Week 9 - Externalities

Question 1

what is a market?

Answer 1

An institution that involves the exchange of goods and
services AND the rights (property rights) to use them.
 Individuals with purely selfish motives mutually benefit from exchange.

Question 2

Define market failure

Answer 2

Situations where the market fails to achieve an efficient outcome, or where efficient, the outcome is deemed to be socially undesirable

Question 3

Define government failure

Answer 3

Situations where the government fails to achieve an efficient outcome or redress a market failure, or where efficient, the outcome is deemed to be socially undesirable.

Question 4

define public goods

Answer 4

Goods that are neither excludable nor rival in consumption

Question 5

define private goods

Answer 5

Goods that are both excludable and rival in consumption

Question 6

define rival in competition

Answer 6

The property of a good whereby one person’s use diminishes other people’s use

Question 7

define excludable

Answer 7

The property of a good whereby a person can be prevented from using it

Question 8

define ‘free rider problem’

Answer 8

A person who obtains the benefit of a good but does not pay for it
(typically public goods)

Question 9

explain the market failure of asymmetric infomation

Answer 9

Markets use prices to convey information, but some information is not provided in sufficient quantities or somebody in the market knows more than somebody else
Drugs
Certain foods, entertainment activities and products
o Hence the need for health warnings, building codes, prevention of deceptive advertising etc
o Landlords know more about their properties than tenants such a students
o Mortgages: borrower knows more about their ability to repay a loan than the lender
o Used car dealer knows more about a vehicle quality than a buyer
o Inside information of traders in financial markets

Question 10

Define externality

Answer 10

The uncompensated impact of one person’s actions on the wellbeing of a third party not involved in the transaction

o Economic transactions generate costs and benefits
o Often, these costs and benefits fall on third parties.
o Those undertaking the transaction do not consider these costs and benefits.
o Third parties are not compensated for the cost or benefit falling upon them.
o Also know as spillovers

Question 11

Define negative externality

Answer 11

uncompensated cost born on a third party

Question 12

Define positive externality

Answer 12

Uncompensated benefit born on a third party

Question 13

result of negative and positive externality

Answer 13

Negative externalities – lead to oversupply of a good/service

Positive externalities – lead to undersupply of a good/service

Market outcomes are inefficient in the presence of externalities because the individual consumer or producer chooses a quantity that equates his marginal benefit with his marginal cost, but the marginal social cost is larger (negative externality) or the marginal social benefit is larger (positive externality). Thus, markets produce a larger quantity than is socially desirable when there is a negative externality, and a smaller quantity than is socially desirable when there is a positive externality. Economists often refer to externalities as having a missing market, the demand for or supply of the “good” (or “bad”) that affects others.

Question 14

types of externalities

Answer 14

Producer on producer:
Chemical plant polluting a lake used for fishing
Bee-keeper located next to apple grower
Producer on consumer:
Impact of noise from factory on residential areas
Factory builds a sealed road
Contamination of ground water from fertilizers

Consumer on consumer
o	Congestion of roads, automobile emissions 
o	Neighbor renovates their house
o	Knowledge passed on to others
o	Smoking in restaurant
o	Anti-social behaviour
o	Sand dune destruction from 4WDs.
 Consumer on producer
o	Campers burn tree plantation

Government on producer
Knowledge from government research centers
spilling over to industry
US government stabilisation policies on Australian producers
Government on consumer
Government owned coal-fired electric utility plant causing air pollution

Producer on government
Consumer on government

Question 15

define internalising an externality

Answer 15

Altering incentives so that people take into account the external effects of their actions
• E.g. Imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity

Question 16

explain positive externalities

Answer 16

The intersection of the supply curve and the social-value curve determines the optimal output level.
The optimal output level is more than the equilibrium quantity.
The market produces a smaller quantity than is socially desirable.
The social value of the good exceeds the private value of the good.

Internalising externalities: Subsidies Used as the primary method for attempting to internalise positive externalities. Also patent laws – allowing firms to sell off their innovation

Question 17

explain coast theorem

Answer 17

The Coase Theorem = the proposition that if private parties can bargain without cost over allocation of resources, they can solve the problem of externalities on their own
read page 229

Coase (1960) argued that externalities could be resolved as long as property rights exist over a resource and transaction costs are low. Private transactions will be Allocative efficient. Importantly, it does not matter who has the property rights – the polluter or the sufferer
According to Coase’s Theorem, people will never pass up an opportunity to cooperate by means of mutually advantageous exchange

Question 18

Why private solutions do not always work? (coase theorem)

Answer 18

Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.
Transaction costs = are the costs that parties incur in the process of agreeing to and following through on a bargain.

