ECON 1000 Contemporary Economic Issues (Summer 2018) Allocation Function of Government portions for Exam 3

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1 ECON 1000 Contemporary Economic Issues (Summer 2018) Allocation Function of Government portions for Exam 3 Relevant Readings from the Required Textbooks: Chapter 10, Market Failure Definitions and Concepts: externality a benefit or cost that is realized by someone who is not directly engaging in an activity negative externality a cost of an activity borne by someone not engaging in the activity. examples: pollution, noise from low-flying aircraft, speeding on a highway, installation of The Club in a car positive externality a benefit from an activity realized by someone not engaging in the activity examples: vaccines, installation of smoke detector in an attached apartment, installation of Lojack in a car Market provision of a good for which there is an externality is inefficient: Negative externality => free markets provide more than the optimal amount (i.e., too much) of the good Positive externality => free markets provide less than the optimal amount (i.e., not enough) of the good Potential policies to reduce the DWL associated with a negative externality 1. ban the activity entirely ( illegal to emit any pollution ) 2. establish minimum compliance standards for manufacturers ( can only pollute up to a certain level ) 3. cap and trade issue a certain number of pollution permits for society as a whole, and allow people to trade these permits amongst themselves 4. offer subsidies to manufacturers that reduce pollution ( pay the polluter to reduce their level of pollution ) 5. charge manufacturers a fee for each unit of pollution emitted ( polluter must pay for the right to pollute ) internalizing an externality policies which introduce a cost (or foregone gain) that is realized if the person continues to generate a negative externality Coasian solution to the problem of externalities Ronald Coase ( ; Noble Prize in 1991; Professor Emeritus at Univ. of Chicago Law School) argued that problems of externalities are at their core due to undefined property rights and can be address by the following approach: i. clearly and fully define property rights ii. make individuals pay compensation if they infringe upon the property rights of others iii. allow parties to negotiate with one another regarding infringements on property rights caused by the externality

2 Coase showed that regardless of which party is given the property right, negotiation between the parties will result in the efficient level of the externality (so long as the costs of negotiation and enforcement are low enough) defining property rights and allowing parties to negotiate essentially internalizes the externality market failure due to lack of information for some goods consumers may have difficulty knowing their true reservation price => especially common for goods purchased infrequently or for which quality is difficult to observe (e.g., house, car, education, medical procedure, meal at a restaurant) when consumers lack accurate information about costs or benefits of consuming a good, they may fail to make efficient choices in the marketplace Further note, information is often a club good (non-rival in consumption and excludable). o Once a club good is produced, the additional cost of providing it to the next person is essentially zero => to maximize social surplus, everyone who has a positive value for the information should be able to access it o Additionally, as long as the information is accurate, total costs to society are minimized if the information is only generated once (e.g., it is a waste of resources to have both the National Weather Service and AccuWeather come up with weather forecasts) In such cases, have government license, inspect, and/or regulate providers of such goods in order to: i. provide people with the important information needed to make good decisions in markets and ii. minimize the costs to society of providing the information o e.g., Cobb and Douglas Public Health inspects restaurants and assigns letter grades based upon compliance with health codes => government regulates product and provides information

3 Problem: 1. The production of phosphate fertilizers results in substantial pollution. The graph below illustrates Marginal Private Benefits, Marginal Private Costs, and Marginal Social Costs for different levels of trade in this market. Answer the questions below based upon the information conveyed in this graph. $ Marginal Social Costs = (Marginal Private Costs) + (Marginal External Costs) Supply = (Marginal Private Costs) Demand = (Marginal Private Benefits) quantity 0 3,100 4,750 5,625 1A. Focusing on the 3,100 th unit of output, what is the value of the external cost of producing this unit? Explain. 1B. Continuing to focus on the 3,100 th unit of output, would producing/trading this unit increase or decrease Total Social Surplus? Explain. 1C. Without any intervention in this market, what level of trade would result (i.e., what is the free market level of trade )? 1D. Determine the efficient or Total Social Surplus maximizing level of production/trade in this market. 1E. Would the free market lead to too much trade, too little trade, or just the right amount of trade? Explain. 1F. Is the best level of pollution zero pollution? Explain. Multiple Choice Questions: 8. In the presence of a negative externality, the free market would A. provide more than the efficient amount of the good. B. provide less than the efficient amount of the good. C. have trade take place at a price of $0. D. None of the above answers are correct.

4 For Questions 9 through 11, consider a good with Marginal Private Benefits, Marginal Private Costs, Marginal Social Benefits, and Marginal Social Costs as illustrated below. $ a b c e (Marginal Social Costs) = (Marginal Private Costs) Marginal Social Benefits 0 d Marginal Private Benefits quantity 0 4,100 5,900 6, Based upon this graph, it appears as if A. the government is imposing a substantial per unit tax on this good. B. this good is clearly produced by a monopolist. C. production/consumption of this good generates a positive externality. D. production/consumption of this good generates a negative externality. 10. If this good were traded in a free market (without any government intervention),, although the Social Welfare Maximizing level of trade is. A. 6,800 units would be traded; 5,900 units. B. 5,900 units would be traded; 4,100 units. C. 4,100 units would be traded; 5,900 units. D. 0 units would be traded; 6,800 units. 11. At the free market outcome (without any government intervention) there would be a Deadweight-Loss equal to A. area (c). B. area (e). C. areas (a)+(b). D. areas (a)+(b)+(c).

