Module 8 – Public Goods and Externalities Flashcards Preview

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Flashcards in Module 8 – Public Goods and Externalities Deck (53):
1

What should we do if we really want a clean environment?

A. Increase the social awareness of our citizens.
B. Pay for it in less of other things.
C. Abandon our predominantly free-enterprise system.
D. Discipline ourselves not to be polluters.

The correct answer is B. The problem of pollution is better understood in terms of a failure of the price system rather than a defect in people’s moral fibre. In some instances, markets fail to provide adequate information to decision makers and as a consequence they fail to take into account some undesirable effects of their eco- nomic activity. In these cases the private cost of production is less than the total cost (including the social cost), and consumers respond by consuming too much of the goods in question because they are not paying their full cost. In order to reduce pollution, we must either reduce the external effects by consuming less of the goods whose production creates the pollution or we must use other resources to offset the external effects (e.g. anti-smog devices on cars). Either way, to obtain a pollution- reduced environment will require paying the cost of having less of other things.

2

Let pg denote public good. Which of the following explains why the marginal equivalency conditions do not hold without collective action to determine which public goods should be produced and who should pay for them?

A. MCpg <> MC_any_other_good

B. MUpg/Ppg <> MU_any_other_good/P_any_other_good

C. MUpg > MU_any_other_good

D. MUpg < MU_any_other_good

The correct answer is B. For households who enjoy public goods but do not pay for them MUpg/Ppg > MU/p of any other good. The actual MCs could be equal and the MUpgcould be > or < the MU of any other good. Thus A, C and D are wrong.

3

Which of the following is correct? If a paper mill pollutes a stream so that it cannot be used for downstream city water
without expensive treatment, the effect of the economic distortion involved is most likely to be

A. unemployment in the paper industry.

B. a transfer of income from paper users to the owners of the paper mill.

C. too few resources devoted to paper production.

D. a transfer of income from city taxpayers to paper users.

The correct answer is D. The paper mill, in polluting the river, is not taking into account the extra costs incurred by society, i.e. the pollution, in the production of paper. Thus the cost of paper will not reflect the true cost of production, and this means that paper users are being subsidised by other members of society – in this case the city taxpayers.

3

To which of the following does the free rider problem refer?

It refers to someone
A. riding on a subway without paying
B. flying in an aeroplane with a standby fare
C. enjoying a service without having to pay for it
D. receiving a gift from the individual who purchased it

The correct answer is C. This is a definitional question. A public good, when produced, can be enjoyed by anyone without denying others. Those who do enjoy such a good or service but do not contribute to the cost of its production are known as free riders.

3

A public good has two characteristics
I. excludability
II. rivalry

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

The correct answer is D. Excludability means if you buy an item other people cannot have that specific item. Rivalry means that your buying some of a good leaves less for other consumers. Excludability and rivalry are characteristics of private goods. Public goods have the opposite characteristics. Your consuming a good does not exclude others and does not diminish the amount available for others, e.g. a lighthouse’s light. Thus I and II are wrong.

3

The local council decides there was little point in collecting tolls on the four lane motorway bridge across the river between 22.00 and 6.00 hours because the toll fares collected did not come close to paying the toll collector’s wages. ‘There’s just no traffic during these hours and the marginal cost of having a toll collector greatly exceeds any toll revenue collected’ argued the council treasurer. ‘Just because toll revenue is very high during the day is no reason to squander resources at night.’

Which of the following is the most accurate description of the bridge over the river?

A. A private good between 22.00 and 6.00; a public good between 6.00 and 22.00
B. A public good between 22.00 and 6.00; a private good between 6.00 and 22.00
C. A public good between 22.00 and 6.00; a public good between 6.00 and 22.00
D. A private good between 22.00 and 6.00; a private good between 6.00 and 22.00

The correct answer is B. When the bridge is empty/non congested it is a public good. Its use by any motorist does not deny any other motorist and is freely available to all. Thus between 22.00 and 6.00 the bridge is a public good. Between 6.00 and 22.00 the bridge is widely used and when it becomes congested assumes the characteristics of a private good, i.e. rivalry and excludability.

