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Unformatted text preview: 9160335_CH14_p315-334.qxd 6/22/09 9:06 AM Page 315 PA RT FIVE Market Failure and Government 14 Externalities After studying this chapter,
y ou will be able to:
■ Explain how externalities arise ■ Explain why negative externalities lead to inefficient overproduction and how property rights, emission charges,
marketable permits, and taxes can be used to achieve a
more efficient outcome ■ Explain why positive externalities lead to inefficient underproduction and how public provision, subsidies, vouchers,
and patents can increase economic efficiency We burn huge quantities of fossil fuels—coal, natural
gas, and oil—that cause acid rain and global warming. We
dump toxic waste into rivers, lakes, and oceans. These environmental issues are simultaneously everybody’s problem and
nobody’s problem. How can we take account of the damage
that we cause others every time we turn on our heating or airconditioning systems? In this chapter, we study the problems that arise because Almost every day, we hear about a new discovery—in many of our actions affect other people, for good or ill, in medicine, engineering, chemistry, physics, or even econom- ways that we do not take into account when we make our ics. The advance of knowledge seems boundless. Ever more own economic choices. We will focus on two big areas— people are learning more and more of what is already pollution and knowledge. In Reading Between the Lines at known. The stock of knowledge is increasing, apparently with- the end of the chapter, we look at the effects of a carbon out limit. But are we spending enough on research and edu- tax designed to lower carbon emissions and address global cation? Do enough people remain in school for long enough? warming. 315 9160335_CH14_p315-334.qxd 316 6/22/09 9:06 AM Page 316 CHAPTER 14 Externalities ◆ Externalities in Our Lives
An externality is a cost or a benefit that arises from
production and falls on someone other than the producer, or a cost or benefit that arises from consumption
and falls on someone other than the consumer.
We call an externality that imposes a cost a negative
externality; and we call an externality that provides a
benefit a positive externality.
We identify externalities as four types:
■ Negative production externalities
Negative consumption externalities
Positive production externalities
Positive consumption externalities Negative Production Externalities
Congestion, pollution, and carbon emission are the
sources of the most costly and widespread negative
Congestion The Lincoln Tunnel, which connects
New Jersey to Manhattan under the Hudson River, is
1.5 miles long. Yet it can take 2 hours to get through
the tunnel in the worst traffic.
The costs of congestion are time costs and fuel
costs. Drivers and their passengers spend extra hours sitting in stalled traffic, burning additional fuel. Each
rush-hour user of the Lincoln Tunnel imposes a cost
on the other users. This cost is a negative production
The economic analysis of externalities looks at
alternative ways of dealing with problems such as the
cost of congestion in the Lincoln Tunnel.
Pollution and Carbon Emission When you run your
air-conditioning, use hot water, drive a car, take a trip
by airplane, or even ride a bus or train, your action
contributes to pollution and increases your carbon
Economic activity pollutes air, water, and land,
and these individual areas of pollution interact
through the ecosystem. Sixty percent of our air pollution comes
from road transportation and industrial processes.
Only 20 percent arises from electric power generation. See the trends in U.S. air pollution since 1980
A common belief is that air pollution is getting
worse. In many developing countries, air pollution is
getting worse. The rapid economic development of
China has created a serious air quality problem for
Beijing. During the 2008 Olympics, construction
activity was halted and factories closed in an attempt Air Pollution 40 Cleaner and Safer 20 The figure shows the trends in the concentrations of
six air pollutants. Lead has been almost eliminated
from our air. Sulfur dioxide, carbon monoxide, and
suspended particulates have been reduced to around
a half of their 1980 levels. And even the more stubborn ozone and nitrogen dioxide have been reduced
to around 70 percent of their 1980 levels.
These reductions in air pollution levels are even
more impressive when they are seen against the trends
in economic activity. Between 1980 and 2007, total production in the United States increased by 123 percent.
During this same period, vehicle miles traveled
increased by 90 percent, energy consumption
increased by 82 percent, and the population increased
by 35 percent. While all this economic activity was on
the increase, air pollution from all sources decreased by
more than 30 percent. Above(+) below(–) national standard
(percent) U.S. Air Pollution Trends National
standard Ozone 0
1984 1988 1992 1996 2000 2004 Year
Six Sources of Air Pollution Source of data: Latest Findings on National Air Quality: Status and
Trends through 2006, United States Environmental Protection Agency,
http://www.epa.gov/air/airtrends/2007/ 2008 6/22/09 9:06 AM Page 317 Externalities in Our Lives to provide temporary relief from air that would
endanger the health of athletes.
But air pollution in the world’s richest countries is
getting less severe for most substances. Air pollution
in the United States has been on a downward trend
for more than 30 years.
In contrast to the trends in air pollution, carbon
emissions and emissions of other global warming gases
such as methane are on the increase, and consequently
the carbon dioxide concentration in the Earth’s atmosphere is increasing at an unprecedented pace.
The costs of air pollution and carbon emission are
high and widespread. Sulfur dioxide and nitrogen
oxide emissions from coal-fired and oil-fired generators
of electric utilities cause acid rain, which damages trees and crops. Airborne substances such as lead from
leaded gasoline are believed to cause cancer and other
life-threatening conditions. Depletion of the ozone
layer exposes us to higher doses of cancer-causing
ultraviolet rays from the sun. And most costly of all,
the increased carbon concentration is bringing global
warming and potentially extremely costly climate
Some technological changes to cut costs, lessen air
pollution, and slow the carbon buildup are possible
either now or with further research and development.
Road vehicles can be made “greener” with new
fuels including ethanol, alcohol, natural gas, propane
and butane, and hydrogen. Vehicles can also be powered by electricity or batteries. But whether this Global Temperature and CO2 Trends 390 6 Global temperature (degrees celsius
deviation from 1961–1990 average) The Greatest Market Failure?
British economist Nicholas Stern prepared a major
report on global warming and climate change for the
United Kingdom government and his report, the
Stern Review on the Economics of Climate Change has
attracted a great deal of attention. Stern calls climate
change “the greatest market failure the world has ever
seen.” To avoid the risk of catastrophic damage from
climate change, he says that greenhouse gas levels
must be held at not more than 550 parts per million
(ppm) of CO2 (and its equivalent in other greenhouse gases). The level in 2007 was 430ppm but it is
rising at more than 2ppm a year, so the world will
reach the critical level by about 2070.
Global temperature and CO2 trends are starkly
opposite to those of U.S. air pollution, as the figure
shows. Scientists debate the contribution of human
economic activity to these trends but most say it is
the major source. Although ice-core estimates show
long swings in CO2, there has never been a time
when its concentration increased so rapidly.
To hold greenhouse gas levels at 550ppm, emissions need to be cut to 75 percent or less of their current levels by 2050 and eventually, cut to 20 percent
of their current levels.
The cost of achieving these cuts is high. Stern’s
estimate is 1 percent of the value of global production. If this cost were to be met by the people who
live in the rich countries, and realistically they are the
only ones who could afford to pay, it would cost
about $750 per person every year. 317 4 Global CO2
concentration 370 2 350 0 330 –2 310 –4
temperature CO2 concentration (parts per million) 9160335_CH14_p315-334.qxd –8
1850 1870 1890 1910 1930 1950 1970 1990 2010
Year Global Warming Trends Sources of data: Met Office Hadley Centre and Scripps Institution of
Oceanography. Some economists question Stern’s assumptions and
conclusions and argue that the cost of reducing emissions will be much lower if we go a bit more slowly
and take advantage of future technological advances
that will lower the cost of renewable energy
sources—the sun, tide, and wind.
