Submitted By: Group 2 (Tanuja Pokhrel, Renu Shah, Uttam

Mahato & Sujata Chaudhary)

Question for Review

1. A negative externality occurs when a third party suffers a cost due to an economic
transaction. Example: Air pollution from a factory is a negative externality. The factory
produces goods and profits, but the surrounding community suffers from poor air quality,
leading to health problems and environmental damage. A positive externality occurs
when a third party benefits from an economic transaction without paying for it. Example:
Education is a positive externality. When individuals receive higher education, society
benefits through increased productivity, lower crime rates, and greater innovation, even
though these benefits extend beyond the individual receiving the education.

2. Figure 1 illustrates the effect of a negative externality in production. The equilibrium

3. The patent system helps society address the positive externality problem associated with
innovation by providing inventors with temporary exclusive rights to their creations.
Innovation generates positive externalities because new ideas and technologies benefit
not just the inventor but also society as a whole. However, without protection, firms and
individuals may underinvest in research and development (R&D) since competitors could
easily copy their ideas, making it difficult to recover costs. By granting patents, the
system incentivizes investment in innovation by allowing inventors to profit from their
discoveries, thereby preventing free-riding. Additionally, patents require public
disclosure of new inventions, promoting knowledge sharing and further technological
advancements. Once the patent expires, society fully benefits as the innovation becomes
available for broader use, ensuring continued progress and economic growth.
 4. Economists prefer Pigovian taxes over regulations as a way to protect the environment
from pollution because they can reduce pollution at a lower cost to society. A tax can be
set to reduce pollution to the same level as a regulation. The tax has the advantage of
letting the market determine the least expensive way to reduce pollution. The tax gives
firms incentive to develop cleaner technologies, since doing so reduces the taxes they
have to pay.

5. Externalities can be solved without government intervention through moral codes and
social sanctions (which tell us to internalize externalities, such as not to litter), charities
(donations to organizations like the Sierra Club to protect the environment or to
universities to support education), merging firms whose externalities affect each other
(for example, the apple grower and the beekeeper), or by contract.

6. According to the Coase theorem, your roommate and you will bargain over whether your
roommate will smoke in the room. If you value clean air more than your roommate
values smoking, the bargaining process will lead to your roommate not smoking. But if
your roommate values smoking more than you value clean air, the bargaining process
will lead to your roommate smoking. The outcome is efficient as long as transaction costs
do not prevent an agreement from taking place. The solution may be reached by one of
you paying off the other either not to smoke or for the right to smoke.

Problems and Applications

1. a. The statement, "The benefits of Pigovian taxes as a way to reduce pollution have to be
weighed against the deadweight losses that these taxes cause," is false. In fact, Pigovian taxes
reduce the inefficiency of pollution by reducing the quantity of the good being produced that has
pollution as a by-product. So, Pigovian taxes reduce deadweight loss, they don't increase it.

b. The statement, "A negative production externality calls for a Pigovian tax on producers,
whereas a negative consumption externality calls for a Pigovian tax on consumers," is inaccurate.
It doesn't matter on whom the tax is imposed--the incidence of the tax will be identical. So
whether the externality is from production or consumption of the good, a tax on either producers
or consumers will lead to the same reduction of quantity and change in the prices producers
receive or consumers pay.

a. Fire extinguishers exhibit positive externalities in consumption because even though people
buy them for their own use, they prevent fire from damaging the property of others.

b. Figure 2 illustrates the positive externality from fire extinguishers. Notice that the social value
curve is above the demand curve.

с. The market equilibrium level is denoted QMARKET and the efficient level of output is denoted
QOPTIMUM The quantities differ because in deciding to buy fire extinguishers, people don't
account for the benefits they provide to other people.

d. A government policy that would result in the efficient outcome would be to subsidize people
$10 for every fire extinguisher they buy.

