inflation that can erode purchasing power and impair the functioning of financial markets.

Question 53

What is the government’s role in ensuring efficient functioning of markets?

Answer 53

The government’s role represents an important complement to the efficient functioning of markets. It includes ensuring that buyers and sellers have access to complete information about products and services, testing new drugs, establishing standards for safety in the workplace, stabilizing the economy through monetary and fiscal policies, and avoiding excessive inflation that can erode purchasing power and impair the functioning of financial markets.