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Universidad Carlos III de Madrid – Department of Economics Principle of Economics – Year 2013- Problem Set 7
Conceptual Questions (For grading)
- 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.
- 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.
- 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.
- 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).
Another private solution, in line with the Coase Theorem, is to define property rights on all the goods that are relevant for the externality; Coase Theorem states that externalities do not create problems if property rights are well-defined on every existing good and if transaction costs are low enough as not to impede the formation of contracts. Of course, in the real world there are some cases in which the definition of these property rights is complex (air for instance); moreover, the distribution of property rights is not irrelevant because it affects welfare.
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- What do we mean by excludable goods? What is rivalry in consumption? What is a public good? Give examples of public goods. What differentiates a public good from a common resource?
Solution : Excludable goods are goods for which some people can be excluded from consumption (to be admitted in a theater you need to buy a ticket). Rivalry in consumption means that if a certain quantity of a good is consumed by someone, that same quantity of the good cannot be consumed by someone else. A public good is a good that is neither rival nor excludable. Examples of public goods: a lighthouse, national defense, fountains (unless the square in which they are is very crowded).
Problems (For grading)
- Fishing vessels operating at night near the Spanish coast are concerned about their safety. Due to the crises, the government is unable to finance the construction and management of lighthouses along the coast. For this reason, fishers have decided to join forces for doing it themselves. The cost of building and maintaining a lighthouse is 150,000 Euros, but lighthouses contribute to increase income of fishermen by the amounts indicated in the table below.
a) Explain why a lighthouse is a public good.
It is neither exclusive nor rival. Non-exclusive: it is not possible to prevent that others use it. Non-rival: The use by one person does not reduce the use by another one.
b) Calculate the marginal cost and marginal income of individual fishing boat according to the number of operating lighthouses on the coast. Also calculate total (social) income and social marginal revenue, assuming that there are 15 fishing boats in business.
c) If only one boat owner were to cover the cost of its navigation aid from lighthouses, will he do it? How many boats are needed to make the social marginal income due to lighthouses equal to the marginal cost of building and operating a lighthouse?
A single fisherman decides not afford the cost of lighthouses. The total revenue of the fisherman is lower than the total cost of a lighthouse. Thus, paying the cost of lighthouse is not profitable. 15 boats are needed.
Number of lighthouses
Total cost of lighthouses
Marginal cost of lighthouses
Income of each fishing vessel attributable to lighthouses
Total (social) income due to lighthouses (N=15)
Marginal social income due to lighthouses (N=15) 0 0 0 0 1 150 150 10 150 150 2 300 150 16 240 90 3 450 150 18 270 30 4 600 150 19 285 15
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B. When there are 25 boats contributing: 2 lighthouses will be built and in operation.
C. When there are 75 boats contributing: 3 lighthouses will be built and in operation.
Total cost of the lighthouses Marginal cost of the lighthouses Individual income due to the lighthouses
Total(Social) income (N=25) due to the lighthouses Marginal social income due to the lighthouses (N=25)
Total cost of the lighthouses
Marginal cost of the lighthouses
Individual income due to the lighthouses
Total(Social) income (N=75) due to the lighthouses
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D. When there are 150 boats contributing: 4 lighthouses will be built and in operation.
Other Questions (For grading)
- A tax on pollution caused by chemical factories discharging into a river:
a) Induce the firm to reduce the polluting production because it makes them internalize the external costs of such production. b) Should be equal to the marginal external cost of discharges. c) Has the same effect as tradable discharge permits to the extent that sets a limit on production equal to the socially optimal production. This is because the opportunity cost of permits acts as a tax on pollution, we call such a tax Pigovian. d) All the above statements are correct.
- Currently, two companies of electric power, Powerama and Watts-Are-Us, each emits 100 units of pollution. Each company has the ability to "clean its own production" at some cost. The cost of eliminating each unit of pollution is 200 Euros for Powerama and 300 Euros for Watts-Are-Us. The government establishes a program of tradable pollution permits, so that each company must have a permit for each unit of pollution it emits. The Government issued a total of 100 permits, 50 permits for each company. If the two companies can trade permits with each other, what would be the likely outcome?
a) Powerama completely eliminates its own pollution and sells all its permits to Watts-Are-Us. c) Watts-Are-Us completely eliminates its own pollution and sells all its permits to Powerama.
Total cost of the lighthouses Marginal cost of the lighthouses Individual income due to the lighthouses Total(Social) income (N=150) due to the lighthouses Marginal social income due to the lighthouses (N=150)
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C) Discuss what measures could be taken to mitigate the loss of welfare. Do you think it would be efficient to provide free vaccine to all individuals in society? For whom this would be just a pure transfer of income?
Suppose that the marginal utility (private value) of all individuals is the same, but the society is divided into two groups of equal size: those who generate a small externality once they have been vaccinated and those who generate a greater externality once they have been vaccinated. Furthermore, suppose that the marginal cost of producing the vaccines is increasing and linear.
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D) Give two examples that would be included in each group. Think of teachers, doctors, nurses…
_- Greater externality: people who are in contact with a lot of people or in contact with children (teachers, doctors) o people whose work performance is very important for society (teachers, doctors, government ministers, president of the country).
- Smaller externality: the rest of the population._
E) Suppose that the marginal cost of vaccinating a group equals the private value of been vaccinated. What group do you think all its members should be vaccinated? How do you calculate the percentage of members of the second group that should undergo vaccination?
Marginal Cost (Supply)
Social Marginal Utility
Private Marginal Utility (Demand)
%
Q
P
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