Module 8 – Public Goods and Externalities Flashcards
What should we do if we really want a clean environment?
A. Increase the social awareness of our citizens.
B. Pay for it in less of other things.
C. Abandon our predominantly free-enterprise system.
D. Discipline ourselves not to be polluters.
The correct answer is B. The problem of pollution is better understood in terms of a failure of the price system rather than a defect in people’s moral fibre. In some instances, markets fail to provide adequate information to decision makers and as a consequence they fail to take into account some undesirable effects of their eco- nomic activity. In these cases the private cost of production is less than the total cost (including the social cost), and consumers respond by consuming too much of the goods in question because they are not paying their full cost. In order to reduce pollution, we must either reduce the external effects by consuming less of the goods whose production creates the pollution or we must use other resources to offset the external effects (e.g. anti-smog devices on cars). Either way, to obtain a pollution- reduced environment will require paying the cost of having less of other things.
Let pg denote public good. Which of the following explains why the marginal equivalency conditions do not hold without collective action to determine which public goods should be produced and who should pay for them?
A. MCpg <> MC_any_other_good
B. MUpg/Ppg <> MU_any_other_good/P_any_other_good
C. MUpg > MU_any_other_good
D. MUpg < MU_any_other_good
The correct answer is B. For households who enjoy public goods but do not pay for them MUpg/Ppg > MU/p of any other good. The actual MCs could be equal and the MUpgcould be > or < the MU of any other good. Thus A, C and D are wrong.
Which of the following is correct? If a paper mill pollutes a stream so that it cannot be used for downstream city water
without expensive treatment, the effect of the economic distortion involved is most likely to be
A. unemployment in the paper industry.
B. a transfer of income from paper users to the owners of the paper mill.
C. too few resources devoted to paper production.
D. a transfer of income from city taxpayers to paper users.
The correct answer is D. The paper mill, in polluting the river, is not taking into account the extra costs incurred by society, i.e. the pollution, in the production of paper. Thus the cost of paper will not reflect the true cost of production, and this means that paper users are being subsidised by other members of society – in this case the city taxpayers.
To which of the following does the free rider problem refer?
It refers to someone
A. riding on a subway without paying
B. flying in an aeroplane with a standby fare
C. enjoying a service without having to pay for it
D. receiving a gift from the individual who purchased it
The correct answer is C. This is a definitional question. A public good, when produced, can be enjoyed by anyone without denying others. Those who do enjoy such a good or service but do not contribute to the cost of its production are known as free riders.
A public good has two characteristics
I. excludability
II. rivalry
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
The correct answer is D. Excludability means if you buy an item other people cannot have that specific item. Rivalry means that your buying some of a good leaves less for other consumers. Excludability and rivalry are characteristics of private goods. Public goods have the opposite characteristics. Your consuming a good does not exclude others and does not diminish the amount available for others, e.g. a lighthouse’s light. Thus I and II are wrong.
The local council decides there was little point in collecting tolls on the four lane motorway bridge across the river between 22.00 and 6.00 hours because the toll fares collected did not come close to paying the toll collector’s wages. ‘There’s just no traffic during these hours and the marginal cost of having a toll collector greatly exceeds any toll revenue collected’ argued the council treasurer. ‘Just because toll revenue is very high during the day is no reason to squander resources at night.’
Which of the following is the most accurate description of the bridge over the river?
A. A private good between 22.00 and 6.00; a public good between 6.00 and 22.00
B. A public good between 22.00 and 6.00; a private good between 6.00 and 22.00
C. A public good between 22.00 and 6.00; a public good between 6.00 and 22.00
D. A private good between 22.00 and 6.00; a private good between 6.00 and 22.00
The correct answer is B. When the bridge is empty/non congested it is a public good. Its use by any motorist does not deny any other motorist and is freely available to all. Thus between 22.00 and 6.00 the bridge is a public good. Between 6.00 and 22.00 the bridge is widely used and when it becomes congested assumes the characteristics of a private good, i.e. rivalry and excludability.
