Solutions and Activitiesfor CHAPTER 5 EXTERNALITIES: PROBLEMS AND SOLUTIONS Questions and Problems 1. Peterson, Hoffer, and Millner (1995) showed that air bag use has led to increases in car crashes. Despite this finding, the government mandates that new cars have airbags, rather than taxing their use. Is this policy a contradiction? For the sake of argument, let us assume that the paper showed beyond a reasonable doubt that air bag use leads to more car crashes. Then the natural conclusion to reach, based on the analysis in this chapter, is that air bag use should be taxed: accidents impose negative externalities (on the people in the car you crash into!). This suggests that the policy of mandating air bags is undesirable. However, there may be other effects that make this policy reasonable. For example, note that some people who get into accidents have no medical insurance, and these individuals impose negative externalities on hospitals, which are required to provide them with free care. These externalities may be reduced by air bags, if they mitigate injuries caused by accidents. More plausibly: if air bags reduce the cost of injury, they may reduce insurance premiums for everybody—not just for the person with air bags. This reduction is a positive externality from air bag use that may offset the negative externality noted in the paper. 2. When the state of Virginia imposed stricter regulations on air pollution in 2003, it also authorized an auction of pollution permits, allowing some plants to emit larger amounts of ozone-depleting chemicals than would otherwise be allowed, and some to emit less. Theory predicts that this auction will lead to a socially efficient allocation of pollution. Describe how this outcome would occur. Assuming that the given level of pollution permits was set correctly, an auction would lead to a socially efficient allocation of permits across firms. Firms that would benefit the most from having the right to pollute—say, because it would be very costly for them to produce without polluting—would be the most willing to pay for the right. Therefore, those firms would bid more at the auction and would receive the permits. Firms that find it easy to adopt less-polluting technologies in their production process would be less willing to pay for the right to pollute and therefore would not bid as much at the auction and would not receive as many permits. This means that the permits would be allocated to the firms that cannot easily reduce pollution, while the firms that could most easily reduce emissions would do so instead of buying permits and continuing to pollute. This is the socially efficient outcome: pollution would be reduced, and it would be reduced most by firms that could most cheaply reduce it. 3. Can an activity generate both positive and negative externalities at the same time? Explain your answer. Sometimes externalities are in the eye (or nose or ear) of the beholder. If you like the music your roommate plays, you can free ride when he or she is playing music, enjoying a 1 But if too many people drive by every night. The Coasian approach of assigning property rights and then allowing the affected parties to negotiate a solution can internalize an externality. The sponsor of the bill might offer his or her support for other bills in exchange for votes on this bill. could deter negotiation. 4. Why do you think this is true? When a state approves new polluting industries. more important reasons for them to locate their polluting industries on the eastern border of their state. It is unlikely that downwind states have figured out a way to make upwind states fully internalize their externalities. Sometimes a positive externality becomes too much of a good thing. For example. enforceable right to engage in an activity that generates an externality. States are therefore unlikely to fully take into account the costs they impose on other states by locating their polluting plants near their eastern borders. and the Twin Cities. On the other hand. however. though. some people construct elaborate displays that everyone can enjoy just by driving by them. If one party has a clear. then the injured party or parties have an incentive to pay the externality generator to stop or curtail the activity. Of course. or worse than direct government intervention? Explain your answers and describe one of the difficulties associated with this solution. During the holiday season. they will tend to take into account the pollution costs they would impose on themselves by locating their plants farther west. and when it is difficult to identify the source of the externality. there may be other. a person or firm that profits from generating the externality might be able to negotiate for the purchase of the right to operate. a manufacturing firm might easily pay off residents of a poor neighborhood to acquire