5 For questions 17 through 19 consider the following scenario. Company Z wants to construct a new manufacturing facility near an existing residential neighborhood. If they construct and operate the facility, they can do so at one of three different sizes: small plant, medium plant, or large plant. However, their economic activity would impose external costs from pollution on the nearby residents. The resulting profit (for Company Z ) and external costs (to residents of the adjacent neighborhood) of each possible choice are specified in the table below: no plant small plant medium plant large plant Profit $0 $400,000 $700,000 $900,000 External Costs $0 $50,000 $250,000 $650, If Company Z was able to choose its plant size without having to account for the external cost to nearby residents whatsoever, they would choose A. no plant. B. small plant. C. medium plant. D. large plant. 18. The socially efficient outcome is for Company Z to construct and operate A. no plant. B. a small plant. C. a medium plant. D. a large plant. 19. Suppose that property rights can be clearly defined, individuals must pay compensation if they infringe upon the property rights of others, and the impacted parties can negotiate with one another. We would expect the ultimate outcome to be if the homeowners are given the right to a pollution free environment and if Company Z is given the right to pollute the environment. A. no plant; large plant. B. large plant; no plant. C. small plant; small plant. D. medium plant; medium plant. 20. A government policy that attempts to Internalize an Externality can be generally described as A. a policy which completely bans an activity that generates an externality. B. a policy which introduces a cost (or foregone gain) that would be realized by a decision maker who generates an externality. C. a policy which mandates the exact level of an activity that decision makers must engage in. D. None of the above answers are correct.

6 22. Which of the following was discussed in lecture to illustrate how something akin to the Coasian Solution to Externalities has been implemented in practice? A. How total social welfare (on a global level) was likely decreased by President Barack Obama flying to Copenhagen in order to lobby the International Olympic Committee on behalf of Chicago s bid to host the 2012 Summer Olympics. B. How the Defenders of Wildlife established the Bailey Wildlife Wolf Compensation Trust in order to facilitate the re-introduction of the gray wolf into the wild in the western United States. C. Why efficiency dictates that any activity which generates a negative externality should be completely banned. D. Why a free market would tend to provide less than the efficient amount of national defense. 23. Which of the following policies could likely reduce Deadweight-Loss in the presence of a negative externality, such as pollution? A. Establish minimum compliance standards for manufacturers in the industry (allowing them to generate only a certain amount of the negative externality). B. Do nothing (i.e., just let the market allocate the good as is currently the case, with no deliberate government action whatsoever). C. Offer subsidies to manufacturers for reducing the amount of the negative externality that they generate. D. More than one (perhaps all) of the above answers is correct

7 Answer to Problem: 1A. Since Social Costs are equal to the sum of Private Costs and External Costs, it follows that External Costs could be thought of as the difference between Social Costs and Private Costs. Focusing on just the 3,100 th unit, the External Cost of producing/trading this unit is the difference between the Marginal Social Cost of producing/trading this unit and the Marginal Private Cost of producing this unit. From the graph we see that this difference is: (13.10)-(8.60)=(4.50). 1B. In general, the Social Surplus from trading any particular unit is equal to the difference between the Marginal Social Benefits and the Marginal Social Costs of trading the unit. In this market there is no positive externality, so that Marginal Social Benefits are simply equal to Marginal Private Benefits. Therefore, from the graph we see that producing/trading this unit would generate a Social Surplus of: (28.85)-(13.10)=(15.75). Since this difference is positive, Total Social would be increased by producing/trading this unit. 1C. Without any intervention in the market, self-interested buyers would base their purchasing decisions upon their Marginal Private Benefits and self-interested sellers would base their supply decisions upon their Marginal Private Costs. Market forces would ensure that trade would occur on all units for which Marginal Private Benefits are greater than Marginal Private Costs. Thus, we see from the graph that (5,625) units would be traded. 1D. In order to maximize Total Social Surplus we should only produce/trade those units for which Marginal Social Benefits are greater than Marginal Social Costs. Again, since there is no positive externality in this market, it follows that Marginal Social Benefits are simply equal to Marginal Private Benefits. Therefore, we see from the graph that Total Social Surplus is largest when (4,750) units are traded. 1E. From the answers to parts (1c) and (1d), it follows that in the presence of this negative externality, the free market would lead to too much trade (since 5,625 is greater than 4,750). 1F. No, the best level of pollution (that is, the amount of pollution generated at the efficient level of production/trade) is not equal to zero. In order to generate zero pollution, society would have to refrain from producing/trading any units for which there was a positive Marginal External Cost. From the graph it is clear that there is a positive Marginal External Cost from every unit produced. However, from the standpoint of society, it is clear that the Social Benefits are greater than the Social Costs for each of the initial 4,750 units produced/traded in this market.

8 1. B 2. A 3. D 4. D 5. B 6. B 7. C 12. A 13. C 14. D 15. D 16. B 24. C 25. D 26. C Answers to Multiple Choice Questions: 8. A 9. C 10. C 11. C 17. D 18. C 19. D 20. B 21. A 22. B 23. D