All economists agree that solving the global warming problem will require changes in the incentives
that people face. The cost of carbon-emitting activities must rise and the cost of the search for new
energy technologies must fall. 9160335_CH14_p315-334.qxd 318 6/22/09 9:06 AM Page 318 CHAPTER 14 Externalities change lessens air pollution and carbon emissions
depends on how electricity is produced.
Pollution-free electricity can be generated by harnessing wind power, solar power, tidal power, or geothermal power. Another alternative is nuclear power.
This method is good for air pollution but creates a
potential long-term problem for land and water pollution because there is no known entirely safe
method of disposing of spent nuclear fuel.
The dumping of industrial waste and
untreated sewage and the runoff from fertilizers pollute oceans, lakes, and rivers.
There are two main alternatives to polluting the
waterways and oceans. One is the chemical processing of waste to render it inert or biodegradable. The
other, in wide use for nuclear waste, is to use land
sites for storage in secure containers. Water Pollution Land Pollution Land pollution arises from dumping
toxic waste products. Ordinary household garbage
does not pose a pollution problem unless contaminants from dumped garbage seep into the water supply. Recycling is an apparently attractive alternative,
but it requires an investment in new technologies to
be effective. Incineration is a high-cost alternative to
landfill, and it produces air pollution. Furthermore,
these alternatives are not free, and they become efficient only when the cost of using landfill is high. Negative Consumption Externalities
Negative consumption externalities are a source of
irritation for most of us. Smoking tobacco in a confined space creates fumes that many people find
unpleasant and that pose a health risk. Smoking creates a negative consumption externality. To deal
with this externality, in many places and in almost
all public places, smoking is banned. But banning
smoking imposes a negative consumption externality on smokers! The majority imposes a cost on the
minority—the smokers who would prefer to consume tobacco while dining or taking a plane trip.
Noisy parties and outdoor rock concerts are other
examples of negative consumption externalities. They
are also examples of the fact that a simple ban on an
activity is not a solution. Banning noisy parties
avoids the external cost on sleep-seeking neighbors,
but it results in the sleepers imposing an external cost
on the fun-seeking partygoers.
Permitting dandelions to grow in lawns, not picking up leaves in the fall, and allowing a dog to bark loudly or to foul a neighbor’s lawn are other sources
of negative consumption externalities. Positive Production Externalities
If a honey farmer places beehives beside an orange
grower’s orchard, two positive production externalities arise. The honey farmer gets a positive production externality from the orange grower because the
bees collect pollen and nectar from orange blossoms. And the orange grower gets a positive production externality because the bees pollinate the
blossoms. Positive Consumption Externalities
When you get a flu vaccination, you lower your risk
of getting infected this winter. But if you avoid the
flu, your neighbor who didn’t get vaccinated has a
better chance of avoiding it too. Flu vaccination
generates positive consumption externalities.
When the owner of a historic building restores it,
everyone who sees the building gets pleasure from it.
Similarly, when someone erects a spectacular house—
such as those built by Frank Lloyd Wright during the
1920s and 1930s—or another exciting building—
such as the Chrysler Building and the Empire State
Building in New York or the Wrigley Building in
Chicago—an external consumption benefit flows to
everyone who has an opportunity to view it. Education, which we examine in this chapter, is another
example of this type of externality. Review Quiz ◆
3 What are the four types of externality?
Give an example of each type of externality that
is different from the ones described above.
How are the externalities that you’ve described
addressed, either by the market or by public
Work Study Plan 14.1
and get instant feedback. We’ve described the four types of externalities and
provided some examples of each. Pollution is the
most important of the negative externalities and it is
this example that we use to study the economics of
external costs. 9160335_CH14_p315-334.qxd 6/22/09 9:06 AM Page 319 Negative Externalities: Pollution To study the economics of the negative externalities
that arise from pollution, we distinguish between
the private cost and the social cost of production. Private Costs and Social Costs
A private cost of production is a cost that is borne by
the producer of a good or service. Marginal cost is
the cost of producing an additional unit of a good or
service. So marginal private cost (MC ) is the cost of
producing an additional unit of a good or service that
is borne by the producer of that good or service.
An external cost is a cost of producing a good or
service that is not borne by the producer but borne by
other people. A marginal external cost is the cost of producing an additional unit of a good or service that falls
on people other than the producer.
Marginal social cost (MSC ) is the marginal cost
incurred by the producer and by everyone else on
whom the cost falls—by society. It is the sum of marginal private cost and marginal external cost. That is,
MSC = MC + Marginal external cost.
We express costs in dollars, but we must always
remember that a cost is an opportunity cost—something real, such as a clean river or clean air, is given
up to get something.
Valuing an External Cost Economists use market
prices to put a dollar value on the cost of pollution.
For example, suppose that there are two similar rivers,
one polluted and the other clean. Five hundred identical homes are built along the side of each river. The
homes on the clean river rent for $2,500 a month,
and those on the polluted river rent for $1,500 a
month. If the pollution is the only detectable difference between the two rivers and the two locations,
the rent decrease of $1,000 per month is the cost of
the pollution. For the 500 homes on the polluted
river, the external cost is $500,000 a month.
External Cost and Output Figure 14.1 shows an example of the relationship between output and cost
in a chemical industry that pollutes. The marginal
cost curve, MC, describes the marginal private cost
borne by the firms that produce the chemical.
Marginal cost increases as the quantity of chemical
produced increases. If the firms dump waste into a river, they impose an external cost that increases
with the amount of the chemical produced. The
marginal social cost curve, MSC, is the sum of marginal private cost and marginal external cost. For
example, when output is 4,000 tons of chemical a
month, marginal private cost is $100 a ton, marginal external cost is $125 a ton, and marginal social
cost is $225 a ton.
In Fig. 14.1, when the quantity of chemical
produced increases, the amount of pollution increases
and the external cost of pollution increases.
Figure 14.1 shows the relationship between the
quantity of chemical produced and the cost of the
pollution it creates, but it doesn’t tell us how much
pollution gets created. That quantity depends on how
the market for the chemical operates. First, we’ll see
what happens when the industry is free to pollute.
Cost (dollars per ton) ◆ Negative Externalities: Pollution 319 An External Cost 300 MSC
cost 150 MC 100
private cost 0 2
Quantity (thousands of tons of chemical per month) The MC curve shows the marginal private cost borne by the
factories that produce a chemical. The MSC curve shows the
sum of marginal private cost and marginal external cost.
When output is 4,000 tons of chemical a month, marginal
private cost is $100 a ton, marginal external cost is $125 a
ton, and marginal social cost is $225 a ton.
animation 9160335_CH14_p315-334.qxd 320 6/22/09 9:06 AM Page 320 CHAPTER 14 Externalities Production and Pollution: How Much? Property Rights
Sometimes it is possible to reduce the inefficiency arising from an externality by establishing a property right
where one does not currently exist. Property rights are
legally established titles to the ownership, use, and disposal of factors of production and goods and services
that are enforceable in the courts.
Suppose that the chemical factories own the river
and the 500 homes alongside it. The rent that people
are willing to pay depends on the amount of pollution.