the right to dispose of toxic materials. statestend to more easily approve new polluting industries near their eastern borders than in other parts of the state. better than. Chicago. which some people might regard as inequitable. or logrolling. so remaining un-decided . would experience a negative externality. Milwaukee. and they are therefore more likely to approve new polluting industries near their eastern borders. the holiday display creates a negative externality. Your other roommate. Similarly. traffic congestion becomes a problem for those living in the neighborhood: for them. Social norms or large power or wealth differentials. the sponsor may be willing to offer more to obtain the support needed to pass the bill.CHAPTER 5 / Externalities: Problems and Solutions -2- positive externality. 6. It may be that industrial plants tend to be located near such population (employment) centers. Suppose vote trading. when one of the affected parties engages in the “holdout” strategy. many members of Congress choose to remain “undecided” until the last moment. large cities in midwestern states tend to be located on the eastern borders of their states. This might be better than government intervention when the number of affected people is small and there are no barriers to negotiation. Hence. Possibly because of patterns of settlement (east to west). 5. Why might they do this? What lesson does this example teach about a potential shortcoming of the Coasian solution to the externality problem? Members of Congress who remain undecided until the last moment may be engaging in a form of the holdout strategy. it imposes an externality on neighboring “downwind” states. if the injured parties have a right to be free of an externality but also have an enforceable right to sell the freedom. the private cost of installing plants in the eastern part of the states will tend to be smaller than the private cost of installing plants in the western part. who hates that kind of music. In close congressional votes. Some other difficulties with this solution arise when there are too many affected parties to be able to negotiate a transaction. is occurring with respect to a piece of legislation. As the call for the vote approaches. where winds tend to blow from west to east. In the midwestern United States. Can government assignment and enforcement of property rights internalize an externality? Will this approach work as well as. examples include Detroit. Taxing consumption of a good that generates a negative externality—gasoline. If. 8.. each individual seller can delay settling to pressure the purchaser to increase the price. (Or. which suggests that people choose vehicles that are larger than is socially optimal.CHAPTER 5 / Externalities: Problems and Solutions -3- increases a Congress member’s negotiating strength. 7. which imposes an increasingly large cost on the residents of the town where it operates: the marginal external cost associated with the Qth unit of production is given by 6Q. then using a tax to curtail consumption will tend to cause smaller deadweight losses than quantity regulations. and death probabilities are increasing in the size of the vehicle you collide with. so the government should use taxation to correct the externality. The firm’s production process generates a toxic waste. In fact. Quantity restrictions may seem more equitable but may also be seen as violations of our freedoms. the marginal damage curve is very steep. Critically examine this argument using the concept of externalities. driving a smaller vehicle imposes positive externalities on other drivers. What it needs to think about in this case is whether it is likely to cause more deadweight loss by getting the tax rate a little wrong or by getting the regulated quantity of consumption a little wrong. death probabilities are decreasing in the size of the vehicle you are driving. on the other hand. There may also be a political component to these differences. When it is uncertain. . it will not be able to reach the socially optimal level of consumption anymore. it can easily compute the socially optimal level of consumption. Why do governments sometimes impose quantity regulations that limit the level of negative-externality-inducing consumption? Why do governments sometimes impose price regulations by taxing this consumption? If the government has perfect knowledge about the marginal benefits of consumption and the marginal damage caused by the externality. then it will instead want to use quantity regulations. passengers in the larger vehicle are significantly more likely to survive than are passengers in the smaller vehicle.e. In two-car automobile accidents. Suppose that a firm’s marginal production costs are given by MC = 10 + 3Q.) Individuals probably take their own safety into account when selecting an automobile but probably do not fully take into account these externalities. 