3. Charitable organizations are most often organized to deal with externalities. By letting
charitable contributions be deductible under the federal income tax, the government provides a
tax subsidy to charity, thus encouraging private solutions to the externality. People can give to
the organization that they feel provides the most benefit to society, so the tax subsidy may be
more effective than if the government itself tried to solve the externality. For example, churches
may be better at helping the needy than government welfare programs.
4. If the Swiss government subsidizes cattle farming, it must be because there are externalities
associated with it. Since tourists come to Switzerland to see the beautiful countryside,
encouraging farms, as opposed to industrial development, is important to maintaining the tourist
industry. Thus farms produce a positive externality by keeping the land beautiful and unspoiled
by development. The government's subsidy thus helps the market provide the optimal amount of
farms.

5. Figure 3 shows a situation in which studded snow tires should be banned completely. The
demand curve intersects the supply curve at a positive quantity, QMARKET. But the damage to
highways caused by the studded tires means the social value of the tires is much less than the
private value shown by the demand curve. As the figure shows, if the social value curve doesn't
intersect the supply curve, the efficient quantity, QOPTIMUM, is zero.

Figure 4 illustrates the situation in which the use of studded snow tires should be reduced from
the free-market level, but not banned. Now the social value curve intersects the supply curve at a
quantity, QOPTIMUM, which is less than the free-market quantity, QMARKET, but not zero.
6. a. The external cost of producing aluminum cans arises from the pollution generated in
the production process. The external cost of using aluminum cans comes from the fact
that they don't decompose, so they last a long time in landfills.

b. Figure 5 illustrates the market for aluminum cans. The quantity of cans that will be sold in
the free market is QMARKET, and the efficient quantity is QOPTIMUM.
7. a. The market for alcohol is shown in Figure 6. The social value curve is below the demand
curve because of the externality from increased motor vehicle accidents caused by those who
drink and drive. The free-market equilibrium level of output is QMARKET and the efficient level of
output is QOPTIMUM.

b. The triangular area between points A, B, and C represents the deadweight loss of the market
equilibrium. This area shows the amount by which social costs exceed social value for the
quantity of alcohol consumption beyond the efficient level.

8. a. It's efficient to have different amounts of pollution reduction at different firms because the
costs of reducing pollution differ across firms. If they were all made to reduce pollution by the
same amount, the costs would be low at some firms and prohibitive at others, imposing a greater
burden overall.

b. Command-and-control approaches that rely on uniform pollution reduction among firms give
the firms no incentive to reduce pollution beyond the mandated amount. Instead, every firm will
reduce pollution by just the amount required and no more.

c. Pigovian taxes or tradable pollution rights give firms greater incentives to reduce pollution.
Firms are rewarded by paying lower taxes or spending less on permits if they find methods to
reduce pollution, so they have the incentive to engage in research on pollution control. The
government doesn't have to figure out which firms can reduce pollution the most--it lets the
market give firms the incentive to reduce pollution on their own.

If the government knew the cost of reduction at each firm, it would have Acme eliminate all its
pollution (at a cost of $10 per ton times 100 tons = $1,000) and have Creative eliminate half of
its pollution (at a cost of $100 per ton times 50 tons $5,000). This minimizes the total cost
($6,000) of reducing the remaining pollution to 50 tons.

b. If each firm had to reduce pollution to 25 tons (so each had to reduce pollution by 75 tons), the
cost to Acme would be 75 x $10 $750 and the cost to Creative would be 75 x $100 $7,500. The
total cost would be $8,250.

с. In part a, it costs $6,000 to reduce total pollution to 50 tons, but in part b it costs $8,250. So it's
definitely less costly to have Acme reduce all its pollution and have Creative cut its pollution in
half. Even without knowing the costs of pollution reduction, the government could achieve the
same result by auctioning off pollution permits that would allow only 50 tons of pollution. This
would ensure that Acme reduced its pollution to zero (since Creative would outbid it for the
permits) and Creative would then reduce its pollution to 50 tons.