Using the earlier example, people are willing to pay
$2,500 a month to live alongside a pollution-free river
but only $1,500 a month to live with the pollution
created by 4,000 tons of chemical a month. If the
factories produce this quantity, they lose $1,000 a
month for each home for a total of $500,000 a month. Price and cost (dollars per ton) When an industry is unregulated, the amount of pollution it creates depends on the market equilibrium
price and quantity of the good produced. In Fig. 14.2,
the demand curve for a pollution-creating chemical is D.
This curve also measures the marginal social benefit,
MSB, of the chemical. The supply curve is S. This
curve also measures the producers’ marginal private
cost, MC. The supply curve is the marginal private
cost curve because when firms make their production
and supply decisions, they consider only the costs that
they will bear. Market equilibrium occurs at a price of
$100 a ton and 4,000 tons of chemical a month.
This equilibrium is inefficient. You learned in
Chapter 5 that the allocation of resources is efficient
when marginal social benefit equals marginal social
cost. But we must count all the costs—private and
external—when we compare marginal social benefit
and marginal social cost. So with an external cost, the
allocation is efficient when marginal social benefit
equals marginal social cost. This outcome occurs
when the quantity of chemical produced is 2,000
tons a month. The unregulated market overproduces
by 2,000 tons of chemical a month and creates a
deadweight loss shown by the gray triangle.
How can the people who live by the polluted river
get the chemical factories to decrease their output of
chemical and create less pollution? If some method
can be found to achieve this outcome, everyone—the
owners of the chemical factories and the residents of
the riverside homes—can gain. Let’s explore some
solutions. FIGURE 14.2 Inefficiency with an
External Cost 300
cost MSC 225
equilibrium 150 S = MC
75 D = MSB
quantity 0 2
Quantity (thousands of tons of chemical per month) The supply curve is the marginal private cost curve, S =
MC. The demand curve is the marginal social benefit curve,
D = MSB. Market equilibrium at a price of $100 a ton and
4,000 tons a month is inefficient because marginal social
cost exceeds marginal social benefit. The efficient quantity
is 2,000 tons a month. The gray triangle shows the deadweight loss created by the pollution externality.
animation The chemical factories are now confronted with the
cost of their pollution—forgone rent from the people
who live by the river.
Figure 14.3 illustrates the outcome by using the
same example as in Fig. 14.2. With property rights in
place, the MC curve no longer measures all the costs
that the factories face in producing the chemical. It
excludes the pollution costs that they must now bear.
The MSC curve now becomes the marginal private
cost curve MC. All the costs fall on the factories, so
the market supply curve is based on all the marginal
costs and is the curve labeled S MC MSC.
Market equilibrium now occurs at a price of $150
a ton and 2,000 tons of chemical a month. This outcome is efficient. The factories still produce some
pollution, but it is the efficient quantity. 9160335_CH14_p315-334.qxd 6/22/09 9:06 AM Page 321 Negative Externalities: Pollution Price and cost (dollars per ton) FIGURE 14.3 Property Rights Achieve an
Efficient Outcome 300
cost and marginal
equilibrium S = MC = MSC Cost of
polluter MC excluding
pollution cost 150 100
75 D = MSB 0 2
Quantity (thousands of tons of chemical per month) With property rights, the marginal cost cur ve that excludes
pollution costs shows only part of the producers’ marginal
cost. The marginal private cost curve includes the cost of
pollution, so the supply curve is S = MC = MSC. Market
equilibrium is at a price of $150 a ton and 2,000 tons of
chemical a month and is efficient because marginal social
cost equals marginal social benefit. The efficient quantity of
pollution is not zero.
animation The Coase Theorem
Does it matter how property rights are assigned? Does
it matter whether the polluter or the victim of the pollution owns the resource that might be polluted? Until
1960, everyone thought that it did matter. But in
1960, Ronald Coase had a remarkable insight, now
called the Coase theorem.
The Coase theorem is the proposition that if property rights exist, if only a small number of parties are
involved, and if transactions costs are low, then private transactions are efficient. There are no externalities because the transacting parties take all the costs
and benefits into account. Furthermore, it doesn’t
matter who has the property rights. 321 Application of the Coase Theorem In the example that we’ve just studied, the factories own the river
and the homes. Suppose that instead, the residents
own their homes and the river. Now the factories
must pay a fee to the homeowners for the right to
dump their waste. The greater the quantity of waste
dumped into the river, the more the factories must
pay. So again, the factories face the opportunity cost
of the pollution they create. The quantity of chemical
produced and the amount of waste dumped are the
same whoever owns the homes and the river. If the
factories own them, they bear the cost of pollution
because they receive a lower income from home
rents. And if the residents own the homes and the
river, the factories bear the cost of pollution because
they must pay a fee to the homeowners. In both cases,
the factories bear the cost of their pollution and dump
the efficient amount of waste into the river.
The Coase solution works only when transactions
costs are low. Transactions costs are the opportunity
costs of conducting a transaction. For example, when
you buy a house, you incur a series of transactions
costs. You might pay a real estate agent to help you
find the best place and a lawyer to run checks that
assure you that the seller owns the property and that
after you’ve paid for it, the ownership has been properly transferred to you.
In the example of the homes alongside a river, the
transactions costs that are incurred by a small number of chemical factories and a few homeowners
might be low enough to enable them to negotiate the
deals that produce an efficient outcome. But in many
situations, transactions costs are so high that it would
be inefficient to incur them. In these situations, the
Coase solution is not available.
Suppose, for example, that everyone owns the airspace above their homes up to, say, 10 miles. If someone pollutes your airspace, you can charge a fee. But
to collect the fee, you must identify who is polluting
your airspace and persuade them to pay you. Imagine
the costs of negotiating and enforcing agreements
with the 50 million people who live in your part of
the United States (and perhaps in Canada or Mexico)
and the several thousand factories that emit sulfur
dioxide and create acid rain that falls on your property! In this situation, we use public choices to cope
with externalities. But the transactions costs that
block a market solution are real costs, so attempts by
the government to deal with externalities offer no
easy solution. Let’s look at some of these attempts. 9160335_CH14_p315-334.qxd 322 6/22/09 9:06 AM Page 322 CHAPTER 14 Externalities Government Actions in the Face of
External Costs Taxes The government can use taxes as an incentive for producers to cut back on pollution. Taxes used in
this way are called Pigovian taxes, in honor of Arthur
Cecil Pigou, the British economist who first worked
out this method of dealing with externalities during
By setting the tax equal to the marginal external
cost, firms can be made to behave in the same way as
they would if they bore the cost of the externality
directly. To see how government actions can change
market outcomes in the face of externalities, let’s
return to the example of the chemical factories and
Assume that the government has assessed the marginal external cost accurately and imposes a tax on
the factories that exactly equals this cost. Figure 14.4
illustrates the effects of this tax.
The demand curve and marginal social benefit
curve, D MSB, and the firms’ marginal cost curve,
MC, are the same as in Fig. 14.2. The pollution tax
equals the marginal external cost of the pollution. We
add this tax to the marginal private cost to find the
market supply curve. This curve is the one labeled
S MC tax MSC. This curve is the market
supply curve because it tells us the quantity supplied
at each price given the firms’ marginal cost and the
tax they must pay. This curve is also the marginal
social cost curve because the pollution tax has been
set equal to the marginal external cost.
Demand and supply now determine the market
equilibrium price at $150 a ton and a quantity of
2,000 tons of chemical a month. At this quantity of
chemical production, the marginal social cost is $150
and the marginal social benefit is $150, so the outcome is efficient. The firms incur a marginal cost of
$88 a ton and pay a tax of $62 a ton. The government collects tax revenue of $124,000 a month.