9. about the exact marginal consumption benefits. So the marginal social cost of producing the 10th unit is 100. What is the marginal private cost associated with the 10th unit produced? What is the total marginal cost to society associated with producing the 10th unit (the marginal social cost of the 10th unit)? The marginal private cost is 10 + 3(10) = 40. Some politicians and lobbyists have argued that this provides a rationale for encouraging the sale of larger vehicles and discouraging legislation that would induce automobile manufacturers to make smaller cars. viewed from the other direction. The situation in which legislators fail to commit their votes until the final hour is analogous to the holdout problem that exists with Coasian solutions that involve several parties. If the purchaser of the right to impose an externality needs to strike a deal with many sellers. Suppose the government knows the entire curve of marginal damage caused by the externality at different levels of consumption. doesn’t depend strongly on the quantity of consumption). The evidence suggests that driving a larger vehicle imposes negative externalities on other drivers. The external cost associated with the 10th unit is 6(10) = 60. The correct conclusion is that intervening to encourage the sale of smaller vehicles (or to discourage the sale of larger vehicles) can improve welfare—just the opposite of the proposed argument. for example. for example—implies that wealthier individuals can purchase the right to generate the externality. It can implement this level either by a tax on consumption or by regulating the total amount of consumption. If it knows that this curve is relatively flat (i. or 288 = 10Q. In Oliviland. Therefore. A firm that purchases a patent or license is in some sense using a market mechanism to partially compensate the researching firm for its contribution to the knowledge base. The problem of secondhand smoke is unlikely to be solved by private markets. It would be virtually impossible to identify the beneficiaries of increased vaccination rates. In Oliviland. Private compensation for the reduced risk of exposure associated with vaccinations seems unlikely. b. For Linneland. Individual vaccinations generate positive consumption externalities by reducing the number of people in the population who have a communicable illness. However. The optimal level in Oliviland is equal to 28. the marginal benefit associated with pollution cleanup is MB = 200 – 4Q. i. or 188 = 4Q. The optimal level in Linneland is equal to 47. does it seem likely that private markets will arise that allow this externality to be internalized? Why or why not? i. Warrenia has two regions. Smoke is widely dispersed. it should be relatively easy for a firm which places a high value on the ability to produce toxic waste to compensate them in exchange for the right to pollute. the marginal benefit is 200 – 4Q. the value of smoking a single cigarette is likely to be small relative to the transaction costs of negotiating the solution. Advanced Questions 11. iv. and whether it is a consumption or production externality. the equation to solve for Oliviland is 300 – 10Q = 12. (ii) toxic waste production by firms. the marginal benefit associated with pollution cleanup is MB = 300 – 10Q. In addition. marginal cost is 12. Setting the benefit equal to 12 yields 200 – 4Q = 12. the marginal benefit is 300 – 10Q. Research and development by a high-tech firm generates positive production externalities when the results of that research expand the knowledge and productivity of all firms. making it difficult to account for and negotiate with every affected person. iii. ii. Toxic waste production by firms generates negative production externalities because the harm (or toxicity) is a by-product of the firm’s production. and (iv) individual vaccination against communicable illness. including references to whether it is positive or negative. (iii) research and development by a high-tech firm. Answer the following two questions for each of the following examples: (i) smoking by individuals. . a. ii. Is there an externality? If so. What is the optimal level of pollution cleanup in each of the two regions? The optimal level of cleanup will occur when the marginal benefit just equals the marginal cost. iii. If there is an externality. The problem of toxic waste might be amenable to a private market solution. Smoking by individuals generates negative consumption externalities by generating secondhand smoke. it is hard to completely restrict or contain the flow of information. the probability of catching the illness is reduced for everyone. It is unlikely that a private market for intellectual property could completely internalize this externality. If local residents have property rights to restrict toxic waste production. The generator can be easily identified. Suppose that the marginal cost of cleanup is constant at $12 per unit.CHAPTER 5 / Externalities: Problems and Solutions -4- 10.8. and a finite number of people in a localized town or community are likely to be affected. iv. describe it. When the number of infected people is reduced. while in Linneland. 