3

Consider the marginal equivalency condition (MEC) MUa/MCa = MUb/MCb. For the MEC to prevail 

I. the MCs must be societal MCs
II. the MUs must be private MUs

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

The correct answer is A. For MEC to prevail the last dollar’s worth of resources in any given industry must yield the same societal utility as the last dollar’s worth of resources in all other industries. Thus II is wrong. The cost of the resources must reflect all relevant costs, i.e. societal costs. Thus I is correct.

4

Example fo when Mua/Mca = MUb/MCb  des not hold rue?

  • For economic efficiency: Mua/Mca = MUb/MCb
  • The MU and MCs above are societal and so if externalities exist in activity A then Mua/Mca may be understated and so Mua/Mca = MUb/MCb may not hold i.e. not economic efficiency

5

A firm producing commodity X dumps waste in the local river, causing pollution and killing all salmon and trout. Does the pattern of river utilisation constitute an economi-
cal use of resources? Which of the following is correct?

A. No, because rivers should be preserved for fishing.
B. No, because the firm does not take into account all the costs of using the river for dumping of waste.
C. Yes, if more consumers buy X than buy fish.
D. Yes, if X can be produced more cheaply by using the river to dispose of the
firm’s waste.

The correct answer is B. The river is a source of only two benefits: waste disposal and commercial fish. The greater the amount of waste deposited in the river, the greater the number of fish killed and consequently the smaller the commercial fishing catch. Because the benefits and costs to society from both activities – dumping waste and fishing commercially – are not enumerated, we do not know the best mix of these two uses of the river. What we do know is that the chemical producer, in deciding to dump wastes into the river, is considering the private cost of waste disposal (the cost to himself) but not the social cost. He ignores the cost that his actions impose on the commercial fishermen, and as a result the marginal social benefit from this waste disposal is less than the marginal social cost. This implies that efficiency would be increased if less waste were dumped into the river and more fish caught, even though it would mean higher-priced chemicals.

6

In order to establish economic efficiency in the presence of pollution, which of the following should a society do? It should

A. make pollution illegal.

B. impose a general income tax to pay for rectifying the effects of pollution.

C. impose a tax on polluters equal to the value of the damage they cause.

D. impose a tax on polluters high enough to get them to stop it.

The correct answer is C

For efficiency to prevail in an economy, prices of goods must reflect their marginal cost to society. When pollution occurs, the firms responsible ignore the additional costs to society of the pollution; they are con-cerned only with the costs directly incurred by them, e.g. labour, materials, etc. The idea of a tax on polluters is to force them to pay the full societal costs, i.e. their direct costs plus the cost of pollution. Put another way, the imposed tax should equal total costs (social costs) minus private costs.

7

When we argued that a competitive market economy would tend to be economi-cally efficient, there were two underlying assumptions that were never stated explicitly; they are:

  • We assumed, first, that whenever a firm produced a good or service it would have to pay all the costs of production; that seems to be quite a reasonable assumption
  • Second, we assumed that if a household wanted a good or service it would have to pay for it – remember our households voting with their dollar bills so as to indicate to firms their preferences for different goods and services. That also appeared to be quite a reasonable assumption

7

Definition of public good?

• A public good is one for which each unit is consumed by everyone and no-one is excluded e.g. national defence

8

The MEC exist in an economy and a new good x appears in the market in which external benefits exist in the consumption of x.

To re-establish the MEC what would be required?

A. A tax should be levied on the individuals who receive the external benefit but do nothing for it.

B. The price of x should be revised by means of a tax so that MUx/Px = MUa/Pa = MUb/Pb = ...

C. A subsidy should be paid to firms producing x

D. The price of x should be lowered by means of a price ceiling to increase consumption of x and lower its marginal utility

The correct answer is C. A subsidy would lower firms’ marginal costs and shift the industry supply curve to the right causing price to decrease and quantity consumed to increase.