Emission Charges Emission charges are an alternative to a tax for confronting a polluter with the external cost
of pollution. The government sets a price per unit of
pollution. The more pollution a firm creates, the more it Price and cost (dollars per ton) The three main methods that governments use to
cope with externalities are
■ Emission charges
■ Marketable permits A Pollution Tax to Achieve an
Efficient Outcome FIGURE 14.4 300 S = MC + tax = MSC
cost and marginal
tax 150 MC
revenue 0 D = MSB 2
Quantity (thousands of tons of chemical per month) A pollution tax is imposed equal to the marginal external
cost of pollution. The supply curve becomes the marginal
private cost curve, MC, plus the tax—S = MC + tax. Market
equilibrium is at a price of $150 a ton and 2,000 tons of
chemical a month and is efficient because marginal social
cost equals marginal social benefit. The government collects
a tax revenue shown by the purple rectangle.
animation pays in emission charges. This method of dealing with
pollution externalities has been used only modestly in
the United States but is common in Europe where, for
example, France, Germany, and the Netherlands make
water polluters pay a waste disposal charge.
To work out the emission charge that achieves efficiency, the government needs a lot of information
about the polluting industry that, in practice, is rarely
Marketable Permits Instead of taxing or imposing emission charges on polluters, each potential polluter
might be assigned a permitted pollution limit. Each
firm knows its own costs and benefits of pollution,
and making pollution limits marketable is a clever
way of using this private information that is unknown
to the government. The government issues each firm a 9160335_CH14_p315-334.qxd 6/22/09 9:06 AM Page 323 Positive Externalities: Knowledge permit to emit a certain amount of pollution, and
firms can buy and sell these permits. Firms that have a
low marginal cost of reducing pollution sell their permits, and firms that have a high marginal cost of
reducing pollution buy permits. The market in permits determines the price at which firms trade permits. Each firm buys or sells permits until its marginal
cost of pollution equals the market price of a permit.
This method of dealing with pollution provides an
even stronger incentive than emission charges to find
lower-polluting technologies because the price of a permit to pollute rises as the demand for permits increases.
The Market for Emission Permits in the United
States Trading in lead pollution permits became common during the 1980s, and this marketable permit program has been rated a success. It enabled
lead to be virtually eliminated from the atmosphere
of the United States (see p. 316). But this success
might not easily translate to other situations because
lead pollution has some special features. First, most
lead pollution came from a single source: leaded
gasoline. Second, lead in gasoline is easily monitored. Third, the objective of the program was clear:
to eliminate lead in gasoline.
The Environmental Protection Agency is now
considering using marketable permits to promote
efficiency in the control of chlorofluorocarbons, the
gases that are believed to damage the ozone layer. Review Quiz ◆
2 3 4 5 What is the distinction between private cost
and social cost?
How does a negative externality prevent a
competitive market from allocating resources
How can a negative externality be eliminated by
assigning property rights? How does this
method of coping with an externality work?
How do taxes help us to cope with negative
externalities? At what level must a pollution tax
be set if it is to induce firms to produce the efficient quantity of pollution?
How do emission charges and marketable
pollution permits work?
Work Study Plan 14.2
and get instant feedback. 323 ◆ Positive Externalities: Knowledge
Knowledge comes from education and research. To
study the economics of knowledge, we distinguish
between private benefits and social benefits. Private Benefits and Social Benefits
A private benefit is a benefit that the consumer of a
good or service receives. Marginal benefit is the benefit from an additional unit of a good or service. So a
marginal private benefit (MB) is the benefit from an
additional unit of a good or service that the consumer of that good or service receives.
The external benefit from a good or service is
the benefit that someone other than the consumer
receives. A marginal external benefit is the benefit from
an additional unit of a good or service that people
other than the consumer enjoy.
Marginal social benefit (MSB) is the marginal benefit enjoyed by society—by the consumer of a good or
service (marginal private benefit) plus the marginal
benefit enjoyed by others (the marginal external benefit). That is,
MSB = MB + Marginal external benefit.
Figure 14.5 shows an example of the relationship
between marginal private benefit, marginal external
benefit, and marginal social benefit. The marginal
benefit curve, MB, describes the marginal private
benefit—such as expanded job opportunities and
higher incomes—enjoyed by college graduates.
Marginal private benefit decreases as the quantity
of education increases.
But college graduates generate external benefits.
On the average, they tend to be better citizens.
Their crime rates are lower, and they are more tolerant of the views of others. A society with a large
number of college graduates can support activities
such as high-quality newspapers and television
channels, music, theater, and other organized social
In the example in Fig. 14.5, the marginal external
benefit is $15,000 per student per year when 15 million
students enroll in college. The marginal social benefit
curve, MSB, is the sum of marginal private benefit
and marginal external benefit. For example, when
15 million students a year enroll in college, the marginal private benefit is $10,000 per student and the 9160335_CH14_p315-334.qxd 6/22/09 Page 324 CHAPTER 14 Externalities FIGURE 14.5 An External Benefit FIGURE 14.6 40 Marginal
benefit 20 MSB
0 5 10 Price and cost (thousands of dollars per student per year) 324 Price (thousands of dollars per student per year) 9:06 AM 40
38 30 20 Deadweight
equilibrium 20 15 MSB
social cost 25 0 5 7.5 10 Quantity (millions of students per year) The MB curve shows the marginal private benefit enjoyed
by the people who receive a college education. The MSB
curve shows the sum of marginal private benefit and marginal external benefit. When 15 million students attend college, marginal private benefit is $10,000 per student,
marginal external benefit is $15,000 per student, and marginal social benefit is $25,000 per student.
animation marginal external benefit is $15,000 per student, so
the marginal social benefit is $25,000 per student.
When people make schooling decisions, they
ignore its external benefits and consider only its private benefits. So if education were provided by private schools that charged full-cost tuition, we would
produce too few college graduates.
Figure 14.6 illustrates the underproduction that
would exist if the government left education to the
private market. The supply curve is the marginal
social cost curve, S MSC. The demand curve is
the marginal private benefit curve, D MB. Market
equilibrium occurs at a tuition of $15,000 per student per year and 7.5 million students per year. At
this equilibrium, marginal social benefit is $38,000
per student, which exceeds marginal social cost by
$23,000. There are too few students in college. The
efficient number is 15 million per year, where marginal S = MSC Marginal
benefit 25 MB 15 Inefficiency with an
External Benefit D = MB Efficient
15 20 25 Quantity (millions of students per year) The market demand curve is the marginal private benefit
curve, D = MB. The supply curve is the marginal social cost
curve, S = MSC. Market equilibrium at a tuition of $15,000
a year and 7.5 million students is inefficient because marginal social benefit exceeds marginal social cost. The efficient quantity is 15 million students. A deadweight loss arises
(gray triangle) because too few students enroll in college.
animation social benefit equals marginal social cost. The gray
triangle shows the deadweight loss.
Underproduction similar to that in Fig. 14.6
would occur in grade school and high school if public
education was left to an unregulated market. When
children learn basic reading, writing, and number
skills, they receive the private benefit of increased
earning power. But even these basic skills bring the
external benefit of developing better citizens.
