Week 12 - Externalities and Public goods

Question 1

What is a negative externality?

Answer 1

A negative externality is a cost of an activity that falls on people other than those who pursue the activity.

Question 2

What is a positive externality?

Answer 2

A positive externality is a benefit of an activity received by people other than those who pursue the activity.

Question 3

Why do people tend to make decisions based on private costs and benefits?

Answer 3

People tend to make decisions based on the costs they actually incur and the benefits they actually receive (private costs/benefits).

Question 4

What happens when there is a positive externality in terms of decision-making?

Answer 4

An activity will be undertaken at a level less than what is socially optimal

Question 5

What happens when there is a negative externality in terms of decision-making?

Answer 5

An activity will be undertaken at a level greater than what is socially optimal.

Question 6

In the COVID vaccine example, if the monetary benefit to a self-interested person is £100 and the additional benefit to society is also £100, but the cost of the vaccine is £150, will the person purchase the vaccine?

Answer 6

The person will not purchase the vaccine because their private benefit (£100) is less than the cost (£150), even though it would be socially optimal for them to get vaccinated, as the total social benefit exceeds the cost.

Question 7

What is the result when a market has no external costs or benefits?

Answer 7

The resulting equilibrium quantity and price are socially optimal.

Question 8

What do the private marginal cost (MC) and demand (also marginal benefit, MB) curves represent?

Answer 8

The private MC and demand curves represent the private costs and benefits in the market, without considering externalities.

Question 9

What happens when there are no externalities in the market in terms of equilibrium?

Answer 9

The market reaches an equilibrium quantity and price where the private MC and demand (MB) curves intersect, and this outcome is socially optimal.

Question 10

What happens when the production of a good has an external cost?

Answer 10

The market equilibrium price is too low, and the market equilibrium quantity is too high.

Question 11

What is the equation for Social Marginal Cost (Social MC) when external costs (XC) are present?

Answer 11

Social MC = Private MC + XC, where XC represents the external cost per unit

Question 12

What is the socially optimal level of production in terms of marginal social benefit (MSB) and marginal social cost (MSC)?

Answer 12

The socially optimal level of a good occurs when the marginal social benefit (MSB) equals the marginal social cost (MSC).

Question 13

What is deadweight loss?

Answer 13

Deadweight loss is the loss of total surplus (consumer and producer surplus) that occurs when a market is not in equilibrium, typically due to externalities or market distortions like taxes or subsidies.

Question 14

How does deadweight loss relate to externalities?

Answer 14

When externalities are present, the market produces either too much (in the case of negative externalities) or too little (in the case of positive externalities) of a good, leading to deadweight loss as the quantity produced is not socially optimal.

Question 15

How is deadweight loss represented in a graph with externalities?

Answer 15

Deadweight loss is represented by the area between the supply curve (or private MC curve) and the demand curve (or MB curve) at the quantity produced in the market, where the socially optimal quantity is not being reached.

Question 16

How does deadweight loss occur in the case of a negative externality?

Answer 16

In the presence of a negative externality (like pollution), the market produces more than the socially optimal quantity, causing an overproduction of the good and resulting in deadweight loss.

Question 17

How does deadweight loss occur in the case of a positive externality?

Answer 17

In the presence of a positive externality (like vaccination), the market produces less than the socially optimal quantity, leading to underproduction and deadweight loss.

Question 18

What is the socially optimal quantity in the context of externalities?

Answer 18

The socially optimal quantity is the level of output where marginal social benefit equals marginal social cost, maximising total welfare and eliminating deadweight loss.

Question 19

What happens when externalities are present in a market?

Answer 19

The market outcome may be inefficient, resulting in either overproduction or underproduction of a good relative to the socially optimal level.

Question 20

What is the equilibrium price and quantity when there are no externalities?

Answer 20

The market equilibrium quantity is Q_PVT, and the equilibrium price is P_PVT. This is the socially optimal outcome in the absence of external costs or benefits.

Question 21

What is the relationship between the market equilibrium quantity and the socially optimal quantity when there are externalities?

Answer 21

When externalities are present, the market equilibrium quantity Q_PVT is smaller than the socially optimal quantity Q_SOC because individual buyers only account for the benefits they personally reap.

Question 22

How is social demand different from private demand?

Answer 22

Social demand is the private demand plus the external benefit X_B (for positive externalities), reflecting the total benefit to society.

