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Chapter 05
Externalities
Multiple Choice Questions
1. Marginal damages are hard to measure because
A. they can be generated from multiple
sources.
B. they are hard to
graph.
C. they happen over
time.
D. no one cares about
them.
5-1
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.2. In the figure below, if the marginal damages line did not originate at 0,
3. A. it would mean that marginal damages did
not exist.
B. there is no way to find
MSC.
C. MSC would not originate at the same intercept
as MPC.
D. all of these answer options are
correct.
Externalities can be positive because
A. marginal damages do not last over
time.
B. utility can be impacted positively as well as
negatively.
C. there is no concept for marginal
benefit.
D. positive externalities are
subsidies.
5-2
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.4. Refer to the following graphs. Which graph(s) represent(s) an externality?
A. graph
A
B. graphs A and
B
C. graph
B
D. neither graph A nor
graph B
5-3
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.5. Refer to the figure below. What is the total amount of tax paid by Bart?
A. 0
B. 5
0
C. 1
5
D. 75
0
6. Congestion pricing
7. A. is a
tax.
B. keeps nasal passages
clear.
C. is never
efficient.
D. all of these answer options are
correct.
Pollution rights may be traded if
A. polluters try to hide
pollution.
B. administrators are uncertain about Pigouvian
taxes.
C. there is no market for
pollution.
D. pollution is
harmless.
5-4
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.8. Externalities can be produced by ____________, as well as ____________.
9. A. individuals;
firms
B. market prices; market
incomes
C. oceans;
streams
D. none of these answer options are
correct.
A Pigouvian tax corrects for
A. market
congestion.
B. market
losses.
C. inefficient
sales.
D. low market
prices.
10.Which of the following is correct?
A. SMC = PMC –
MD
B. MPB = MSB +
MEB
C. SMC = PMC +
MD
D. MSC =
MPB
E. MSB = MSC +
MPB
11.Marginal benefits are downward sloping when
A. there are no total
benefits.
B. the slope of the marginal benefits curve is
negative.
C. total benefits are increasing at a
decreasing rate.
D. marginal costs are upward
sloping.
5-5
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.12.A Pigouvian subsidy
A. cannot exist with
externalities.
B. is the same thing as a Pigouvian
tax.
C. is measured in terms of Pigouvian
dollars.
D. moves production to the socially optimal level of
output.
13.As a general rule, zero pollution is not socially desirable because
A. there would be no
production.
B. the Environmental Protection Agency (EPA) needs to have
something to do.
C. no pollution would lead to global
warming.
D. all of these answer options are
correct.
14.Externalities require government intervention when
A. violence will result between disputing
parties.
B. there are only a few sellers in the
market.
C. property rights are not clearly
established.
D. the government imposes sales
taxes.
E. all of these answer options are
correct.
15.Marginal damages
A. must always be considered in social marginal
costs.
B. must not be considered in social marginal
costs.
C. must sometimes be considered in social
marginal costs.
D. have nothing to do with social marginal
costs.
5-6
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.16.A tax levied on each unit of pollution is
A. an income
tax.
B. a emissions
fee.
C. a flat
tax.
D. an international
tax.
17.A cap-and-trade policy
A. has a set number of
permits.
B. allows polluters to trade
permits.
C. caps the total level of pollution
allowed.
D. all of these answer options are
correct.
18.Command-and-control regulations
A. are less flexible than incentive based
regulations.
B. come from the private
sector.
C. have technology standards a type of
control.
D. are less flexible than incentive based regulations and have technology standards a
type of control.
E. are less flexible than incentive based regulations and come from the
private sector.
19.Technology standards work in reducing externalities of all kinds.
A. Tru
e
B. Fals
e
C. Uncertai
n
5-7
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.20.Negative externalities cause loss of welfare not transmitted by market factors.
A. Tru
e
B. Fals
e
C. Uncertai
n
21.Externalities can be positive, as well as negative.
A. Tru
e
B. Fals
e
C. Uncertai
n
22.Pure public goods involve positive externalities.