Consider the marginal equivalency condition (MEC) MUa/MCa = MUb/MCb. For the MEC to prevail
I. the MCs must be societal MCs
II. the MUs must be private MUs
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
The correct answer is A. For MEC to prevail the last dollar’s worth of resources in any given industry must yield the same societal utility as the last dollar’s worth of resources in all other industries. Thus II is wrong. The cost of the resources must reflect all relevant costs, i.e. societal costs. Thus I is correct.
Example fo when Mua/Mca = MUb/MCb des not hold rue?
- For economic efficiency: Mua/Mca = MUb/MCb
- The MU and MCs above are societal and so if externalities exist in activity A then Mua/Mca may be understated and so Mua/Mca = MUb/MCb may not hold i.e. not economic efficiency
A firm producing commodity X dumps waste in the local river, causing pollution and killing all salmon and trout. Does the pattern of river utilisation constitute an economi-
cal use of resources? Which of the following is correct?
A. No, because rivers should be preserved for fishing.
B. No, because the firm does not take into account all the costs of using the river for dumping of waste.
C. Yes, if more consumers buy X than buy fish.
D. Yes, if X can be produced more cheaply by using the river to dispose of the
firm’s waste.
The correct answer is B. The river is a source of only two benefits: waste disposal and commercial fish. The greater the amount of waste deposited in the river, the greater the number of fish killed and consequently the smaller the commercial fishing catch. Because the benefits and costs to society from both activities – dumping waste and fishing commercially – are not enumerated, we do not know the best mix of these two uses of the river. What we do know is that the chemical producer, in deciding to dump wastes into the river, is considering the private cost of waste disposal (the cost to himself) but not the social cost. He ignores the cost that his actions impose on the commercial fishermen, and as a result the marginal social benefit from this waste disposal is less than the marginal social cost. This implies that efficiency would be increased if less waste were dumped into the river and more fish caught, even though it would mean higher-priced chemicals.
In order to establish economic efficiency in the presence of pollution, which of the following should a society do? It should
A. make pollution illegal.
B. impose a general income tax to pay for rectifying the effects of pollution.
C. impose a tax on polluters equal to the value of the damage they cause.
D. impose a tax on polluters high enough to get them to stop it.
The correct answer is C
For efficiency to prevail in an economy, prices of goods must reflect their marginal cost to society. When pollution occurs, the firms responsible ignore the additional costs to society of the pollution; they are con-cerned only with the costs directly incurred by them, e.g. labour, materials, etc. The idea of a tax on polluters is to force them to pay the full societal costs, i.e. their direct costs plus the cost of pollution. Put another way, the imposed tax should equal total costs (social costs) minus private costs.
When we argued that a competitive market economy would tend to be economi-cally efficient, there were two underlying assumptions that were never stated explicitly; they are:
- We assumed, first, that whenever a firm produced a good or service it would have to pay all the costs of production; that seems to be quite a reasonable assumption
- Second, we assumed that if a household wanted a good or service it would have to pay for it – remember our households voting with their dollar bills so as to indicate to firms their preferences for different goods and services. That also appeared to be quite a reasonable assumption
Definition of public good?
• A public good is one for which each unit is consumed by everyone and no-one is excluded e.g. national defence
The MEC exist in an economy and a new good x appears in the market in which external benefits exist in the consumption of x.
To re-establish the MEC what would be required?
A. A tax should be levied on the individuals who receive the external benefit but do nothing for it.
B. The price of x should be revised by means of a tax so that MUx/Px = MUa/Pa = MUb/Pb = …
C. A subsidy should be paid to firms producing x
D. The price of x should be lowered by means of a price ceiling to increase consumption of x and lower its marginal utility
The correct answer is C. A subsidy would lower firms’ marginal costs and shift the industry supply curve to the right causing price to decrease and quantity consumed to increase.