Question 23

What condition should hold for the socially optimal level of a good?

Answer 23

The socially optimal level of a good should occur where the marginal social benefit (MSB) equals the marginal social cost (MSC).

Question 24

In a graph with externalities, how is the socially optimal quantity (QSOC) determined?

Answer 24

The socially optimal quantity Q_SOC is where the marginal social benefit curve intersects the marginal social cost curve, which considers both private and external costs/benefits.

Question 25

What is the Coase Theorem?

Answer 25

The Coase Theorem suggests that, under certain conditions, people can arrive at efficient solutions to the problems caused by externalities through bargaining, without government intervention.

Question 26

1. In the example of Zoe (factory owner) and Ian (fisherman), what happens if Zoe dumps toxic waste into the river without a filter? 2. What happens if Zoe installs a filter to prevent the toxic waste from being dumped into the river? 3. In the case where Zoe and Ian can communicate, is there a way for both to benefit? 4. What happens if Zoe and Ian cannot communicate? 5. How can the problem of externalities be solved through the Coase Theorem in this example?

Answer 26

1. Zoe earns £130/day, and Ian earns £50/day, but Ian is negatively affected by the pollution. 2. Zoe earns £100/day (due to the cost of the filter), and Ian earns £100/day (since his fishing is no longer impacted by the pollution). 3. Yes, Ian can offer Zoe £40/day to install the filter. After this arrangement, Zoe earns £130/day and Ian earns £100/day, both benefiting from the agreement. 4. Zoe will not install the filter because the cost (£100/day) outweighs her benefit (£130/day). Ian, however, would want the filter installed, as it would increase his earnings from £50/day to £100/day. 5. If transaction costs are low, Ian can offer Zoe £40/day to install the filter. This would compensate Zoe for the cost and address Ian's concern, solving the externality problem.

Question 27

What is the central idea of the Coase Theorem?

Answer 27

The Coase Theorem states that if contracting is possible at no cost (i.e., no transaction costs), people can always arrive at efficient solutions to the problems caused by externalities.

Question 28

Who is Ronald Coase, and what is his contribution to economics?

Answer 28

Ronald Coase was a British economist who won the Nobel Prize in 1991 for his observation that efficient solutions to externalities can be achieved through bargaining when transaction costs are zero.

Question 29

Under the Coase Theorem, what condition must hold for individuals to reach an efficient solution to externalities?

Answer 29

Contracting must be possible without any costs (i.e., no transaction costs), allowing parties to negotiate and internalise the externality.

Question 30

How does the Coase Theorem differ from traditional government intervention in externalities?

Answer 30

The Coase Theorem suggests that private bargaining, without government intervention, can solve externalities efficiently, provided there are no transaction costs.

Question 31

In the Coase Theorem, what role do property rights play?

Answer 31

Property rights determine who has the authority to allow or prevent externalities, and this shapes the direction of negotiation, but the efficient outcome can still be achieved if bargaining is costless.

Question 32

1. In the example where Ian owns the river, what is Zoe’s default option? 2. Can Zoe and Ian still reach an efficient outcome if Zoe values not using the filter by more than £30/day and Ian values clean water by more than £30/day?

Answer 32

1. Zoe must install a filter unless Ian grants her permission to pollute the river. 2. Yes. Zoe could pay Ian (e.g., £40/day) to allow her to operate without a filter, compensating him for the pollution, achieving efficiency.

Question 33

What is a key practical limitation of the Coase Theorem?

Answer 33

It assumes costless negotiations, which is rarely true in real life due to legal, informational, and coordination costs.

Question 34

What can governments do when negotiation is costly or impractical?

Answer 34

They can use legal remedies such as taxes (e.g., carbon tax), subsidies (e.g., for vaccines), or regulations to align private incentives with social welfare.

Question 35

What is the policy goal of taxes and subsidies in correcting externalities?

Answer 35

To internalise the externality—making private decision-makers bear the full social cost or benefit of their actions.

Question 36

What is a private good?

Answer 36

A private good is both excludable and rivalrous—its use by one person reduces availability for others, and people can be prevented from using it.

Question 37

What does excludability mean in economics?

Answer 37

Excludability means a person can be prevented from using a good, usually through pricing or ownership rights.

Question 38

What does rivalry in consumption mean?

Answer 38

Rivalry means that one person’s use of a good reduces its availability for others.