23.A subsidy for pollution not produced can induce producers to pollute at the efficient
A. Tru
e
B. Fals
e
C. Uncertai
n
level.
A. Tru
e
B. Fals
e
C. Uncertai
n
24.Pollution rights can be traded and are always efficient.
A. Tru
e
B. Fals
e
C. Uncertai
n
5-8
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.25.In the 1970s, the U.S. relied on Command-and-Control models of pollution
regulation.
A. Tru
e
B. Fals
e
C. Uncertai
n
26.The desire in the U.S. for owner-occupied housing led to subsidies that contributed to
the recession which started in 2007.
A. Tru
e
B. Fals
e
C. Uncertai
n
27.Market-oriented solutions to externalities rarely work.
A. Tru
e
B. Fals
e
C. Uncertai
n
28.For market efficiency, MSC must be equated to MSB.
A. Tru
e
B. Fals
e
C. Uncertai
n
29.College education is an example of a positive externality.
A. Tru
e
B. Fals
e
C. Uncertai
n
5-9
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.30.An emissions fee is preferable to a cap-and-trade when MSB are elastic and costs are
uncertain.
A. Tru
e
B. Fals
e
C. Uncertai
n
31.Incentive-based regulations provide polluters no incentive to reduce pollution and are
thus not used often.
A. Tru
e
B. Fals
e
C. Uncertai
n
Essay Questions
32.Suppose the factory Afro-Puffs Inc. produces wigs. As a by-product of this wig
production, they also produce dangerous emissions of toxic gases (as a result of the
strong glue used to hold the hair in place). The De-Lite car factory, down the road,
experiences a negative externality from this production process. Suppose that the
supply curve (private marginal costs) for the wig factory is X = (2/5)P – 2, and it faces
a market demand of Xd = 15 – P/2. The marginal damages caused by the production
of wigs can be written as X = P – 1/2.
(a) Find the equilibrium price and quantity in the market for wigs.
(b) Find the socially optimal level of wigs and the corresponding price.
(c) How much should the wig factory be taxed per wig?
5-10
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.33.A steel factory has the right to discharge waste into a river. The waste reduces the
number of fish, causing damage for fisheries. Let X denotes the quantity of waste
dumped. The marginal damage, denoted MD, is given by the equation MD = 2 + 5Q.
The marginal benefit (MB) of dumping waste is given by the equation MB = 34 – 3Q.
(a) Calculate the efficient quantity of waste.
(b) What is the efficient fee, in dollars per unit of waste, which would cause the firm
to dump only an efficient quantity of waste?
(c) What would be the quantity dumped if the firm did not care about the fishery?
34.The private marginal benefit for commodity X is given by 15 – X, where X is the
number of units consumed. The private marginal cost of producing X is constant at
10. In the absence of any government intervention, how much X is produced? What is
the gain to society involved in moving from the inefficient to the efficient level of
production?
5-11
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.35.Consider the case of two farmers, Tony and Hakim, depicted in the following figure.
Both use DDT (a chemical pesticide) for their crops. The use of DDT causes an
externality for swimmers down river from the farms.
(a) Show the amount of pesticides used if each uses the privately optimal level of
pesticides.
(b) Show the amount of pesticides used if they are socially concerned.
(c) Why is a reduction back to XH = HT not socially desired?
5-12
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.36.Refer to the figures below to answer this question:
Cap-and-trade versus emissions fee when marginal social benefits are inelastic and
costs are uncertain:
5-13
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.Cap-and-trade versus emissions fee when marginal social benefits are elastic and
costs are uncertain:
a) In case of an inelastic marginal social benefit curve, what type of pollution
reduction system should the government employ? Why?
b) If the social benefit curve is elastic, do you answer change?
c) What are advantages and disadvantages of Cap-and-Trade systems over Emission
Fee systems when the inflation and change in marginal costs are considered?
37.Why are command- and -control regulations less flexible than incentive based
systems?
38.Which policy is more effective when handling externalities: Cap-and-trade or
emissions fee?
5-14
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.39.List and discuss three problems that might arise when using the Coase theorem.