67. so solve by setting damage averted equal to the marginal cost: 200 – 5Q = 10 + Q. a. To implement the social optimum of 312/3 units of pollution therefore requires a tax of 10 + 312/3 = 412/3. Then demand would be Q = 1. To answer this question. first calculate what the free market would do by setting demand equal to supply: 1. Setting a tax of T effectively increases the PMC by T per unit sold. Deadweight loss is the area of a triangle of height 8 and width 102/3: ½ (8 × 102/3) ≈ 42. 102/3 units less than provided by the free market.200 – 4P and supply is Q = –200 + 2P. How many more units of this product will the free market produce than is socially optimal? Calculate the deadweight loss associated with the externality. Suppose the $8 externality were added to the price each consumer had to pay. The marginal damage averted from pollution cleanup is MD = 200 – 5Q. the government decides to impose a tax of T per unit sold. 13. The marginal cost associated with pollution cleanup is MC = 10 + Q.200 – 4(P + 8). Solving for P.200 – 4(233. The new equilibrium quantity solves 360 – 4Q = 6Q + T. Suppose that demand for a product is Q = 1. Show that this level of pollution reduction could be accomplished through taxation. so QFree Market = 1. QSocial Opt = 256. the marginal external damage associated with this good’s production is MD = 2Q.200 – 944. P ≈ 233. Furthermore. 1.67. or P = 228. Setting Q = 30 and solving for T gives T = 60. 1. or Q* = 30. So the total amount of pollution cleanup for a given tax will solve: 10 + Q* = T. b. The private marginal benefit associated with a product’s consumption is PMB = 360 – 4Q and the private marginal cost associated with its production is PMC = 6Q.CHAPTER 5 / Externalities: Problems and Solutions -5- 12. To correct the externality. or 312/3.200 – 4P = –200 + 2P. 14.200 – 4(P + 8) = –200 + 2P. A tax of T = 60 will achieve the social optimum. the government will induce the polluters to clean it up as long as the marginal cost of cleanup is less than or equal to the tax. suppose that the marginal external damage of this product is $8 per unit. or 1. What tax per unit would generate the optimal amount of pollution reduction? By setting a tax T on each unit of pollution.33) ≈ 266. .33. What tax T should it set to achieve the social optimum? Find the social optimum by setting PMB = PMC + MD (= SMC): 360 – 4Q = 8Q. Furthermore. What is the optimal level of pollution reduction? Damage averted is the benefit. Solving for Q.400 = 6P. The socially optimal level occurs when the marginal external cost is included in the calculation.200 – 4(228 + 8) = 1. (3) require both firms to reduce pollution by the same amount but allow pollution permits to be bought and sold. it is 10 + 8Q = 400 – 4Q. the social optimum must solve MCA = MCB = MB. MCB) when QB = 27. setting MCB = MB. but firm B takes some pollution reduction steps for which the marginal cost exceeds marginal benefit. setting MCA = MCB and solving for QA in terms of QB gives QA = 2QB – 2.5 and QB = 20.e. 2. since it would be less costly for firm A to reduce pollution by more and for firm B to reduce pollution by less (since MCA < MCB at 27.5) + QB) This gives QB = 20. In the second interpretation. There are two ways of interpreting this question: the marginal benefit pollution reduction applies either to the overall level of pollution reduction (for the two firms combined) or to each firm separately. This is not socially efficient. Firm A’s marginal costs associated with pollution reduction are MC = 20 + 4Q.5. .75 units. we set MC = MB separately for each firm: For firm A.25 units). Requiring both firms to reduce pollution by 27. Under the second interpretation: 1. The same total reduction could be achieved by requiring each firm to reduce pollution by 28. This continues to be true as long as QA < 37.5. or 390 = 12Q. QB = 32.. For firm B.5. Firm B’s marginal costs associated with pollution reduction are MC = 10 + 8Q. A common tax could be used to achieve the social optimum.. Firm A stops reducing pollution before it has exhausted all reduction steps for which the marginal cost is less than the marginal benefit. The same level of pollution reduction could be achieved by requiring both firms to reduce pollution by 40 units.5. This would be less efficient than the social optimum. Two firms are ordered by the federal government to reduce their pollution levels. Setting a tax of 170 would lead firm A (respectively. Under the first interpretation: 1. or when 380 = 8Q. so both can gain by trading a unit of