External benefits also arise from the discovery of
new knowledge. When Isaac Newton worked out the
formulas for calculating the rate of response of one
variable to another—calculus—everyone was free to
use his method. When a spreadsheet program called
VisiCalc was invented, Lotus Corporation and
Microsoft were free to copy the basic idea and create
1-2-3 and Excel. When the first shopping mall was
built and found to be a successful way of arranging 9160335_CH14_p315-334.qxd 6/22/09 9:06 AM Page 325 Positive Externalities: Knowledge Government Actions in the Face
of External Benefits retailing, everyone was free to copy the idea, and
malls sprouted like mushrooms.
Once someone has discovered a basic idea others
can copy it. Because they do have to work to copy an
idea, they face an opportunity cost, but they do not
usually have to pay a fee for the idea. When people
make decisions, they ignore the external benefits and
consider only the private benefits.
When people make decisions about the amount
of education or research to undertake, they balance
the marginal private cost against the marginal private benefit. They ignore the external benefit. As a
result, if we left education and research to unregulated market forces, we would get too little of these
To get closer to producing the efficient quantity of
a good or service that generates an external benefit,
we make public choices, through governments, to
modify the market outcome. S = MSC Efficient
equilibrium Marginal social
20 Paid by
taxpayers Tuition MSB 10
0 5 Public provision
Patents and copyrights ■
■ Public Provision Under public provision, a public authority that receives its revenue from the government produces the good or service. The education
services produced by the public universities, colleges,
and schools are examples of public provision.
Figure 14.7(a) shows how public provision might
overcome the underproduction that arises in Fig. 14.6. Public Provision or Private Subsidy to Achieve an Efficient Outcome 40 30 Four devices that governments can use to achieve a
more efficient allocation of resources in the presence
of external benefits are 10 Price and cost (thousands of dollars per student per year) Price and cost (thousands of dollars per student per year) FIGURE 14.7 325 40 S0 = MSC 30
25 20 25 Subsidy of
per student 20 MSB 10
equilibrium 0 5 Quantity (millions of students per year)
(a) Public provision In part (a), marginal social benefit equals marginal social cost
with 15 million students per year, the efficient quantity. Tuition is
set at $10,000 per student equal to marginal private benefit.
Taxpayers cover the other $15,000 of cost per student.
animation S1 = MSC – subsidy Dollar
price D = MB 15 Marginal social
cost D = MB 10 15 20 25 Quantity (millions of students per year)
(b) Private subsidy In part (b), with a subsidy of $15,000 per student, the supply
curve is S1 = MSC – subsidy. The equilibrium price is $10,000,
and the market equilibrium is efficient with 15 million students
per year. Marginal social benefit equals marginal social cost. 9160335_CH14_p315-334.qxd 9:06 AM Page 326 CHAPTER 14 Externalities Public provision cannot lower the cost of production,
so marginal social cost is the same as before. Marginal
private benefit and marginal external benefit are also
the same as before.
The efficient quantity occurs where marginal social
benefit equals marginal social cost. In Fig. 14.7(a), this
quantity is 15 million students. Tuition is set to ensure
that the efficient number of students enrolls. That is,
tuition is set equal to the marginal private benefit at
the efficient quantity. In Fig. 14.7(a), tuition is
$10,000 a year. The rest of the cost of the public university is borne by the taxpayers and, in this example,
is $15,000 per student per year.
Private Subsidies A subsidy is a payment that the government makes to private producers. By making
the subsidy depend on the level of output, the government can induce private decision makers to consider external benefits when they make their choices.
Figure 14.7(b) shows how a subsidy to private colleges works. In the absence of a subsidy, the market
supply curve is S0 MSC. The demand curve is the
marginal private benefit curve, D MB. If the government provides a subsidy to colleges of $15,000 per
student per year, we must subtract the subsidy from
the colleges’ marginal cost to find the new market supply curve. That curve is S1 MSC subsidy. The
market equilibrium is tuition of $10,000 a year and
15 million students a year. The marginal social cost
of educating 15 million students is $25,000 and the
marginal social benefit is $25,000. So with marginal
social cost equal to marginal social benefit, the subsidy has achieved an efficient outcome. The tuition
and the subsidy just cover the colleges’ marginal cost.
Vouchers A voucher is a token that the government provides to households, which they can use to buy
specified goods or services. Food stamps are examples
of vouchers. The vouchers (stamps) can be spent only
on food and are designed to improve the diet and
health of extremely poor families.
School vouchers have been advocated as a means
of improving the quality of education and are used in
A school voucher allows parents to choose the
school their children will attend and to use the
voucher to pay part of the cost. The school cashes
the vouchers to pay its bills. A voucher could be
provided to a college student in a similar way, and
although technically not a voucher, a federal Pell
Grant has a similar effect. FIGURE 14.8
Price and cost (thousands of dollars per student per year) 326 6/22/09 Vouchers Achieve an
Efficient Outcome 40 30 S = MSC Efficient
equilibrium Price, marginal
social benefit, and
cost are equal 25
price Value of
voucher D = MSB 10 MB 0 5 10 15 20 25 Quantity (millions of students per year) With vouchers, buyers are willing to pay MB plus the value
of the voucher, so the demand curve becomes the marginal
social benefit curve, D = MSB. Market equilibrium is efficient with 15 million students enrolled in college because
price, marginal social benefit, and marginal social cost are
equal. The tuition consists of the dollar price of $10,000
and a voucher valued at $15,000.
animation Because vouchers can be spent only on a specified
item, they increase the willingness to pay for that item
and so increase the demand for it. Figure 14.8 shows
how a voucher system works. The government provides a voucher per student equal to the marginal
external benefit. Parents (or students) use these vouchers to supplement the dollars they pay for education.
The marginal social benefit curve becomes the demand
for college education, D MSB. The market equilibrium occurs at a price of $25,000 per student per year,
and 15 million students attend college. Each student
pays $10,000 tuition, and schools collect an additional
$15,000 per student from the voucher.
If the government estimates the value of the external benefit correctly and makes the value of the
voucher equal the marginal external benefit, the
outcome from the voucher scheme is efficient. 9160335_CH14_p315-334.qxd 6/22/09 9:06 AM Page 327 Positive Externalities: Knowledge Marginal social cost equals marginal social benefit,
and the deadweight loss is eliminated.
Vouchers are similar to subsidies, but their advocates say that they are more efficient than subsidies
because the consumer can monitor school performance more effectively than the government can.
Patents and Copyrights Knowledge might be an
exception to the principle of diminishing marginal
benefit. Additional knowledge (about the right
things) makes people more productive. And there
seems to be no tendency for the additional productivity from additional knowledge to diminish.
For example, in just 15 years, advances in knowledge about microprocessors have given us a sequence
of processor chips that has made our personal computers increasingly powerful. Each advance in knowledge
about how to design and manufacture a processor chip
has brought apparently ever larger increments in performance and productivity. Similarly, each advance in
knowledge about how to design and build an airplane
has brought apparently ever larger increments in performance: Orville and Wilbur Wright’s 1903 Flyer was
a one-seat plane that could hop a farmer’s field. The
Lockheed Constellation, designed in 1949, was an airplane that could fly 120 passengers from New York to
London, but with two refueling stops in Newfoundland and Ireland. The latest version of the Boeing 747
can carry 400 people nonstop from Los Angeles to
Sydney, Australia, or New York to Tokyo (flights of
7,500 miles that take 13 hours). Similar examples can
be found in agriculture, biogenetics, communications,
engineering, entertainment, and medicine.