5-15
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.Chapter 05 Externalities Answer Key
Multiple Choice Questions
1. Marginal damages are hard to measure because
A. they can be generated from multiple
sources.
B. they are hard to
graph.
C. they happen over
time.
D. no one cares about
them.
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Topic: Graphical Analysis
5-16
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.2. In the figure below, if the marginal damages line did not originate at 0,
A. it would mean that marginal damages did
not exist.
B. there is no way to find
MSC.
C. MSC would not originate at the same intercept
as MPC.
D. all of these answer options are
correct.
AACSB: Reflective Thinking
Blooms: Understand
Difficulty: 2 Medium
Topic: Public Responses to Externalities: Taxes and Subsidies
3. Externalities can be positive because
A. marginal damages do not last over
time.
B. utility can be impacted positively as well as
negatively.
C. there is no concept for marginal
benefit.
D. positive externalities are
subsidies.
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Topic: The Nature of Externalities
5-17
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.4. Refer to the following graphs. Which graph(s) represent(s) an externality?
A. graph
A
B. graphs A and
B
C. graph
B
D. neither graph A nor
graph B
AACSB: Reflective Thinking
Blooms: Understand
Difficulty: 2 Medium
Topic: Graphical Analysis
5-18
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.5. Refer to the figure below. What is the total amount of tax paid by Bart?
A. 0
B. 5
0
C. 1
5
D. 75
0
AACSB: Reflective Thinking
Blooms: Understand
Difficulty: 2 Medium
Topic: Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
6. Congestion pricing
A. is a
tax.
B. keeps nasal passages
clear.
C. is never
efficient.
D. all of these answer options are
correct.
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
5-19
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.7. Pollution rights may be traded if
A. polluters try to hide
pollution.
B. administrators are uncertain about Pigouvian
taxes.
C. there is no market for
pollution.
D. pollution is
harmless.
8. AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Topic: Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
Externalities can be produced by ____________, as well as ____________.
A. individuals;
firms
B. market prices; market
incomes
C. oceans;
streams
D. none of these answer options are
correct.
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: The Nature of Externalities
9. A Pigouvian tax corrects for
A. market
congestion.
B. market
losses.
C. inefficient
sales.
D. low market
prices.
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Public Responses to Externalities: Taxes and Subsidies
5-20
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.10. Which of the following is correct?
A. SMC = PMC –
MD
B. MPB = MSB +
MEB
C. SMC = PMC +
MD
D. MSC =
MPB
E. MSB = MSC +
MPB
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Graphical Analysis
11. Marginal benefits are downward sloping when
A. there are no total
benefits.
B. the slope of the marginal benefits curve is
negative.
C. total benefits are increasing at a
decreasing rate.
D. marginal costs are upward
sloping.
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
12. A Pigouvian subsidy
A. cannot exist with
externalities.
B. is the same thing as a Pigouvian
tax.
C. is measured in terms of Pigouvian
dollars.
D. moves production to the socially optimal level of
output.
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Public Responses to Externalities: Taxes and Subsidies
5-21
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.13. As a general rule, zero pollution is not socially desirable because
A. there would be no
production.
B. the Environmental Protection Agency (EPA) needs to have
something to do.
C. no pollution would lead to global
warming.
D. all of these answer options are
correct.
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Graphical Analysis
14. Externalities require government intervention when
A. violence will result between disputing
parties.
B. there are only a few sellers in the
market.
C. property rights are not clearly
established.
D. the government imposes sales
taxes.
E. all of these answer options are
correct.
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Private Responses
15. Marginal damages
A. must always be considered in social marginal
costs.
B. must not be considered in social marginal
costs.
C. must sometimes be considered in social
marginal costs.
D. have nothing to do with social marginal
costs.
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Graphical Analysis
5-22
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.16. A tax levied on each unit of pollution is
A. an income
tax.
B. a emissions
fee.
C. a flat
tax.
D. an international
tax.
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
17. A cap-and-trade policy
A. has a set number of
permits.
B. allows polluters to trade
permits.
C. caps the total level of pollution
allowed.