pollution permits. MC = MB when 20 + 4Q = 400 – 4Q.5 and QB > 20—so they will trade until QA = 37.CHAPTER 5 / Externalities: Problems and Solutions -6- 15. QA = 47. (2) charge a common tax per unit of pollution.25 units but allowing them to trade pollution permits can also be used to achieve the social optimum. MCB) is higher than the cost to firm A of reducing pollution by one unit (i. B) to reduce pollution to the point where MCA = 170 (respectively MCB = 170). The marginal benefit of pollution reduction is MB = 400 – 4Q. We offer answers for both. Next. What is the socially optimal level of each firm’s pollution reduction? In the first interpretation.e. Solving gives QA = 37.25 = QA. a. and therefore QA = 37. or 20 + 4 QA = 10 + 8 QB = 400 – 4 (QA + QB) We can solve in two steps.5 and QB = 20. Total reduction is 80 units. plug in for QA in terms of QB and solve for QB: 10 + 8QB = 400 – 4((2QB – 2. The value to firm B of being able to produce 1 more unit of pollution (i. First. Compare the social efficiency of three possible outcomes: (1) require both firms to reduce pollution by the same amount. b. 3. The federal government wants to reduce pollution levels. To measure total marginal costs. Toll booths do not typically have scales built in. it is a strange sort of toll—it depends on the weight of the vehicle. why? Social optimality requires MB = total marginal costs. One hundred commuters need to use a strip of highway to get to work. Individual decision makers will reoptimize by setting private marginal benefit equal to the marginal cost they are now charged. when both private and external costs are included.5 more units and sell the permits to firm B. The optimal car weight. when all costs are included. so this is hard to administer in practice. a. or 4 = 3w and choose a car that weighs 1¹/3. yields wsocial optimal = 1. the socially optimal weight. They all drive alone and prefer to drive big cars—it gives them more prestige and makes them feel safer. Private individuals who do not consider external costs will set MB = MC. and a tax designed to be optimal for firm B would induce firm A to reduce by too much. Students who have taken calculus should be able to answer this question if they understand marginal to mean a partial derivative. While this toll system would correct the externality. you need to include the damage to the roads. in 16b. A common tax would yield the same result: a tax designed to be optimal for firm A would be too low to induce firm B to reduce to the efficient quantity. yielding the same result as in a. but this only goes part-way towards a fully weight-dependent toll. Similarly. (1/3)w3. Setting marginal benefits equal to total marginal costs gives the equation for optimality: 4 = 3w + w. while the costs are (3/2)w2. Bigger cars cost more per mile to operate. The weight of the car is w. The marginal costs associated with pollution reduction are MCA = 50 + 3QA for firm A and MCB = 20 + 6QB for firm B. is less than the optimal weight chosen by individuals when they ignore the external costs they impose. Solving for w. Can you design a toll system that causes drivers to choose the optimal car weight? If so. is w.CHAPTER 5 / Externalities: Problems and Solutions -7- 2. a pollution permit market would allow firm A to reduce its pollution by 7. c. where QA and QB are the quantities of pollution reduced by each firm. weight costs them more. the weight of the car. the road damage. marginal (private) cost is 3w. A private decision maker will choose w = 1. bigger cars cause greater permanent damage to roads. Firms A and B each produce 80 units of pollution. The reason is that internalizing the externality would make decision makers take into account the external cost. or w. Worse yet. Here it will be 4 = 4w. 16. Adding this cost to the private marginal cost of driving makes the total marginal cost of driving 4w. Assume that individuals have utility functions of the form U = x. if costs are (3/2)w2. since their gas mileage is lower. . marginal benefits are 4.) 17. b. If the firms started at the pollution reduction levels suggested in part (1). When they do. What is the optimal car weight? If this differs from a. then how would such a system work? A toll just equal to the externality will internalize this externality. What car weight will be chosen by drivers? If benefits are 4w. Suppose that the benefits from driving are 4w. (Note that some tolls roads charge on the basis of the number of axles on the vehicle. where x is the net benefits from driving a car of a given size. 3. The marginal damage is the first derivative of road damage with respect to weight. Society’s marginal benefit from pollution reduction is given by MB = 590 – 3Qtot. The marginal external cost was calculated to be w. where Qtot is the total reduction in pollution. Here the marginal external cost. The damage to roads is (1/3)w3. Setting