One reason why the stock of knowledge increases
without diminishing returns is the sheer number of
different techniques that can in principle be tried. Paul
Romer, an economist at Stanford University, explains
this fact. “Suppose that to make a finished good, 20
different parts have to be attached to a frame, one at a
time. A worker could proceed in numerical order,
attaching part one first, then part two. … Or the
worker could proceed in some other order, starting
with part 10, then adding part seven. …With 20
parts, … there are [more] different sequences … than
the total number of seconds that have elapsed since the
big bang created the universe, so we can be confident
that in all activities, only a very small fraction of the
possible sequences have ever been tried.”1
1 Paul Romer, “Ideas and Things,” in The Future Surveyed, supplement to The Economist, September 11, 1993, pp. 71–72. 327 Think about all the processes, all the products,
and all the different bits and pieces that go into each,
and you can see that we have only begun to scratch
the surface of what is possible.
Because knowledge is productive and generates
external benefits, it is necessary to use public policies
to ensure that those who develop new ideas have
incentives to encourage an efficient level of effort.
The main way of providing the right incentives uses
the central idea of the Coase theorem and assigns
property rights—called intellectual property rights—to
creators. The legal device for establishing intellectual
property rights is the patent or copyright. A patent or
copyright is a government-sanctioned exclusive right
granted to the inventor of a good, service, or productive process to produce, use, and sell the invention
for a given number of years. A patent enables the
developer of a new idea to prevent others from benefiting freely from an invention for a limited number
Although patents encourage invention and innovation, they do so at an economic cost. While a patent
is in place, its holder has a monopoly. And monopoly
is another source of inefficiency (which is explained
in Chapter 11). But without a patent, the effort to
develop new goods, services, or processes is diminished and the flow of new inventions is slowed. So
the efficient outcome is a compromise that balances
the benefits of more inventions against the cost of
temporary monopoly in newly invented activities. Review Quiz ◆
2 3 What is special about knowledge that creates
How might governments use public provision,
private subsidies, and vouchers to achieve an
efficient amount of education?
How might governments use public provision,
private subsidies, vouchers, and patents and
copyrights to achieve an efficient amount of
research and development?
Work Study Plan 14.3
and get instant feedback. ◆ Reading Between the Lines on pp. 328–329 looks
at the effects of a carbon tax and solar subsidy to
reduce greenhouse gas emissions. 9160335_CH14_p315-334.qxd 6/22/09 9:06 AM Page 328 READING BETWEEN THE LINES Fighting Carbon Emissions with
a Carbon Tax and Solar Subsidy
On Carbon, Tax and Don’t Spend
March 25, 2008 … a carbon tax isn’t a new idea. Denmark, Finland, Norway and Sweden have had carbon taxes
in place since the 1990s, but the tax has not led to large declines in emissions in most of these
countries—in the case of Norway, emissions have actually increased by 43 percent per capita. …
The one country in which carbon taxes have led to a large decrease in emissions is Denmark, …
What did Denmark do right? …
Denmark avoids the temptation to maximize the tax revenue by giving the proceeds back to
industry, earmarking much of it to subsidize environmental innovation. Danish firms are
pushed away from carbon and pulled into environmental innovation, and the country’s
economy isn’t put at a competitive disadvantage. So this is lesson No. 1 from Denmark.
The second lesson is that the carbon tax worked in Denmark because it was easy for Danish
firms to switch to cleaner fuels. Danish policy makers made huge investments in renewable
energy and subsidized environmental innovation. Denmark back then was more reliant on
coal than the other three countries were (but not more so than the United States is today), so
when the tax gave companies a reason to leave coal and the investments in renewable energy
gave them an easy way to do so, they switched. The key was providing easy substitutes. …
An increase in gasoline taxes … would … be the wrong policy. … Higher gas taxes would
raise revenue but do little to curb pollution.
Instead, if we want to reduce carbon emissions, then we should follow Denmark’s example:
tax the industrial emission of carbon and return the revenue to industry through subsidies for
research and investment in alternative energy sources, cleaner-burning fuel, carbon-capture
technologies and other environmental innovations.
Copyright 2008 The New York Times Company. Reprinted by permission. Further reproduction prohibited. Essence of the Story
■ Denmark, Finland, Norway and Sweden have had
carbon taxes since the 1990s. ■ A gas tax increase in the United States would raise
revenue but not curb pollution. ■ Emissions increased in Norway, changed little in
Finland and Sweden, and decreased in Denmark. ■ The United States should follow Denmark’s example. ■ Denmark used the carbon tax revenues to make it easy
for power utilities to switch from coal. 328 6/22/09 9:06 AM Page 329 Economic Analysis
■ Figure 1 illustrates why, as the article states, a carbon
tax on gasoline would do little to curb pollution. ■ The demand for gasoline in the short run, DSR, is inelastic. If the U.S. gas price was raised (by a carbon tax)
to the European level, gasoline consumption would decrease by very little. ■ ■ ■ ■ Assume that the marginal social cost of producing electricity equals the marginal benefit of electricity at 30
cents per kilowatt hour (kWh) and that the market price
of electricity is also 30 cents per kWh.
In part (a), a carbon tax equal to the marginal external
cost raises the producer’s marginal cost to equal the
marginal social cost. 8 50 Carbon tax on
shuts down MSC United States
in 2008 4 DLR 2 DSR
0 100 350 400
Gasoline consumption (gallons per person) Figure 1 A carbon tax on gasoline ■ But with a carbon tax and a solar subsidy, the marginal coal-fired power station shuts down and switches to solar power. As the article says, the subsidy
makes fuel substitution easy for the producer. ■ The combination of the tax and subsidy is inefficient.
Electricity is now being produced by solar power at a
marginal social cost of 50 cents per kWh instead of
the efficient 30 cents per kWh using coal. With no subsidy for solar, a coal-fired power station
continues to operate and produces 5 MWh. 60 United States
in 2008 with
European gas tax 10 Figure 2 illustrates why a carbon tax that is spent on
subsidies to clean fuel cuts pollution, as the article
Figure 2(a) shows the costs of producing electricity
using coal, which has an external cost: MSC exceeds
MC. Figure 2(b) shows the cost using solar power,
which has no external cost: MC = MSC. Europe
in 2008 6 Cost (cents per kWh) ■ 12 The demand for gasoline in the long run, DLR, is elastic,
so consumption might fall to the European level eventually, but it would take many years. Cost (cents per kWh) ■ Price (dollars per gallon) 9160335_CH14_p315-334.qxd 60 MC = MSC Solar subsidy:
replaces coal 50 40 MC – subsidy 40 30 Solar
Carbon tax 20 20 MC
10 0 10 5 10
Quantity (MWh per year) (a) Coal generation 0 5 10
Quantity (MWh per year) (b) Solar generation Figure 2 Using carbon tax to subsidize alternative fuels 329 9160335_CH14_p315-334.qxd 330 6/22/09 9:06 AM Page 330 CHAPTER 14 Externalities SUMMARY ◆ Key Points Positive Externalities: Knowledge (pp. 323–327)
■ Externalities in Our Lives (p. 316–318)
■ An externality can arise from either a production
activity or a consumption activity.
A negative externality imposes an external cost.
A positive externality provides an external benefit. Negative Externalities: Pollution (pp. 319–323)
■ ■ ■ ■ External costs are costs of production that fall on
people other than the producer of a good or service. Marginal social cost equals marginal private
cost plus marginal external cost.