D. all of these answer options are
correct.
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
18. Command-and-control regulations
A. are less flexible than incentive based
regulations.
B. come from the private
sector.
C. have technology standards a type of
control.
D. are less flexible than incentive based regulations and have technology
standards a type of control.
E. are less flexible than incentive based regulations and come from the
private sector.
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
5-23
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.19. Technology standards work in reducing externalities of all kinds.
A. Tru
e
B. Fals
e
C. Uncertai
n
20. AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
Negative externalities cause loss of welfare not transmitted by market factors.
A. Tru
e
B. Fals
e
C. Uncertai
n
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Introduction
21. Externalities can be positive, as well as negative.
A. Tru
e
B. Fals
e
C. Uncertai
n
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: The Nature of Externalities
5-24
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.22. Pure public goods involve positive externalities.
A. Tru
e
B. Fals
e
C. Uncertai
n
23. AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: The Nature of Externalities
A subsidy for pollution not produced can induce producers to pollute at the
efficient level.
A. Tru
e
B. Fals
e
C. Uncertai
n
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Public Responses to Externalities: Taxes and Subsidies
24. Pollution rights can be traded and are always efficient.
A. Tru
e
B. Fals
e
C. Uncertai
n
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
5-25
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.25. In the 1970s, the U.S. relied on Command-and-Control models of pollution
regulation.
A. Tru
e
B. Fals
e
C. Uncertai
n
26. AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: The U.S. Response
The desire in the U.S. for owner-occupied housing led to subsidies that contributed
to the recession which started in 2007.
A. Tru
e
B. Fals
e
C. Uncertai
n
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Positive Externalities
27. Market-oriented solutions to externalities rarely work.
A. Tru
e
B. Fals
e
C. Uncertai
n
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: The U.S. Response
5-26
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.28. For market efficiency, MSC must be equated to MSB.
A. Tru
e
B. Fals
e
C. Uncertai
n
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Positive Externalities
29. College education is an example of a positive externality.
A. Tru
e
B. Fals
e
C. Uncertai
n
30. AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Topic: The Nature of Externalities
An emissions fee is preferable to a cap-and-trade when MSB are elastic and costs
are uncertain.
A. Tru
e
B. Fals
e
C. Uncertai
n
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Topic: Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
5-27
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.31. Incentive-based regulations provide polluters no incentive to reduce pollution and
are thus not used often.
A. Tru
e
B. Fals
e
C. Uncertai
n
AACSB: Reflective Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Topic: Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
Essay Questions
32. Suppose the factory Afro-Puffs Inc. produces wigs. As a by-product of this wig
production, they also produce dangerous emissions of toxic gases (as a result of
the strong glue used to hold the hair in place). The De-Lite car factory, down the
road, experiences a negative externality from this production process. Suppose
that the supply curve (private marginal costs) for the wig factory is X = (2/5)P – 2,
and it faces a market demand of Xd = 15 – P/2. The marginal damages caused by
the production of wigs can be written as X = P – 1/2.
(a) Find the equilibrium price and quantity in the market for wigs.
(b) Find the socially optimal level of wigs and the corresponding price.
(c) How much should the wig factory be taxed per wig?
(a) Set PMC equal to demand and solve for P and X. X = 50/9, P = 170/9.
(b) Find SMC by adding PMC to MD. Set SMC equal to demand and solve for P and
X. X = 49/11, P = 232/11.
(c) At X = 49/11, subtract PMC from SMC. Tax = 109/22.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Topic: Public Responses to Externalities: Taxes and Subsidies
5-28
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.33. A steel factory has the right to discharge waste into a river. The waste reduces the
number of fish, causing damage for fisheries. Let X denotes the quantity of waste
dumped. The marginal damage, denoted MD, is given by the equation MD = 2 +
5Q. The marginal benefit (MB) of dumping waste is given by the equation MB = 34
– 3Q.
(a) Calculate the efficient quantity of waste.
(b) What is the efficient fee, in dollars per unit of waste, which would cause the
firm to dump only an efficient quantity of waste?