10. a. An improvement in the technology for controlling pollution would reduce the demand for
pollution rights, shifting the demand curve to the left. Figure 10-7 illustrates what would happen
if there were a Pigovian tax, while Figure 10-8 shows the impact if there were a fixed supply of
pollution permits. In both figures, the curve labeled D, is the original demand for pollution rights
and the curve labeled D, is the new demand for pollution rights after the improvement in
technology.
b. With a Pigovian tax, the price of pollution remains unchanged and the quantity of pollution
declines, as Figure 10-7 shows. With pollution permits, the price of pollution declines and the
quantity of pollution is unchanged, as Figure 8 illustrates.

11. a. In terms of economic efficiency in the market for pollution, it doesn't matter if the
government distributes the permits or auctions them off, as long as firms can sell the permits to
each other. The only difference would be that the government could make money if it auctioned
the permits off, thus allowing it to reduce taxes, which would help reduce the deadweight loss
from taxation.

b. If the government allocated the permits to firms who didn't value them as highly as other
firms, the firms could sell the permits to each other so they'd end up in the hands of the firms
who value them most highly. Thus the allocation of permits among firms wouldn't matter for
efficiency. But it would affect the distribution of wealth, since those who got the permits and
sold them would be better off.

12. The advantage of allowing the permits to be traded throughout the entire West Coast would
be to broaden the market, allowing greater gains from trade. The disadvantage would be that
pollution is only a critical problem in certain areas, like the Los Angeles area. So the costs of
pollution are higher there and the permits should thus be priced higher or be in more limited
supply.

13. a. International cooperation is needed because the externality from global warming is
worldwide, so the benefits from solving the problem are worldwide. Further, the efficient
solution to the problem involves minimizing the costs to society; in this case, society means the
entire world.

b. Since it would be efficient to reduce carbon dioxide most in countries where the costs of
reducing carbon dioxide emissions are low, some compensation scheme needs to be put in place
to encourage the reduction of emissions. One possibility would be to monitor emissions, taxing
those countries whose emissions are high and using the proceeds to subsidize those who reduce
their emissions. This gives the incentive to reduce emissions in those areas where the cost of
doing so is the least. In countries where the cost of reducing emissions is high, they'll just pay the
tax. A system of uniform emission reductions would impose high costs on some countries and
low costs on others, and wouldn't give anyone the incentive to reduce emissions beyond the
mandated amount.

14. All activities, including reducing pollution, involve opportunity costs. Under command-and-
control policies, there's an opportunity cost in terms of the resources that firms must use to
reduce pollution. Using market-based methods merely recognizes that fact and gives firms
economic incentives to reduce pollution, thus reducing the costs of reducing pollution. Since
market-based methods can be priced to reduce pollution by the same amount as command-and-
control policies, they can achieve the same results at lower costs.

15. a. A permit is worth $25 to firm B, $20 to firm A, and $10 to firm C, since that's the cost of
reducing pollution by one unit. Since firm B faces the highest costs of reducing pollution, it will
keep its own 40 permits and buy 40 permits from the other firms, so that it can still pollute by 80
units. That leaves 40 permits for firms A and C. Since firm A values them most highly, it will
keep its own 40 permits. So it must be that firm C sells its 40 permits to firm B. Thus firm B
doesn't reduce its pollution at all, firm A reduces its pollution by 30 units at a cost of $20 x 30 =
$600, and firm C reduces its pollution by 50 units at a cost of $10 x 50 $500. The total cost of
pollution reduction is $1,100.

b. If the permits couldn't be traded, then firm A would have to reduce its pollution by 30 units at
a cost of $20 x 30 = $600, firm B would reduce its pollution by 40 units at a cost of $25 x 40 =
$1,000, and firm C would reduce its pollution by 10 units at a cost of $10 x 10 = $100. The total
cost of pollution reduction would be $1,700. That's $600 higher than in the case in which the
permits could be traded.
 CHAPTER 11: PUBLIC GOODS AND COMMON RESOURCES

Questions for Review

1. An excludable good is one that people can be prevented from using. A rival good is one for
which one person's use of it diminishes another person's enjoyment of it. Pizza is both
excludable, since a pizza producer can prevent someone from eating it who doesn't pay for it, and
rival, since when one person eats it, no one else can eat it.