9

A method of regulation imposed on firms that do not account for external costs in their decisions

  • per unit tax
  • Such a tax would add to each producer’s profit-maximising price
  • Conversely, a subsidy paid to producers who generate external benefits by their decisions would have the effect of lowering each producer’s marginal cost.

10

Every economic decision involves

 costs and benefits

11

Two important characteristics of private goods are:

- excludability: buying a beer automatically excludes anyone else from purchasing that exact beer
- rivalry: buying that beer leaves less beer for other to enjoy

12

A paper mill situated on the bank of a river dumps its used chemicals in the river. For a one mile stretch down river an unpleasant smell exists; as a result this stretch of the river is not used for fishing much to the annoy-ance of the local population.

If the paper mill were to purchase the fishing rights on the mile of river downstream which of the following would occur?

A. The paper mill would stop polluting the river
B. The externality would be internalised
C. The paper mill would have no incentive to stop polluting the river
D. The number of fish caught in the river would increase

The correct answer is B. By owning the fishing rights the paper mill would take into account the cost of polluting the river which previously it had ignored. Why? Because the pollution affects the fish catch which is now owned by the paper mill. The costs of pollution are now borne by the mill; the externality has been internalised. The paper mill may stop polluting the river and cause more fish to be caught but that is not guaranteed; it would depend on marginal benefits and marginal costs as would the incentive to stop polluting. Thus there is no guarantee that A or C or D is true.

13

A paper mill situated on the bank of a river dumps its used chemicals in the river. For a one mile stretch down river an unpleasant smell exists; as a result this stretch of the river is not used for fishing much to the annoy-ance of the local population.

Why will the MEC not hold in the presence of the paper mill?

A. The marginal utility of paper will exceed the marginal utility of other goods
B. The marginal utility of paper will be less than the marginal utility of other goods
C. The price of paper will be less than societal marginal cost of production
D. The price of paper will be greater than societal marginal cost of production

The correct answer is C. The MEC are made up of two parts utility maximising behaviour of households and profit maximising behaviour of firms. For the latter in equilibrium, price = societal marginal cost. In the paper mill case the firm is using private marginal cost which is less than societal marginal cost.

14

There are two principal reasons why we as a society do not rely on market forces completely in determining the allocation of scarce resources; what are they?

  • The first is to help achieve economic
    efficiency
  • The second is to alter the distribution of goods and services to house-
    holds

15

Suppose all consumers, voting independently and honestly, indicated the maximum amount that they would be willing to pay for public good Y, and that this amount was
the same for each. If each consumer contributed this amount, all of which was devoted to producing this good, then, in terms of economic efficiency which of the following
would happen?

A. Too much of Y would be produced.
B. Too little of Y would be produced.
C. Just the right amount of Y would be produced.
D. Without more information, you cannot tell whether too much, too little or just the right amount would be produced.

The correct answer is A. Each consumer, in voting honestly, would indicate how much of good Y that consumer wished. But by its nature other people could enjoy the public good purchased by the consumer, who in turn would enjoy more of the same good purchased by all other consumers voting honestly and independently. For instance, then, each consumer might vote for his own policeman and society would finish up with far too many policemen.

16

Without collective action there is likely to be under provision of public goods because

I. a non contributing individual can enjoy a public good if someone else provides it
II. a purchaser of a public good cannot deny access to those who refuse to contribute to its purchase
III. each public good requires more resources than any single individual owns

Which of the following is correct?

