Principles_ProblemSet7 Sol.docx - Department of Economics...

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Department of Economics Principle of Economics Problem Set 7 Conceptual Questions 1. When do we say that there is an externality? What are the types of externalities according to their impact and their origin? Give several examples of different types of externality. Solution: The is an externality when the exchange that takes place in the market affects a third party, and this effect is not internalized by the parties in the market. Examples of negative externalities include pollution, smoking, noise, drug consumption. Examples of positive externalities include physical exercise (better physical condition = less use of public health care = less taxes), education, research; even public goods can be thought as an extreme example of externalities. 2. When is there a negative externality in production or in consumption? In such case, why is market quantity greater than that socially optimal? Solution : A negative externality in production means that producers of a good impose a cost upon a party who is not producing nor demanding the good itself. A negative externality in consumption is the opposite: consumers impose a cost on a third party that is neither a consumer nor a producer of the good. The market quantity is greater than the socially optimal quantity because the marginal cost or the marginal value do not reflect the cost imposed by the externality on the third party. 3. Compare the consequences of a negative externality with the consequences of a positive externality. Solution : a negative externality implies a quantity exchanged that is higher than the socially optimal quantity, a price that is lower than the socially optimal price and a loss for society. A positive externality implies that the quantity exchanged is lower than the socially optimal quantity, the price is higher and society could benefit by a larger exchange of the good. 4. How can you make firms take into account external effects of their actions? How can you bring the market production closer to the socially optimal production? Give examples of private and public solutions. What does the Coase Theorem say about that? Solution : public solutions for improving the market allocation in the presence of externalities are regulations on quantities (to forbid or to render compulsory), regulations on prices, taxes or subsidies. A private solution would be the integration, on the productive side, of the parties that are affected by the externalities (merger between the creators of the externality and producers who bear the burden of the externality), the existence of moral codes or the creation of organizations that try to compensate the inefficient allocation of the market (NGOs for instance).
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