Chapter 11: Externalities

Question 1

What is an externality?

Answer 1

An externality is a cost or benefit that impacts a bystander who did not choose to incur that cost or benefit.

Question 2

What are negative externalities?

Answer 2

Negative externalities are external costs imposed on bystanders, like pollution or noise disturbances, where the group causing harm does not bear the full costs.

Question 3

What are positive externalities?

Answer 3

Positive externalities are benefits that individuals or firms provide to others without receiving compensation, such as getting vaccinated to reduce disease spread.

Question 4

How do externalities affect market equilibrium?

Answer 4

Externalities cause market equilibrium to deviate from the socially efficient outcome, often lowering total surplus.

Question 5

What is social cost?

Answer 5

Social cost is the total cost to society from producing or consuming a good, including both private and external costs.

Question 6

How does social cost relate to negative externalities?

Answer 6

For a good with a negative externality, the social cost curve is above the supply curve, reflecting the additional external costs.

Question 7

What happens when there is a negative externality in a market?

Answer 7

The market produces more than the socially optimal quantity, resulting in a deadweight loss and lower total surplus.

Question 8

What are the four main remedies for externalities?

Answer 8

Taxes and subsidies, tradable permits, command and control regulations, and private solutions.

Question 9

What is the Coase theorem?

Answer 9

The Coase theorem states that private negotiations can resolve externalities if property rights are well-defined and transaction costs are low.

Question 10

How can a tax help address a negative externality?

Answer 10

A tax equal to the external cost shifts the supply curve up to the social cost curve, reducing the quantity to the socially optimal level.

Question 11

What is social value?

Answer 11

Social value is the total benefit to society from a good, including both private and external benefits.

Question 12

How does social value relate to positive externalities?

Answer 12

For a good with a positive externality, the social value curve is above the demand curve, reflecting the additional external benefits.

Question 13

What happens when there is a positive externality in a market?

Answer 13

The market produces less than the socially optimal quantity, resulting in a deadweight loss and lower total surplus.

Question 14

How can a subsidy help address a positive externality?

Answer 14

A subsidy equal to the external benefit shifts the demand curve up to the social value curve, increasing the quantity to the socially optimal level.

Question 15

What is deadweight loss in the context of externalities?

Answer 15

Deadweight loss is the reduction in total surplus caused by a market failure, such as when a market fails to account for external costs or benefits.

Question 16

What is the goal of internalizing an externality?

Answer 16

The goal is to adjust incentives so that individuals consider the external costs or benefits of their actions, leading to a socially efficient outcome.

Question 17

What are the two main types of government approaches to solve externalities?

Answer 17

Command-and-control policies and market-based policies.

Question 18

What is a command-and-control policy?

Answer 18

It mandates specific actions for individuals or businesses, such as pollution regulations for car manufacturers.

Question 19

How do market-based policies work?

Answer 19

They alter incentives so that individuals or businesses choose the socially optimal quantity on their own by internalizing external costs or benefits.

Question 20

What are the two main types of market-based policies?

Answer 20

Corrective taxes (and subsidies) and tradable permits.

Question 21

What is a corrective tax (Pigovian tax)?

Answer 21

A tax designed to make private costs equal social costs by charging for negative externalities, like the carbon tax on CO₂ emissions.

Question 22

What is the purpose of a corrective subsidy?

Answer 22

To encourage activities that produce positive externalities by equalizing private value with social value.

Question 23

Why are corrective taxes considered efficient

Answer 23

They reduce deadweight loss, push the market toward social optimum, and raise government revenue.

Question 24

How do tradable permits work?

Answer 24

The government sets a pollution limit and sells permits; businesses with lower abatement costs reduce pollution, while those with higher costs buy permits.

Question 25

Why are tradable permits considered efficient?

Answer 25

They allow pollution reduction at the lowest cost by targeting firms with the lowest abatement costs, similar to corrective taxes.

Question 26

When is a carbon tax preferred over a cap-and-trade system?

Answer 26

When cost predictability is important, even if the exact reduction in pollution is not known.

Question 27

When is a cap-and-trade system preferred over a carbon tax?

Answer 27

When a country wants precise control over pollution reduction, despite variable costs.

Question 28

What is a common objection to market-based policies like taxes and permits?

Answer 28

Some people believe that “buying the right to pollute” is unethical or inappropriate.

Question 29

When might command-and-control policies be preferable to market-based ones?

Answer 29

When the best solution is known and universal compliance is essential, such as in a vaccination program.

Question 30

What are three types of private solutions to externalities?

Answer 30

Moral codes/social rules, charities, and private contracts.

Question 31

What does the Coase Theorem state?

Answer 31

If transaction costs are low, private parties can negotiate to resolve externalities and reach an efficient outcome.

Question 32

Why might private solutions to externalities fail?

Answer 32

High transaction costs or coordination problems, especially when many people are involved.

Question 33

What is an example of a coordination problem in private solutions?

Answer 33

Organizing residents of a large building to negotiate with noisy bars may be too costly and complex.