Solutions to Topic 12: Externalities

Exercise 12.1

If the equilibrium quantity is less than the socially optimal quantity, one can infer that

        A)           the supply curve for the activity is below the socially optimal supply curve.

        B)            the demand curve for the activity is above the socially optimal demand.

        C)            the production of this good has a positive externality.

        D)           the production of this good has a negative externality.

        E)            firm are not maximizing profits.

The correct answer is (C). When there is positive externality, the external benefits enjoy by outsides make the society prefer to have a larger quantity of output. But the market equilibrium quantity will not consider this external benefit and will produce a smaller quantity.

Exercise 12.2

Assume that reading economics produces a positive externality.  It will be the case that the __________ than the socially optimal amount.

        A)           supply curve for reading will be greater

        B)            price of reading will be greater

        C)            supply curve for reading will be less

        D)           demand curve for reading will be greater

        E)            demand curve for reading will be less

The correct answer is (E). With positive externality, there is external benefit and the marginal social benefit exceeds marginal private benefit. The demand curve for reading is marginal private benefit will be less than the social optimal amount.

Exercise 12.3

Suppose coal mining produces a negative externality in the form of polluted streams.  One can deduce that the unregulated

        A)           price of coal is too high.

        B)            quantity is too small.

        C)            quantity is too large.

        D)           supply curve is lower than the regulated supply curve.

        E)            demand curve is higher than the regulated demand curve.

The correct answer is (C). Producers will ignore the external cost and produces where MPC = MPB.

The society as a whole incur a higher cost and prefer a smaller quantity of output. Thus the market quantity is too large

Exercise 12.4

After correcting an externality, the equilibrium price and quantity both rose. What type of externality is this and what are the likely actions that are implemented to correct this externality?

Solution

This is a positive externality. When there is external benefit, the marginal social benefit exceeds marginal private benefit. The marginal social cost intersects the marginal social benefit at a larger quantity and a higher price compared to the market outcome. When the positive externality is corrected, both price and quantity rise.

The action needed is a government subsidy to increase the marginal private benefit to be the same as marginal social benefit.

Exercise 12.5

Consider the benefit and cost of industrial production, is the ideal amount of pollution equals zero?  Explain.

Solution

The ideal amount of pollution is not zero but the amount where marginal social benefit equals marginal social cost.  Production of goods and services are beneficial to society but bound to create some pollution.  So long as the benefits of having output exceeds the cost of pollution it is efficient to have a small amount of pollution