2. A public good is a good that is neither excludable nor rival. An example is national defense,
which protects the entire nation. No one can be prevented from enjoying the benefits of it, so it
isn't excludable, and an additional person who benefits from it doesn't diminish the value of it to
others, so it isn't rival. The private market won't supply the good, since no one would pay for it,
since they can't be excluded from enjoying it if they don't pay for it.

3. Cost-benefit analysis (CBA) of public goods is a method used to evaluate whether the benefits
of providing a public good, such as clean air, national defense, or public parks, outweigh the
costs of producing and maintaining it. Since public goods are non-excludable (everyone can use
them) and non-rivalrous (one person’s use does not reduce another’s), they are typically provided
by the government or collective organizations. Conducting a CBA for public goods is crucial
because it helps ensure efficient resource allocation, maximize social welfare, justify public
spending, and compare alternative projects. By systematically analyzing costs and benefits,
policymakers can make informed decisions on which public investments generate the most value
for society.

However, conducting a CBA for public goods is challenging due to several factors. One major
difficulty is valuing non-market benefits, as many public goods provide intangible advantages
such as improved quality of life or environmental sustainability, which are difficult to quantify in
monetary terms. Additionally, the free-rider problem complicates the process because individuals
may understate their true willingness to pay, knowing they will benefit regardless. Uncertainty
and long-term effects also pose challenges, as predicting future impacts, external economic
shifts, and technological changes can make estimations unreliable. Furthermore, distributional
concerns arise since public goods affect different social groups unequally, meaning that an
efficient outcome may not always be equitable. Political and ethical issues also play a role, as
public goods often involve ideological debates, where economic efficiency may not align with
broader social priorities. Despite these challenges, economists use techniques such as contingent
valuation (surveying willingness to pay) and revealed preferences (inferring value from
behavior) to estimate the benefits of public goods, though these methods have their own
limitations.

4. A common resource is a good that is rival but not excludable. An example is fish in the ocean.
If someone catches a fish, that leaves fewer fish for everyone else, so it's a rival good. But the
ocean is so vast, you can't charge people for the right to fish, or prevent them from fishing, so it
isn't excludable. Thus, without government intervention, people will use the good too much,
since they don't account for the costs they impose on others when they use the good.

Problems and Applications

1. a. The externalities associated with public goods are positive. Since the benefits from the
public good received by one person don't reduce the benefits received by anyone else, the social
value of public goods is substantially greater than the private value. Examples include national
defense, knowledge, uncongested non-toll roads, and uncongested parks. Since public goods
aren't excludable, the free-market quantity is zero, so it is less than the efficient quantity.

b. The externalities associated with common resources are generally negative. Since common
resources are rival but not excludable (so not priced) the use of the common resources by one
person reduces the amount available for others. Since common resources aren't priced, people
tend to overuse them--their private value for using the resources exceeds the social value.
Examples include fish in the ocean, the environment, congested non-toll roads, the Town
Common, and congested parks.

2. a. (1) Police protection is a natural monopoly, since it is excludable (the police may ignore
some neighborhoods) and not rival (unless the police force is overworked, they're available
whenever a crime arises). You could make an argument that police protection is rival, if the
police are too busy to respond to all crimes, so that one person's use of the police reduces the
amount available for others; in that case, police protection is a private good.
(2) Snow plowing is most likely a common resource. Once a street is plowed, it isn't excludable.
But it is rival, especially right after a big snowfall, since plowing one street means not plowing
another street.

(3) Education is a private good (with a positive externality). It is excludable, since someone who
doesn't pay can be prevented from taking classes. It is rival, since the presence of an additional
student in a class reduces the benefits to others.

(4) Rural roads are public goods. They aren't excludable and they aren't rival since they're
uncongested.