A method of regulation imposed on firms that do not account for external costs in their decisions
- per unit tax
- Such a tax would add to each producer’s profit-maximising price
- Conversely, a subsidy paid to producers who generate external benefits by their decisions would have the effect of lowering each producer’s marginal cost.
Every economic decision involves
costs and benefits
Two important characteristics of private goods are:
- excludability: buying a beer automatically excludes anyone else from purchasing that exact beer
- rivalry: buying that beer leaves less beer for other to enjoy
A paper mill situated on the bank of a river dumps its used chemicals in the river. For a one mile stretch down river an unpleasant smell exists; as a result this stretch of the river is not used for fishing much to the annoy-ance of the local population.
If the paper mill were to purchase the fishing rights on the mile of river downstream which of the following would occur?
A. The paper mill would stop polluting the river
B. The externality would be internalised
C. The paper mill would have no incentive to stop polluting the river
D. The number of fish caught in the river would increase
The correct answer is B. By owning the fishing rights the paper mill would take into account the cost of polluting the river which previously it had ignored. Why? Because the pollution affects the fish catch which is now owned by the paper mill. The costs of pollution are now borne by the mill; the externality has been internalised. The paper mill may stop polluting the river and cause more fish to be caught but that is not guaranteed; it would depend on marginal benefits and marginal costs as would the incentive to stop polluting. Thus there is no guarantee that A or C or D is true.
A paper mill situated on the bank of a river dumps its used chemicals in the river. For a one mile stretch down river an unpleasant smell exists; as a result this stretch of the river is not used for fishing much to the annoy-ance of the local population.
Why will the MEC not hold in the presence of the paper mill?
A. The marginal utility of paper will exceed the marginal utility of other goods
B. The marginal utility of paper will be less than the marginal utility of other goods
C. The price of paper will be less than societal marginal cost of production
D. The price of paper will be greater than societal marginal cost of production
The correct answer is C. The MEC are made up of two parts utility maximising behaviour of households and profit maximising behaviour of firms. For the latter in equilibrium, price = societal marginal cost. In the paper mill case the firm is using private marginal cost which is less than societal marginal cost.
There are two principal reasons why we as a society do not rely on market forces completely in determining the allocation of scarce resources; what are they?
- The first is to help achieve economic
efficiency - The second is to alter the distribution of goods and services to house-
holds
Suppose all consumers, voting independently and honestly, indicated the maximum amount that they would be willing to pay for public good Y, and that this amount was
the same for each. If each consumer contributed this amount, all of which was devoted to producing this good, then, in terms of economic efficiency which of the following
would happen?
A. Too much of Y would be produced.
B. Too little of Y would be produced.
C. Just the right amount of Y would be produced.
D. Without more information, you cannot tell whether too much, too little or just the right amount would be produced.
The correct answer is A. Each consumer, in voting honestly, would indicate how much of good Y that consumer wished. But by its nature other people could enjoy the public good purchased by the consumer, who in turn would enjoy more of the same good purchased by all other consumers voting honestly and independently. For instance, then, each consumer might vote for his own policeman and society would finish up with far too many policemen.
Without collective action there is likely to be under provision of public goods because
I. a non contributing individual can enjoy a public good if someone else provides it
II. a purchaser of a public good cannot deny access to those who refuse to contribute to its purchase
III. each public good requires more resources than any single individual owns
Which of the following is correct?
A. I only
B. I and II only
C. III only
D. I, II and III
The correct answer is B. A free rider is someone who enjoys a good without having to pay for it. If I would like illumination in my street I can enjoy it if my neighbours install a street light; I delay purchase hoping a neighbour will install a light. Thus I is true. I am unwilling to install a light because there is no way I can force my neighbours to contribute to the cost. Thus II is true. I could certainly afford to install a street light; households install security systems that allow close neighbours to be free riders. Thus III is wrong.