(c) What would be the quantity dumped if the firm did not care about the fishery?
(a) Set MD = MB and solve for Q*. Q* = 4.
(b) Insert 4 units into either MD or MB. Fee = 22.
(c) If the firm did not care about the fisheries, then they will discharge was as long
as its marginal benefit is greater than 0. Therefore, set MB equal to zero and solve
for X. X = 34/3.
34. AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Topic: Graphical Analysis
The private marginal benefit for commodity X is given by 15 – X, where X is the
number of units consumed. The private marginal cost of producing X is constant at
10. In the absence of any government intervention, how much X is produced?
What is the gain to society involved in moving from the inefficient to the efficient
level of production?
Without intervention, optimal will be where PMB = 0. X = 15. The efficient level is
X = 5. The area beneath the PMB is gained. Gain = 25.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Topic: Graphical Analysis
5-29
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.5-30
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.35. Consider the case of two farmers, Tony and Hakim, depicted in the following
figure. Both use DDT (a chemical pesticide) for their crops. The use of DDT causes
an externality for swimmers down river from the farms.
(a) Show the amount of pesticides used if each uses the privately optimal level of
pesticides.
(b) Show the amount of pesticides used if they are socially concerned.
(c) Why is a reduction back to XH = HT not socially desired?
(a)
(b)
5-31
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.(c) Not socially optimal.
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
Topic: Graphical Analysis
5-32
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.5-33
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.36. Refer to the figures below to answer this question:
Cap-and-trade versus emissions fee when marginal social benefits are inelastic
and costs are uncertain:
5-34
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.Cap-and-trade versus emissions fee when marginal social benefits are elastic and
costs are uncertain:
a) In case of an inelastic marginal social benefit curve, what type of pollution
reduction system should the government employ? Why?
b) If the social benefit curve is elastic, do you answer change?
c) What are advantages and disadvantages of Cap-and-Trade systems over
Emission Fee systems when the inflation and change in marginal costs are
considered?
a) When the social marginal benefit curve is inelastic then the government should
employ a cap-and-trade system because it is more efficient than the emission fee
system. Emission fee system allows too little pollution compared to fairly higher
pollution than efficient quantity of cap-and-trade system.
b) When the social marginal benefit curve is elastic then the government should
employ an emission fee system because it is more efficient. Cap-and-trade system
allows too much pollution reduction compared to fairly close pollution reduction of
emission fee system.
c) Cap-and-Trade systems are superior in high inflation environments since it
requires no legislative or regulatory action in response to inflation. Moreover,
emission fee systems are not appropriate when the marginal cost of pollution
reduction is not constant. With emission fee systems, pollution reduction
decreases as marginal costs increase. However with cap-and-trade systems,
pollution reduction is constant as marginal costs increase. Finally if the
government is uncertain about the marginal cost of pollution reduction, then the
effective reduction system depends on the elasticity of marginal social benefits.
37. AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
Topic: Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
Why are command- and -control regulations less flexible than incentive based
systems?
Although answers will vary, the main reason is monitoring costs and the costs
involved in punishment strategies for offenders. Incentive systems induce firms to
act in their own best interests which are less time consuming.
AACSB: Reflective Thinking
Blooms: Understand
Difficulty: 2 Medium
Topic: Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
5-35
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.38. Which policy is more effective when handling externalities: Cap-and-trade or
emissions fee?
Although answers may vary, the reader should take into account how responsive
each policy is to inflation. In addition, there should be some mention of the
responsiveness to cost changes and uncertainty. Therefore when marginal social
benefits are inelastic and costs are higher than expected, cap-and-trade achieves
too much reduction and an emissions fee achieves too little reduction.
39. AACSB: Reflective Thinking
Blooms: Understand
Difficulty: 2 Medium
Topic: Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programs
List and discuss three problems that might arise when using the Coase theorem.
Bargaining costs are generally not zero. Identifying damages is difficult. There is
generally some amount of asymmetric information.
AACSB: Reflective Thinking
Blooms: Understand
Difficulty: 2 Medium
Topic: Private Responses
5-36
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
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