Chapter 5 – ExternalitiesBrief Outline1.The Nature of Externalities2.Graphical Analysisa.Implicationsb.Conclusion3.Private Responsesa.Bargaining and the Coase Theoremb.Mergersc.Social Conventions4.Public Responses to Externalities: Taxes and Subsidiesa.Taxesb.Subsidies5.Public Responses to Externalities: Emissions Fees and Cap-and-Trade Programsa.Emissions Feeb.Cap-and-Tradec.Emissions Fee versus Cap-and-Trademand-and-Control Regulation6.The US Responsea.Progress with Incentive-Based Approaches7.Implications for Income Distributionsa.Who Benefits?b.Who Bears the Cost?8.Positive Externalitiesa. A Cautionary NoteAnswers to End-of-Chapter Questions1.Before passengers were charged for checked bags, they would choose whether to checkbags or carry them on based on whether they were willing to trade time for the hassle of dealing with carry-on bags. That is, passengers who valued saving time by not having to deal with baggage claim more than the cost of dealing with carry-on baggage will choose to carry on. The fact that passengers are now charged for checked baggage but not for baggage carried onto the plane will inefficiently allocate overhead space. Passengers will carry on more and bigger bags to save the fee charged, resulting in full overhead luggage containers. Overhead space will go to the first passengers on the plane, rather than being distributed more evenly. Bags checked (without a charge) at the gate forces some who would choose to carry on even without the fee to have to check, which is a loss in efficiency. Those who elect to carry on to avoid the fee, but would rather check their bags, also result in an inefficiency.2.The Coase theorem suggests that the church and the comedy club could negotiate. If thechurch possessed the right to the “noise” in the building, the comedy club could pay the church to be quiet. If the comedy club possessed the right to quiet in the building, the church could compensate the club for the noise.3.It is the case that a carbon tax would be passed on to the consumer. The tax raises coststo the producer for producing the final good. These increased costs would decrease supply, which will increase the price of that final good. In a cap and trade system, businesses must purchase permits in order to emit carbon. If the cost of purchasing and using abatement equipment is less than the cost of buying a permit, the business will use abatement equipment. In either case (buying a permit or using abatement equipment) costs for the producer increase, decreasing supply and increasing the price of the final good. If the carbon tax and the number of permits issued in the cap and trade system were set appropriately, the outlays for both programs would be the same.4.a.The number of parties per month that would be provided privately is P.b.See schedule MSB p.c.P*. Give a per-unit subsidy of $b per party to induce the correct number of parties.d.The optimal subsidy is $b. The total subsidy=abcd. “Society” comes out ahead byghc, assuming the subsidy can be raised without any efficiency costs.(Ca ssanova’s friends gain gchd; Cassanova loses chd but gains abcd, which is asubsidy cost to government.)5.The payment for signing a waiver is a negotiation as suggested by the Coase Theorem. Ifresidents accept the payment and sign the waiver, they are signaling that the noise cost to them is less than the payment. If the residents choose not to accept the payment and sign the waiver, the payment is not great enough to cover the cost of the noise. The Coase Theorem suggest in this case that further negotiation could occur.6.On the surface, the tax on saturated fat seems like a Pigouvian tax, if you assume that the$3 is equivalent to the level of the damage from the saturated fats. The commentator is not correct in his criticism that the tax is levied on an input rather an outcome. If the tax is properly set and is the direct cause of unhealthy consumers, the efficient level of saturated fat will be consumed. However, this tax suffers from the problem of assuming that the saturated fat leads directly to poor health outcomes and is the only source of unhealthy outcomes. Some consumers are healthy no matter the level of consumption of saturated fats. Others are unhealthy even with no consumption of the saturated fats. And many consumers will simply reallocate their consumption to nontaxed unhealthy foods.7.a.It is very likely that the farmer could negotiate with the neighbors, providedproperty rights are clearly defined. The Coase Theorem is therefore applicable.b.It is unlikely that negotiation could result in an efficient outcome in this case. It islikely that there are a great number of farmers involved in both harvesting antsand growing trees, making negotiation very difficult.c.Property rights are not being enforced, making negotiation through the CoaseTheorem impossible.d.There are too many people involved for private negotiation.8.a. The price of imported oil does not reflect the increased political risk byeffectively subsidizing authoritarian regimes like those in Saudi Arabia.b.The tax would estimate the marginal damage (e.g., the increased instability in theMiddle East, etc.) by importing oil from Saudi Arabia.c.The supply of TGRs is vertical at 104.5 billion if government seeks to reduceconsumption of gasoline to 104.5 billion. Consumers must have one TGR inorder to buy one gallon of gasoline, plus they must pay