Question 39

Why is a mobile phone considered a private good?

Answer 39

It’s excludable (you can stop others from using it) and rivalrous (your use prevents others from using it at the same time).

Question 40

What are the two properties used to classify types of goods in economics?

Answer 40

Excludability and Rivalry in consumption.

Question 41

What are the four types of goods based on excludability and rivalry?

Answer 41

Private Goods – Rivalrous and Excludable Common Goods (Common Resources) – Rivalrous and Non-Excludable Club Goods (Collective Goods) – Non-Rivalrous and Excludable Public Goods – Non-Rivalrous and Non-Excludable

Question 42

Give an example of a private good.

Answer 42

A sandwich, a mobile phone — rivalrous and excludable.

Question 43

Give an example of a common good.

Answer 43

Fish in the ocean, public grazing land — rivalrous but non-excludable.

Question 44

Give an example of a club good.

Answer 44

Netflix subscription, private parks — excludable but non-rivalrous (up to a point).

Question 45

Give an example of a public good.

Answer 45

National defence, street lighting — non-rivalrous and non-excludable.

Question 46

What are common goods in economics?

Answer 46

Goods that are rivalrous but non-excludable, meaning anyone can use them, but one person’s use reduces availability for others.

Question 47

Give two examples of common goods.

Answer 47

Fish in the ocean and shared grazing land.

Question 48

What is the Tragedy of the Commons?

Answer 48

The tendency for common goods to be overused or depleted, because individuals act in their own self-interest rather than the collective good.

Question 49

Who first introduced the idea behind the Tragedy of the Commons?

Answer 49

William Forster Lloyd in 1833.

Question 50

Who popularized the term "Tragedy of the Commons"?

Answer 50

Garrett Hardin in a 1968 article.

Question 51

What key condition must exist for a Tragedy of the Commons to occur?

Answer 51

The resource must be open to all—non-excludable and subject to rivalrous use.

Question 52

Why does overuse occur in the commons even if it leads to long-term depletion?

Answer 52

Because each person faces only their private cost, which is lower than the full social cost, leading to overconsumption.

Question 52

In the Tragedy of the Commons, why is adding one more animal individually rational but socially harmful?

Answer 52

Because the marginal private benefit goes entirely to the individual, while the cost of overgrazing is shared among all users.

Question 53

What happens when land reaches grazing capacity in a commons scenario?

Answer 53

Both the private benefit of more grazing and the social cost of overgrazing occur, but the user only considers their own benefit and a fraction of the cost.

Question 54

What is the economic term for the benefit to the individual of adding one more cow?

Answer 54

Marginal Private Benefit (MPB).

Question 55

What is the term for the full cost to society of adding one more cow in a shared grazing area?

Answer 55

Marginal Social Cost (MSC).

Question 56

Why is the marginal private cost of adding another cow lower than the marginal social cost?

Answer 56

Because the negative effects of overgrazing are spread across all users, not just the individual making the decision.

Question 57

What are public goods?

Answer 57

Goods that are non-excludable and non-rivalrous in consumption.

Question 58

What does it mean for a good to be non-excludable?

Answer 58

Individuals cannot be prevented from using the good, even if they don’t pay for it.

Question 59

What does it mean for a good to be non-rivalrous?

Answer 59

One person’s use of the good does not reduce its availability for others.

Question 60

Give three examples of public goods.

Answer 60

National defence, basic scientific research, and flood control dams.

Question 61

What is the free-rider problem?

Answer 61

When people benefit from a public good without contributing to its cost, it reduces the incentive for others to provide or maintain it.

Question 62

Why might public goods be underprovided in a free market?

Answer 62

Because of non-excludability, individuals can free-ride, so there is less incentive for private provision.

Question 63

What is free-riding in the context of public goods?

Answer 63

When individuals benefit from a good without paying, relying on others to bear the cost.

Question 64

What happens if everyone free-rides on a public good?

Answer 64

The good is underprovided or not provided at all, leading to market failure.

Question 65

Why does free-riding cause market failure?

Answer 65

Because private markets lack incentives to supply goods from which they can’t exclude non-payers.

Question 66

Who often provides public goods due to the free-rider problem?

Answer 66

The public sector (government).

Question 67

Can private firms ever profitably provide public goods?

Answer 67

Yes—if they find indirect revenue models, like advertising in broadcast TV or radio.