Producers take account only of marginal private
cost and produce more than the efficient quantity
when there is a marginal external cost.
Sometimes it is possible to overcome a negative
externality by assigning a property right.
When property rights cannot be assigned, governments might overcome externalities by using taxes,
emission charges, or marketable permits. ■ ■ ■ ■ External benefits are benefits that are received by
people other than the consumer of a good or service. Marginal social benefit equals marginal private benefit plus marginal external benefit.
External benefits from education arise because better-educated people tend to be better citizens,
commit fewer crimes, and support social activities.
External benefits from research arise because once
someone has worked out a basic idea, others can
Vouchers or subsidies to schools or the provision
of public education below cost can achieve a more
efficient provision of education.
Patents and copyrights create intellectual property
rights and an incentive to innovate. But they do so
by creating a temporary monopoly, the cost of
which must be balanced against the benefit of
more inventive activity. Key Figures
Figure 14.6 Inefficiency with an External Cost, 320
Property Rights Achieve an Efficient
A Pollution Tax to Achieve an
Efficient Outcome, 322
Inefficiency with an External
Benefit, 324 Figure 14.7
Figure 14.8 Public Provision or Private Subsidy to
Achieve an Efficient Outcome, 325
Vouchers Achieve an Efficient
Outcome, 326 Key Terms
Coase theorem, 321
Intellectual property rights, 327
Marginal external benefit, 323
Marginal external cost, 319
Marginal private benefit, 323 Marginal private cost, 319
Marginal social benefit, 323
Marginal social cost, 319
Negative externality, 316
Pigovian taxes, 322
Positive externality, 316 Property rights, 320
Public provision, 325
Transactions costs, 321
Voucher, 326 9160335_CH14_p315-334.qxd 6/22/09 9:06 AM Page 331 Problems and Applications PROBLEMS and APPLICATIONS 331 ◆ Work problems 1–9 in Chapter 14 Study Plan and get instant feedback.
Work problems 10–18 as Homework, a Quiz, or a Test if assigned by your instructor. Output
per week) 0
benefit (dollars per ton) 0
40 a. If no one owns the lake and if there is no regulation of pollution, what is the quantity of
pesticide produced and what is the marginal
cost of pollution borne by the trout farmer?
b. If the trout farm owns the lake, how much
pesticide is produced and what does the pesticide producer pay the farmer per ton?
c. If the pesticide producer owns the lake, and if
a pollution-free lake rents for $1,000 a week,
how much pesticide is produced and how
much rent does the farmer pay the factory for
the use of the lake? d. Compare the quantities of pesticide produced
in b and c, and explain the relationship
between these quantities.
3. Back at the pesticide plant and trout farm
described in problem 2, suppose that no one
owns the lake and that the government introduces a pollution tax.
a. What is the tax per ton of pesticide produced
that achieves an efficient outcome?
b. Explain the connection between your answer
to a and the answer to problem 2a.
4. Using the information provided in problem 2,
suppose that no one owns the lake and that the
government issues three marketable pollution
permits, two to the farmer and one to the factory. Each permit allows the same amount of pollution of the lake, and the total amount of
pollution is the efficient amount.
a. What is the quantity of pesticide produced?
b. What is the market price of a pollution permit? Who buys and who sells a permit?
c. What is the connection between your answer
and the answers to problems 2a and 3a?
5. The marginal cost of educating a student is
$4,000 a year and is constant. The figure shows
the marginal private benefit curve.
Price and cost
(thousands of dollars per student per year) 1. Consider each of the following activities or
events and say for each one whether it is an externality. If so, say whether it is a positive or negative production or consumption externality.
■ Airplanes take off from LaGuardia Airport
during the U.S. Open tennis tournament,
which is taking place nearby.
■ A sunset over the Pacific Ocean
■ An increase in the number of people who are
studying for graduate degrees
■ A person wears strong perfume while attending an orchestra concert.
■ A homeowner plants an attractive garden in
front of his house.
■ A person drives talking on a cell phone.
■ A bakery bakes bread.
2. The table provides information about costs and
benefits that arise from the pesticide production
that pollutes a lake used by a trout farmer. 6
2 D = MB
Quantity (thousands of students per year) a. With no government involvement and if the
schools are competitive, how many students
are enrolled and what is the tuition? 9160335_CH14_p315-334.qxd 332 6/22/09 9:06 AM Page 332 CHAPTER 14 Externalities b. The external benefit from education is
$2,000 per student per year and is constant.
If the government provides the efficient
amount of education, how many students
will be accepted and what is the tuition?
6. Bag Revolution
[T]raditional plastic bags … aren’t biodegradable and often end up in the ocean. …
Americans consume roughly 110 billion bags
annually. … 28 cities in the U.S. have proposed
laws restricting the use of plastic bags. ... But San
Francisco now requires all retailers with revenue
over $2 million to offer only compostable or
reusable bags, and Seattle has proposed a 25-cent
Fortune, May 12, 2008
a. Describe the externality that arises from plastic bags.
b. Draw a graph to illustrate how plastic bags
create deadweight loss.
c. Explain the effects of Seattle’s policy on the
use of plastic bags.
d. Draw a graph to illustrate Seattle’s policy and
show the change in the deadweight loss that
arises from this policy.
e. Explain why a complete ban on plastic bags
might be inefficient.
7. The Year in Medicine: Cell Phones
Think you’re safer because you talk on a handsfree cell phone while driving? Think again.
Using either type of phone while trying to drive a
car is roughly equivalent to driving with a bloodalcohol concentration … high enough to get you
arrested … for driving under the influence. Folks
who use hands-free cell phones in simulation trials also exhibited slower reaction times and took
longer to hit the brakes than drivers who weren’t
otherwise distracted. Data from real-life driving
tests show that cell-phone use rivals drowsy driving as a major cause of accidents.
Time, December 4, 2006
a. What negative externalities arise from using a
cell phone while driving?
b. Explain why the market for cell-phone service
creates a deadweight loss.
c. Draw a graph to illustrate how a deadweight
loss arises from the use of cell phones.
d. Explain how government intervention might
improve the efficiency of cell-phone use. 8. D.C. Handgun Ban
But it is not just D.C. that has experienced
increases in murder and violent crime after guns
are banned. Chicago also experienced an
increase after its ban in 1982. Island nations
supposedly present ideal environments for gun
control because it is relatively easy for them to
control their borders, but countries such as
Great Britain, Ireland, and Jamaica have experienced large increases in murder and violent
crime after gun bans. For example, after handguns were banned in 1997, the number of
deaths and injuries from gun crime in England
and Wales increased 340 percent in the seven
years from 1998 to 2005. Passing a gun ban
simply doesn’t mean that we are going to get
guns away from criminals. The real problem is
that if it is the law-abiding good citizens who
obey these laws and not the criminals, criminals
have less to fear and crime can go up.
FOXNews, September 14, 2007
a. What external costs do handguns impose?
b. What external benefits do handguns bring?
c. If both negative and positive externalities arise
from handguns, how can we determine
whether gun ownership should be discouraged
or encouraged or neither?
9. My Child, My Choice
Fully vaccinating all U.S. children born in a
given year from birth to adolescence saves 33,000
lives, prevents 14 million infections and saves
$10 billion in medical costs. Part of the reason is
that vaccinations protect not only the kids that
receive the shots but also those who can’t receive
them—such as newborns and cancer patients
with suppressed immune systems. … The higher
the immunization rate in any population, the less
likely that a pathogen will penetrate the group
and find a susceptible person inside.