the price at the pump.Limiting TGRs effectively limits the demand for gasoline, so the price per gallonwill fall, but consumers must have TGRs in order to purchase gasoline. If themarket price of one TGR is $0.75, this means that supply and demand intersect at$0.75, as shown in the graph. This kind of program curbs consumption withoutgiving government more revenue because consumers are purchasing the TGRsfrom each other. However, the total amount of TGRs is limited by government.Those consumers seeking to purchase more gasoline than allowed by the initialallocation of TGRs can purchase additional TGRs from other consumers at themarket price of $0.75. By choosing to use a TGR to purchase gasoline, aconsumer incurs an opportunity cost equal to $0.75 since they cannot sell theTGR once it has been used.9. The use of the drug to treat sick cows leads to a positive externality (the benefit enjoyedby air travelers) as well as a negative externality (the costs created by a larger number of rats and feral dogs). Banning the drug might raise or lower efficiency, depending on whether the positive externality is larger or whether the negative externality is larger. There are many ways to design incentive-based regulations. Policymakers could determine the efficient level of drug usage and then either allocate or sell the right to use the drug for sick cows.10. The program matches prices to changes in demand, fluctuating as demand changes. Thisresults in higher efficiency. Drivers will respond efficiently by choosing to park based on their willingness to pay.11.a. When the Little Pigs hog farm produces on its own, it sets marginal benefit equalto marginal cost. This occurs at 4 units.b. The efficient number of hogs sets marginal benefit equal to marginal social cost,which is the sum of MC and MD. At 2 units, MB=MSC=1600.c. The efficient number of hogs sets marginal benefit equal to marginal social costs.At 3 hogs, MB=MSC=1600.12. Private Marginal Benefit = 10 - XPrivate Marginal Cost = $5TGRs$ 104.5 billion Supply of TGRsDemand for TGRs$0.75External Cost = $2Without government intervention, PMB = PMC; X = 5 units.Social efficiency implies PMB = Social Marginal Costs = $5 + $2 = $7; X = 3 units.Gain to society is the area of the triangle whose base is the distance between the efficient and actual output levels, and whose height is the difference between private and social marginal cost. Hence, the efficiency gain is ½ (5 - 3)(7 - 5) = 2A Pigouvian tax adds to the private marginal cost the amount of the external cost at thesocially optimal level of production. Here a simple tax of $2 per unit will lead to efficient production. This tax would raise ($2) (3 units) = $6 in revenue.13.a.The total cost of emissions reduction is minimized only when the marginal costsare equal across all polluters, therefore a cost-effective solution requires that MC1= MC2 or that 300e1 = 100e2. Substituting 3e1 for e2 in the formula e1 + e2 = 40(since the policy goal is to reduce emissions by 40 units) yields the solution. It iscost-effective for Firm 1 to reduce emissions by 10 units and for Firm 2 to reduceemissions by 30 units.b.In order to achieve cost-effective emission reductions, the emissions fee shouldbeset equal to $3,000. With this emissions fee, Firm 1 reduces 10 units and Firm2 reduces 30 units, but Firm 1 has to pay $3,000 for each unit of pollution theycontinue to produce, which gives them a tax burden of $3,000 x 90 (Firm 1generated 100 units in the absence of government intervention) or $270,000.Firm 2 has a lower tax burden because it is reducing emissions from 80 units to50units. Firm 2 pays $3,000 x 50 = $150,000. As the text concludes, the firmthat cuts back pollution less isn’t really getting aw ay with anything because it hasa larger tax liability than if it were to cut back more.c.From an efficiency standpoint, the initial allocation of permits does not matter. Ifthe two firms could not trade permits, then Firm 2 would have to undertake all ofthe emissions reduction. Initially, Firm 1’s MC is zero, while Firm 2’s MC is$4,000, so there is a strong incentive for Firm 2 to purchase permits from Firm 1.Trading should continue until MC1 = MC2, which is the cost-effective solution.This means that the market price for permits will equal $3,000, the same as theemissions fee. At this price, Firm 2 will purchase 10 permits from Firm 2,allowing Firm 2 to reduce emissions by 30 rather than 40 and requiring Firm 1 toreduce emissions by 10. This solution is the same as the solution achieved withthe emissions fee. However, Firm 1 is better off because instead of having to paytaxes, it will receive a payment of $30,000 for its permits. Firm 2 must pay$30,000 for the extra permits, but it also avoids the payment of taxes. Thegovernment lost $420,000 in tax revenue. The firms must still pay the cost ofemissions reduction, plus Firm 2 must pay for the permits purchased from Firm 1.14.If marginal costs turn out to be lower than anticipated, cap-and-trade achieves too littlepollution reduction and an emissions fee achieves too much pollution reduction. With an inelastic marginal social benefit function, cap-and-trade is not too bad from an efficiency standpoint, while an emissions fee causes pollution reduction to be much greater than the efficient level when marginal cost is lower than anticipated. When marginal social benefits are elastic, the opposite is true.。