A. I only
B. I and II only
C. III only
D. I, II and III

The correct answer is B. A free rider is someone who enjoys a good without having to pay for it. If I would like illumination in my street I can enjoy it if my neighbours install a street light; I delay purchase hoping a neighbour will install a light. Thus I is true. I am unwilling to install a light because there is no way I can force my neighbours to contribute to the cost. Thus II is true. I could certainly afford to install a street light; households install security systems that allow close neighbours to be free riders. Thus III is wrong.

18

In maximizing utility, each individual will ignore ___________

externalities

19

Definition of private good?

A private good is one for which each unit is consumed by only one individual or household

20

The MEC exist in an economy and a new good x appears in the market in which external benefits exist in the consumption of x.

Which of the following indicates this situation if MUx represents societal benefits?

A. MUx > MU of any other good
B. MUx/ Px > MU/p of any other good
of any other good
C. Px > P of any other good
D. MUx/ Px < MU/p of any other good

The correct answer is B. When the MEC exist for all goods initially then MUa/Pa = MUb/ Pb = ... (choosing any two goods a and b).

When good x is marketed consumers who purchase x will maximise utility when MUx/Px = Mua/Pa = ...

Since MUx reflects societal marginal utility the MUxsociatel MUxsocietal>MUxprivate and therefore MUx/Px will be greater than MU/p of any good.

21

When the costs that firms actually do pay differ from total production costs and when some households can consume goods and services without having to pay for them, a competitive market economy will tend not... 

...to allocate resources efficiently.

22

In some cases, individuals not directly involved in the activity receive benefit – these are known as _________________

external benefits or positive externalities

23

The government announced a national motorway floodlighting programme in an attempt to reduce road accidents. The programme will be financed out of additional income taxes levied in such a way that the income distribution after the new tax is imposed will be the same as it is now, i.e. before the tax is imposed.
Which of the following is correct?

The implication of the government proposal to finance the motorway floodlight is

A. every household will pay an equal amount of new tax
B. every household will pay the same proportion of its income in the new tax
C. every poor household will pay relatively more of its income in the new tax
D. every rich household will pay relatively more of its income in the new tax

The correct answer is B. Consider only two households, one rich with an income of 100, one poor with an income of 10; the ratio of rich/poor being 100/10 or 10/1. Impose a tax of 10% of each household’s income in tax, i.e. taking 10 in taxes from the rich and 1 in taxes from the poor. The after tax incomes are now 90 and 9, the ratio 90/9 or 10/1, i.e. unaltered. Thus the tax scheme which would leave the income distribution unaltered would be an equal proportion of income tax.

24

An example fo external costs or negative externalities is ______? 

pollution

25

The local council has decided to create a wilderness area of hundreds of acres of beach and woodland and create walkways, paths and recreational areas. Local residents only will have access to this park which is enormous for such a small community.

To achieve economic efficiency who should pay for the creation of the park and the annual cost of its upkeep?

A. The community for the creation costs, users for the upkeep costs
B. The community for the creation costs, community for the upkeep costs
C. The users for the creation costs, users for the upkeep costs
D. The issue of who pays is an equity not an economic efficiency issue

The correct answer is D. The park is obviously a public good; the use by any individual does not deny use by other members of the community. Upkeep costs can be assumed to be independent of use. Once it has been decided to create the park the issue of who pays for the park and its upkeep involves considerations of equity not efficiency.

26

The local council has decided to create a wilderness area of hundreds of acres of beach and woodland and create walkways, paths and recreational areas. Local residents only will have access to this park which is enormous for such a small community.

The council, besides providing the wilderness area (W), is responsible for the local police force (P), junior schools (JS), highway maintenance (H) and garbage collection (G). The council has accurate measures of the marginal social benefit (MSB) and marginal social cost (MSC) of each of its spending programmes. The council will be providing the optimum level of provision of each of these services when

A. MSBW = MSBP = MSBJS = MSBH = MSBG
B. MSCW = MSCP = MSCJS = MSCH = MSCG
C. MSB = MSC for all public goods
D MSBw/MSCw = MSBp/MSCp = MSBjs/MSCjs = MSBh/MSCh = MSBg/MSCg      

he correct answer is D. To achieve economic efficiency in the provision of public sector services, the last dollar spent on each (MSC) must yield the same marginal social benefit (MSB), i.e. MSBw/MSCw must equal MSBp/MSCp = ... = MSBg/MSCg. Thus D is the correct answer.

