Externalities
1. Which of the following describes an externality and which does not? Explain your answer (1
point)
a) A policy of restricted coffee exports in Brazil causes the US price of coffee to rise – an increase
which in turn also causes the price of tea to rise: The restriction of coffee exports leading to
increase coffee and tea prices is a market effect, not an externality.
b) An advertising blimp distracts a motorist who then hits a telephone pole: The blimp creates a
negative externality that influences the drivers’ safety (since the price charge by the firm does not
reflect the negative externality, too much of this type of advertising is produced from society’s
point of view)
c) Planting flowers in your front garden: The whole neighborhood benefits from you planting flowers
so it is a positive externality. Too little will be planted from society’s point of view.
2. Compare and contrast the following three mechanisms for treating pollution externalities when the
costs and benefits of abatement are uncertain: a) an emission fee; b) an emissions standard; c) a
system of transferable emissions permits (1.5 points)
Since pollution is not reflected in the marginal cost of production, its emission creates an externality.
The choice between a fee and a standard will depend on the marginal cost and marginal benefit of
reducing pollution. If small changes in abatement yield large benefits while adding little to cost, the
cost of not reducing emissions is high. Thus, standards should be used. However, if small changes in
abatement yield little benefit while adding greatly to cost, the cost of reducing emissions is high and
fees/taxes should be used.
A system of transferable permits combines fees and standards. First, a standard is set, and then fees are
used to transfer permits across firms (the firm with the highest MCA will buy the most permits). Note
a problem arises id the total number of permits is incorrectly chosen.
3. Suppose a clothing factory is located downwind from a copper smelting plant. The copper smelting
plant emits particulates into the air that cause $100,000 in damage per year to the clothing factory
in terms of fabric discoloration. The plant could eliminate its emissions by installing a superior
scrubbing technology at a cost of $50,000 per year. Existing regulations do not prohibit the
emission of these particulates. The only way to remedy this inefficiency is through government
intervention. True or false? Explain your answer (1 point)
That the only way to remedy this inefficiency through government intervention is a false statement.
According to the Coase theorem, given that existing regulations do not prohibit the emission of these
particulates, the clothing factory could offer at least $50,000 per year, and no more than $100,000 per
year to the copper smelting plant to install the superior scrubbing technology and thereby eliminate
these emissions.
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