Question 19

When externalities are significant and private solutions are not found, government may attempt to solve the problem through:

Answer 19

1. Command-and-control policies:
   form of regulations:
   forbid certain activities and require certain activities
   Examples:
   • Requirements that all students be immunized.
   • Stipulations on pollution emission levels set by state/territory environmental protection agencies (EPAs).
2. Market-based policies:
   Government uses taxes and subsidies to align private
   • incentives with social efficiency.
   • Pigovian taxes are taxes enacted to correct the effects of a negative externality. (e.g. carbon tax)

Question 20

what are Pigovian taxes

Answer 20

taxes are taxes enacted to correct the effects of a negative externality. (e.g. carbon tax)

Question 21

define corrective tax

Answer 21

A tax enacted to correct the effects of a negative externality

Question 22

draw supply and demand graphs of positive and negative externliaites in consumption and production

Answer 22

:)

Question 23

What command-and-control policy might the landlord impose? Could such a policy lead to an inefficient outcome?

Answer 23

The landlord could impose a rule that music couldn’t be played above a certain decibel level. This could be inefficient because there would be no harm done by Kylie playing her music loud if Nigel isn’t home. Further, if Kylie benefits more from loud music than Nigel suffers, it is actually efficient to play loud music.

Question 24

Suppose the landlord lets the tenants do whatever they want. According to the Coase theorem, how might Kylie and Paul reach an efficient outcome on their own? What might prevent them from reaching an efficient outcome?

Answer 24

Kylie and Paul could negotiate an agreement that might, for example, allow Kylie to play her music loud at certain times of the day. Or, Kylie could compensate Nigel for playing loud music.

They might not be able to reach an agreement if the transactions costs are high or if
bargaining fails because each holds out for a better deal.
Note that Kylie, in compensating Paul if she plays music presumes that, (as is usual), that Paul owns the right to quietude. As such Kylie “purchases” the right to violate it (purchases the noise)

Question 25

Greater consumption for alcohol leads to more vehicle accidents and thus, imposes costs on people who do not drink and drive.
a) Illustrate the market for alcohol, labeling the demand curve, the social-value curve, the supply curve, the social-cost curve, the market equilibrium level of output and the efficient level of output.

Answer 25

week 10 tute
The market for alcohol is shown in the figures below. We can think of the externality as either reducing the social value (marginal social benefit is less than marginal private benefit) or as increasing the social cost (marginal social cost is greater than marginal private cost). Notice that both result in the same optimal output, optimal price, and deadweight loss. Without intervention, the equilibrium is denoted by QLF and PLF. The socially optimal quantity and price are given by P* and Q*. The deadweight loss is given by the shaded area.

learn how to these :)

Question 26

types of goods

Answer 26

Private goods
 are both excludable and rival

 Public goods
 are neither excludable nor rival

 Common resources
 are rival but not excludable

 Natural monopolies
 are excludable but not rival

Question 27

explain  Quasi-Public Goods (also called Near Public Goods)

Answer 27

• Non-rival up to a point, until congestion occurs (e.g. roads, ambulance, police)
• Can exclude others

Question 28

Pure public good:

Answer 28

 National defense, lighthouses, police
• Cannot supply a good or service without providing it to others
• Consumption by person A does not deplete consumption by person B

Question 29

Quasi Public good:

Answer 29

 Museums, roads, bridges, parks, cable-tv, internet access
• Can be non-rival up to a point
• Can exclude others

Question 30

define common resources

Answer 30

Goods that are rival in consumption but not excludable

Question 31

define club goods

Answer 31

Goods that are excludable but not rival in consumption

Question 32

define natural monoply

Answer 32

A monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms

Question 33

explain solving the free rider problem

Answer 33

• The government can decide to provide the public good if the total benefits exceed the costs.
• The government can make everyone better off by providing the public good and paying for it with tax revenue.
• Therefore gov’t intervention
• Particually public goods, as they are neither excludable nor rival

Question 34

expliain tragedy of the commons

Answer 34

A parable that illustrates why common resources get used more than is socially desirable from the standpoint of society as a whole.

• Common resources tend to be used excessively when individuals are not charged for their usage.
• This is similar to a negative externality
• An explanation for the extinction of species

Question 35

To decide whether or not it should fund a public good, the government must conduct a

Answer 35

Cost–benefit analysis: a study that compares the costs and benefits to society of providing a public good.

Question 36

reasons for regulations

Answer 36

Respond to market failure (e.g. externalities & public goods)
Income Guarantee (e.g. minimum wages)
Quality Guarantee (e.g. product information, occupation licensing, doctors)
Paternalistic – the State knows what is best

Question 37

reasons for deregulation

Answer 37

 Price Flexibility
 Resource Allocation Efficiency
 Competition policy results in gains for consumers
 Government Failure

Question 38

explain theories of regulation (3)

Answer 38

Public interest - The State is a neutral arbiter promoting efficiency and equity

 2. Pluralist - Regulation accommodates conflicting claims – consensus regulation

 3. Private interest - The power of the State is captured and used to serve the interests of elites and powerful sections of society.