27

Economic criteria can determine the most efficient amounts of public goods, but they cannot determine the __________  – this involves considerations of equity rath than efficiency

optimal income distribution

28

Which of the following is the main idea behind imposing tax on pollution? It is

A. to hurt the polluter where it really counts – in the wallet.

B. to raise money for government treatment of the effects of pollution.

C. to raise money for pollution control research.

D. to make polluters pay the social cost of their operations.

The correct answer is D. For efficiency to prevail in an economy, prices of goods must reflect their marginal cost to society. When pollution occurs, the firms responsible ignore the additional costs to society of the pollution; they are con-cerned only with the costs directly incurred by them, e.g. labour, materials, etc. The idea of a tax on polluters is to force them to pay the full societal costs, i.e. their direct costs plus the cost of pollution. Put another way, the imposed tax should equal total costs (social costs) minus private costs.

29

When externalities exist, market prices will not lead to the ________ of resources because of the divergence between ________

efficient allocation;

social and private costs and benefits

29

Which of the following is correct?

The paradox of voting is concerned with

A. an individual being unable to choose among goods x, y and z
B. x being preferred to y, y being preferred to z and z being preferred to x
C. societies being unable to decide on the voting methods to select governments
D. the fact that in an election in which there is a large number of voters a single vote does not count

The correct answer is B. This is a definitional question. Pair wise voting can indicate that for a society even if x is preferred to y and y is preferred to z, z may still be preferred to x.

31

To achieve economic efficiency in the presence
of externalities, there is a need for ________ on the part of individuals in a society.

This is a ‘legitimate’ reason for a government (the people collectively) to interfere in a ________ 

collective action; market economy

32

A paper mill situated on the bank of a river dumps its used chemicals in the river. For a one mile stretch down river an unpleasant smell exists; as a result this stretch of the river is not used for fishing much to the annoy-ance of the local population.

Which of the following actions by local government would re-establish the MEC?

A. Raising the price of paper/paper products
B. Lowering the price of paper/paper products
C. Subsidising fishermen
D. Imposing a tax on the paper mill

The correct answer is D. Because the paper mill’s marginal cost of producing paper/paper products is lower than societal cost a tax imposed on the paper mill equivalent to the difference in costs would force the firm to utilise societal marginal cost the only action of the four noted to re-establish MEC.

34

Explain the effect of tax on a firms supply curve

A tax would shift the firms supply curve to the left, a subsidy to the right and the externalities would be taken into account and economic efficiency would prevail

For example:

  • If each firm were forced to pay a per unit tax that reflected the external costs of
    pollution that were ignored in each firm’s private production decision, the industry supply curve would shift to the left
  • Conversely, if the industry provided external benefits that were not accounted for, a subsidy would have the effect of lowering each firm’s marginal cost curve and thereby of shifting the industry supply curve to the right

35

Many goods are neither private goods nor pure public goods. Consider, for ex-ample, a motorway: Give reasons.

If relatively few cars use the motorway, it is a public good.

Your using it does not stop anyone else from using it (non-rivalry) and once the motor-way is built, assuming no tolls, it is available for all (non-excludability).

However, when the motorway becomes congested, it takes on the characteristics of a private good: each additional car reduces the quality of services from the motorway for
everyone else.

36

A paper mill situated on the bank of a river dumps its used chemicals in the river. For a one mile stretch down river an unpleasant smell exists; as a result this stretch of the river is not used for fishing much to the annoy-ance of the local population.