Time, June 2, 2008
a. Describe the private benefits and external benefits of vaccinations and explain why a private
market for vaccinations would produce an inefficient outcome.
b. Draw a graph to illustrate a private market for
vaccinations and show the deadweight loss.
c. Explain how government intervention could
achieve an efficient quantity of vaccinations
and draw a graph to illustrate this outcome. 9160335_CH14_p315-334.qxd 6/22/09 9:06 AM Page 333 P roblems and Applications Price (dollars per ton) 10. The figure illustrates the unregulated market for
a pesticide. When factories produce pesticide,
they also create waste, which they dump into a
lake on the outskirts of the town. The marginal
external cost of the dumped waste is equal to the
marginal private cost of producing the pesticide
(that is, the marginal social cost of producing the
pesticide is double the marginal private cost).
0 10 20 30
Quantity (tons per week) a. What is the quantity of pesticide produced if
no one owns the lake and what is the efficient
quantity of pesticide?
b. If the residents of the town own the lake, what
is the quantity of pesticide produced and how
much do residents of the town charge the factories to dump waste?
c. If the pesticide factories own the lake, how
much pesticide is produced?
d. If no one owns the lake and the government
levies a pollution tax, what is the tax that
achieves the efficient outcome?
11. Betty and Anna work at the same office in
Philadelphia. They both must attend a meeting
in Pittsburgh, so they decide to drive to the
meeting together. Betty is a cigarette smoker and
her marginal benefit from smoking a package of
cigarettes a day is $40. Cigarettes are $6 a pack.
Anna dislikes cigarette smoke, and her marginal
benefit from a smoke-free environment is $50 a
day. What is the outcome if
a. Betty drives her car with Anna as a passenger?
b. Anna drives her car with Betty as a passenger?
12. The first two columns of the table show the
demand schedule for electricity from a coal burning utility; the second and third columns show
the utility’s cost of producing electricity. The Price
(cents per kilowatt) 4
20 333 Quantity Marginal cost (kilowatts per day) (cents per kilowatt) 500
2 marginal external cost of the pollution created is
equal to the marginal cost.
a. With no pollution control, what is the quantity of electricity produced, the price of electricity, and the marginal external cost of the
b. With no pollution control, what is the marginal social cost of the electricity generated
and the deadweight loss?
c. Suppose that the government levies a pollution
tax, such that the utility produces the efficient
quantity. What are the price of electricity, the
tax, and the tax revenue per day?
13. Most nurses in the United States receive their
education in community colleges. Mainly
because of differences in class size, the cost of
educating a nurse is about four times that of an
average community college student. Community
college budgets depend on the number of students and not on the subjects taught.
a. Explain why this funding arrangement might
be expected to lead to an inefficiency in the
number of nurses trained.
b. Suggest a better arrangement and explain how
it would work.
14. China Vows to Clean Up Polluted Lake
… Officials in Jiangsu Province [announced]
plans to spend 108.5 billion yuan, or $14.4 billion, for a cleanup of Lake Tai, the country’s
third-largest freshwater lake. The campaign
would focus initially on eradicating the toxic
algal bloom that choked the lake this spring and
left more than two million people without drinking water. …
Lake Tai, known as China’s ancient “land of rice
and fish,” is a legendary setting, once famous for
its bounty of white shrimp, whitebait, and whitefish. But over time, an industrial buildup transformed the region. More than 2,800 chemical
factories arose around the lake, and industrial
dumping became a severe problem and, eventually, a crisis. … 9160335_CH14_p315-334.qxd 334 6/22/09 9:06 AM Page 334 CHAPTER 14 Externalities “The pollution of Lake Tai has sounded the
alarm for us,” Mr. Wen [Prime Minister] said,
“The problem has never been tackled at its root.”
New York Times, October 27, 2007
a. What are the externalities included in this
b. What are the external costs associated with the
pollution of Lake Tai?
c. What was the “alarm” that the pollution of
Lake Tai sounded and why has the problem
“never been tackled at its root”?
15. Fast-Food Trash Be Gone!
Some Oakland, Calif., residents are sick and tired
of tripping over burger wrappers and soda cans,
and the city is ready to do something about it.
The Oakland City Council is proposing a tax on
fast-food restaurants, gas station markets, liquor
stores and convenience stores that serve take-out
food or beverages. Councilwoman Jane Brunner,
who wrote the legislation, estimates that the tax
will raise approximately $237,000 a year, which
would cover the cost of a clean-up crew and the
initial purchase of trucks and equipment to keep
the streets and sidewalks surrounding the city’s
schools litter-free. “Having a clean city affects
everything,” Brunner said.
CNN, February 6, 2006
a. What is the external cost associated with takeout food and beverages?
b. Draw a graph to illustrate and explain why the
market for take-out food and beverages creates
a deadweight loss.
c. Draw a graph to illustrate and explain how
Oakland’s policy might improve efficiency.
16. On April 7, 2008, MSNBC reported that:
Compact fluorescent light bulbs—the squiggly,
coiled bulbs that generate light by heating gases
in a glass tube—are generally considered to use
more than 50 percent less energy and to last several times longer than incandescent bulbs. …
There is no disputing that overall, fluorescent
bulbs save energy and reduce pollution in general. An average incandescent bulb lasts about
800 to 1,500 hours; a spiral fluorescent bulb can
last as long as 10,000 hours. In just more than a
year—since the beginning of 2007—9 million
fluorescent bulbs have been purchased in
California, preventing the release of 1.5 billion
pounds of carbon dioxide compared with traditional bulbs, according to the U.S.
Environmental Protection Agency.
a. Relative to a traditional bulb, what is the external benefit associated with fluorescent
b. Draw a graph to illustrate and explain why the
market for fluorescent bulbs is inefficient.
c. Draw a graph to illustrate and explain how
government actions might achieve an efficient
outcome in the market for bulbs.
17. Clean Green Flying Machine?
… Aviation generates 2–3 percent of man-made
emissions of carbon dioxide, the main greenhouse gas. … Most environmentalists think that
the only solution is to make air travel more
expensive, say through hefty fuel taxes. … But
the airline industry [says it] produces far more
benefits than ills—[contributing] 8 percent to
global [output] by transporting tourists, business
travelers, and cargo around the globe.
Economist.com, August 14, 2007
a. What are the externalities created by the airline
b. Why will hefty fuel taxes encourage airlines to
operate in the social interest?
18. After you have studied Reading Between the Lines
on pp. 328–329, answer the following questions:
a. How does a carbon tax change the costs faced
by the operator of a coal-fired power plant?
b. How does a solar subsidy change the costs
faced by a solar power station?
c. Why might the operator of a coal-fired power
station be influenced by a solar subsidy?
d. Why might the combination of a carbon tax
and social subsidy lead to producing electricity
at too high a marginal social cost?
e. Would it ever make sense to impose a carbon
tax and pay a solar subsidy?
19. Use the link on MyEconlab (Textbook Resources,
Chapter 14) and read the article about wind farms.
a. What types of externalities arise in the production of electricity using wind technologies?
b. Comparing the externalities from wind technologies with those from burning coal and oil,
which are more costly?
c. How do you think the external costs of using
wind technologies should be dealt with? Compare the alternative range of solutions considered in this chapter. ...
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- Fall '08