(5) City streets are common resources when congested. They aren't excludable, since anyone can
drive on them. But they are rival, since congestion means every additional driver slows down the
progress of other drivers. When they aren't congested, city streets are public goods, since they're
no longer rival.

b. The government may provide goods that aren't public goods, such as education, because of the
externalities associated with them.

3. a. Since knowledge is a public good, the benefits of basic scientific research are available to
many people. The private firm doesn't take this into account when choosing how much research
to undertake; it only takes into account what it will earn.

b. The United States has tried to give private firms incentives to provide basic research by
subsidizing it through organizations like the National Institute of Health and the National
Science Foundation.

c. If it's basic research that adds to knowledge, it isn't excludable at all, unless people in other
countries can be prevented somehow from sharing that knowledge. So perhaps U.S. firms get a
slight advantage because they hear about technological advances first, but knowledge tends to
diffuse rapidly.

4. When a person litters along a highway, others bear the negative externality, so the private
costs are low. Littering in your own yard imposes costs on you, so has a higher private cost, and
is thus rare.

5. When the system is congested, each additional rider imposes costs on other riders. For
example, when all seats are taken, some people must stand. Or if there isn't any room to stand,
some people must wait for a train that isn't as crowded. Increasing the fare during rush hour
internalizes this externality.

6. On privately owned land, the amount of logging is likely to be efficient. Loggers have
incentives to do the right amount of logging, since they care that the trees replenish themselves
and the forest can be logged in the future. Publicly owned land, however, is a common resource,
and is likely to be over logged, since loggers won't worry about the future value of the land.

Since public lands tend to be over logged, the government can improve things by restricting the
quantity of logging to its efficient level. Selling permits to log, or taxing logging, could be used
to reach the appropriate quantity by internalizing the externality. Such restrictions are
unnecessary on privately owned lands, since there is no externality.

7. a. Overfishing is rational for fishermen since they're using a common resource. They don't
bear the costs of reducing the number of fish available to others, so it's rational for them to
overfish. The free-market quantity of fishing exceeds the efficient amount.

b. A solution to the problem could come from regulating the amount of fishing, taxing fishing to
internalize the externality, or auctioning off fishing permits. But these solutions wouldn't be easy
to implement, since many nations have access to oceans, so international cooperation would be
necessary, and enforcement would be difficult, because the sea is so large it's hard to police.

с. By giving property rights to countries, the scope of the problem is reduced, since each country
has a greater incentive to find a solution. Each country can impose a tax or issue permits, and
monitor a smaller area for compliance.

d. Since government agencies, like the Coast Guard in the United States, protect fishermen and
rescue them when they need help, the fishermen aren't bearing the full costs of their fishing.
Thus they fish more than they should.

e. The statement, "Only when fishermen believe they are assured a long-term and exclusive right
to a fishery are they likely to manage it in the same far-sighted way as good farmers manage they
land," is sensible. If fishermen owned the fishery, they'd be sure not to overfish, because they'd
bear the costs of overfishing. This is a case in which property rights help prevent the overuse of a
common resource.
f. Alternatives include regulating the amount of fishing, taxing fishermen, auctioning off fishing
permits, or taxing fish sold in stores. All would tend to reduce the amount of fishing from the
free-market amount to the efficient amount.

8. The private market provides information about the quality or function of goods and services in
several different ways. First, producers advertise, providing people information about the product
and its quality. Second, private firms provide information to consumers with independent reports
on quality; an example is the magazine Consumer Reports. The government plays a role as well,
by regulating advertising, thus preventing firms from exaggerating claims about their products,
regulating certain goods like gasoline and food to be sure they're measured properly and
provided without disease, and not allowing dangerous products on the market.

9. Recognizing that there are opportunity costs that are relevant for cost-benefit analysis is the
key to answering this question. A richer community can afford to place a higher value on life and
safety. So the richer community is willing to pay more for a traffic light, and that should be
considered in cost-benefit analysis.