If the fishermen owned the property/fishing rights on the river and enforced these rights legally this could solve the paper mill pollution problem because the fishermen could sue the paper mill

I. for an amount equivalent to the value of the fish foregone and/or pleasure of fishing and

II. the amount sued for being equal to societal costs of producing paper/paper products

Which of the following is correct?

A. I only
B. II only
C. Both I and II
D. Neither I nor II

The correct answer is A. A negative externality exists because the paper mill ignores the societal cost of producing paper by concerning itself only with private costs, i.e. it ignores the value of the fishing foregone because of the pollution. This value should equal the amount being sued for and will be the difference between societal and private costs. Thus I is true and II is wrong.

38

What is a "free rider"?

A ‘free rider’ is someone who consumes a good without having to pay for it

39

Usually govts finance public goods according to the ability rather than...

... according to who benefits – proportional taxation is used

40

In arguing that a competitive market economy tends to be economically efficient it is assumed that
I. in producing a good the firm in question pays all costs of production
II. to consume a good the household in question would have to pay for it
III. each household earns sufficient income to be able to bid for the goods and services necessary to sustain a reasonable living standard

Which of the following is correct?
A. I only
B. I and II only
C. II only
D. I, II and III

The correct answer is B.

The marginal equivalency conditions (MEC) assume utility maximising households allocating their incomes so that

MUa/Pa = MUb/Pb = MUn/Pn

and profit maximising firms producing, in equilibrium, output so that Pa = MCa, Pb = MCb and Pn = MCn.

Consumers are assumed to pay for the goods and services they consume and the costs of production borne by firms reflect resource inputs/costs. Thus I and II are true.

Economic efficiency implies nothing about the income distribution in an economy. The MEC could be achieved even if a proportion of the population were starving. Thus III is wrong.

41

When external costs or benefits are brought within the scope of a single organisation, the externali-
ties are ________.

internalised;

If an organisation that generates external costs or benefits and the bearers of those costs or benefits were to merge into a single organisation, the full costs or benefits of the organisation’s activities would be taken into account

Example:

Suppose a nightclub and a college bookshop were to be situated directly facing each other across a narrow street. The nightclub has a reputation for its exceptionally noisy
atmosphere, which is the main attraction for most of its customers; in contrast, the bookshop requires a peaceful atmosphere in which students can concentrate on selecting books. Suppose also that, in response to the gradual increase in the noise level emanating from the nightclub over time, the owner of the bookshop is considering

installing various kinds of soundproofing equipment – the more expensive, the greater the degree of soundproofing achieved. As things stand, the cost of the service provided by the nightclub does not take into account the external cost imposed on the bookshop; if, however, the nightclub were to merge with the bookshop and form a single organisa- tion providing two different services on opposite sides of the street, the external cost
associated with the noise level would be internalised. The organisation would now have to take these costs into account in making decisions about both operations. Clearly, the marginal benefits gained by increasing the noise level in the nightclub (i.e. extra revenue from customers) would then be set against the marginal costs of providing various standards of soundproofing equipment

42

Which of the following do economists mean by the statement that pollution is fundamentally due to ‘externalities’?

They mean that

A. people regard pollution as something ‘external’ to them.
B. individual actions have effects on other persons that are not taken into account
by the decision maker.
C. pollution is fundamentally an issue that is external to economics.
D. pollution involves our external environment.

The correct answer is B. An externality exists when one person’s (creature’s) actions have a positive effect (bees pollinating fruit) or negative effect (firms polluting
rivers) on other members of society. When pollution occurs, the polluters ignore the extra cost that their actions impose on other people. If people were indifferent as to whether or not streams and rivers were polluted, there would be no externality (and incidentally, by definition, no pollution).

43

‘Public goods’ are usually not produced privately and sold in the marketplace because

I. they are so expensive that only the richest buyers could afford them.
II. they are needed only by the poor, who cannot afford them.
III. if they are supplied to one buyer, they are automatically made available to non-
buyers as well.