MCB = MB. The cost to firm A of reducing pollution by an additional unit (the 56th unit) would be 218. Journal of Economic Education 33. note that firm A would be willing to reduce pollution by another unit if it was paid 218 or more. Hence.. If permits were tradeable. They would keep making profitable sales of this sort until the social optimum was reached and the cost of an additional unit of pollution reduction was the same for both firms. Jr. d. Patricia L. 50 + 3QA = 20 + 6QB. 4 (Fall 2002). yielding QB = 40. “The Paper River Revisited: A Common Property Externality Exercise. Starting from the situation where each firm has 25 units of pollution. Ryan. 2 (Spring 1999). efficiency could be improved by having firm B produce 1 unit more pollution and having A produce 1 unit less: there would be no change in total pollution. How much total pollution is there in the social optimum? There was a total of 160 units before. It would be inefficient for each firm to be give 25 units of pollution permits. 327–32. What is the socially optimal level of each firm’s pollution reduction? QA The social optimum requires MB = MCA= MCB. or QA = 2QB – 10. Can the social optimum be achieved using a tax on pollution? A tax could be used to achieve the same outcome: setting a tax of 260 would lead firm A to reduce pollution until 50 + 3QA = 260. so the social optimum has 50 units of pollution. the tax would achieve the social optimum. 20 + 6QB = 590 – 3Qtot = 590 – 3(QA+ QB) = 590 – 3((2QB – 10)+ QB) 20 + 6QB = 620 – 9QB 15QB = 600QB = 40. c. and the social optimum has 40 + 70 = 110 units of pollution reduction. no. yielding QA = 70. 141–47. Setting MCA= MCB and solving for in terms of QB. The cost to firm B of the 55th unit of reduction was 350. Firm B would be willing to pay up to 350 to have another pollution permit.CHAPTER 5 / Externalities: Problems and Solutions -8- a. e. plugging in for QA in terms of QB. Explain how the social optimum can be achieved if firms are given equal numbers of pollution permits but are allowed to trade them. but the total cost of abatement would go down by 132.5 in. pp. In-class Project An in-class demonstration of externalities and Coase’s solution is described in “The Paper River: A Demonstration of Externalities and Coase’s Theorem. and solving for QB. pp. In these experiments. Plugging back in for QA gives QA = 70. adds some nice refinements.” by Thomas P.” by Gail M. and Robert G. both firms would benefit by firm A selling a pollution permit to firm B at some intermediate price. “upstream producers” solve several multiplication problems in a short amount of time using small (approximately 1. b. Andrews. Journal of Economic Education 30. Hence. × 2 in. It would lead firm B to reduce pollution until 20 + 6QB = 260. no. Then each firm would have to reduce pollution by 55 units. Explain why it is inefficient to give each firm an equal number of pollution permits (if they are not allowed to trade them). Houston. Hoyt.) slips of paper and either a pen or a . and the cost of the pen or pencil is subtracted to yield the upstream firm’s total points for the round. If the upstream firm uses a pencil. each of which is a three-digit number multiplied by a two-digit number. If the upstream firm uses a pen. The original paper river experiment involved several separate pairs. students are able to negotiate toward an efficient solution. the paper is ruined and cannot be used for airplane production.CHAPTER 5 / Externalities: Problems and Solutions -9- pencil. where “efficient” is defined as maximizing points. It helps to prepare several sets of ten math problems (each one a three-digit number multiplied by a two-digit number) ahead of time on transparencies and to prepare a separate transparency for each set showing the answers. The “downstream firms” then make paper airplanes. By participating in this exercise over three or four rounds. with a time limit of 3 minutes. This simulation can easily be completed in a one-hour class period. each consisting of one upstream and one downstream producer. I have used ten problems. earning two points for each airplane successfully completed in three minutes. Negotiations were limited to agreements between the two firms. If the upstream firm conserves on paper use. The upstream producers can buy either a pen or a pencil to do their calculations. the downstream firm can erase the marks and reuse the paper. Two points are awarded for each correct answer. The catch is that the airplanes must be made of clean paper. . the slips of paper were available to several producers of each type. In the later version. the downstream firm can make airplanes without having to erase. The pen costs the firm 1 point and the pencil costs the firm 2 points (the pen is the cheaper technology). demonstrating the difficulty of arriving at a Coasian solution when many parties are affected.