Which of the following is correct?

A. I only.
B. II only.
C. III only.
D. I, II and III.

The correct answer is C. The disincentives facing an individual contemplating the purchase of a public good is that if anyone else buys it, the individual can enjoy it
without having to pay for it and, vice versa, if an individual buys it that individual cannot prevent other people from enjoying it without paying for it. An example is national defence. This logic applies to both rich and poor.

44

The difference between each method of deciding who pays is one of... 

...income distribution.

46

In assessing whether it is providing an economically efficient level of each type of good and service, a government would have to compare the marginal social benefits of each program with it marginal social costs, only when...

MSBdefense = MSBhealth = ….
MSCdefense    MSCdefense

will the optimum level of provision be obtained
 

47

A paper mill situated on the bank of a river dumps its used chemicals in the river. For a one mile stretch down river an unpleasant smell exists; as a result this stretch of the river is not used for fishing much to the annoy-ance of the local population.

The activities of the paper mill cause an inefficient allocation of resources because
I. the price of paper/paper products for the mill will not reflect societal costs
II. the price of paper/paper products for the mill will not reflect private costs

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

The correct answer is A. In producing paper/paper products the mill will take into account only the costs it incurs in producing paper, i.e. private costs. By ignoring the pollution costs – the gap between societal and private costs – the mill is not taking all costs into account in its operations. Thus I is true and II is wrong.

48

‘European pollution primarily from its heavy industries has blighted much Scandinavian forestry and impoverished significant stretches of agriculture and woodlands. Practical difficulties prevent economic efficiency being achieved via property rights.’

The practical difficulties include:
I. identifying and assessing sources of pollution
II. identifying all parties affected by the pollution
III. transaction costs in bringing together all relevant parties

Which of the following is correct?
A. I only
B. I and II only
C. III only
D. I, II and III

The correct answer is D. When a single source of pollution, e.g. sole factory in a town exists and the damage to crops of the local farmer can be assessed, property rights guaranteeing compensation for damage can resolve the pollution problem. As Coase points out the efficient solution can be achieved without resort to local courts. I, II and III identify some of the real world practical difficulties in the European/Scandinavian example.

50

Which of the following is correct? If a special tax were to be imposed on a polluter to ‘internalise the externality’ of his
activities (i.e. the tax would equal the difference between private and social cost), the tax should be

A. equal to the social cost of his activity.
B. equal to the private cost of his activity.
C. equal to private plus social cost of his activity.
D. equal to the social minus private cost of his activity.

The correct answer is D

For efficiency to prevail in an economy, prices of goods must reflect their marginal cost to society. When pollution occurs, the firms responsible ignore the additional costs to society of the pollution; they are con-cerned only with the costs directly incurred by them, e.g. labour, materials, etc. The idea of a tax on polluters is to force them to pay the full societal costs, i.e. their direct costs plus the cost of pollution. Put another way, the imposed tax should equal total costs (social costs) minus private costs.

51

A paper mill situated on the bank of a river dumps its used chemicals in the river. For a one mile stretch down river an unpleasant smell exists; as a result this stretch of the river is not used for fishing much to the annoy-ance of the local population.

The imposition of a tax on the paper mill could lead to the MEC being re-established because
I. output would be reduced and price would increase
II. fewer resources would be employed in the paper industry

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

The correct answer is C. Because the paper mill considers only private costs the prices of paper/paper products understate their societal costs and as a result too much paper and too many paper products are being produced at too low prices and too many resources are being employed in the paper industry. The imposition of the appropriate tax is equivalent to the firm paying societal costs. Average costs will increase, the supply curve shift to the left, prices will rise, less paper will be produced and fewer resources deployed in the paper industry. Thus both I and II are true.

52

The optimum provision of any public good or service occurs when the marginal social cost of production equals the...

...marginal social benefit obtained.

53

For many activities, the social cost/benefits equals the _________

private cost/benefit