Problems and Applications
1. The Club conveys a negative externality on other car owners because car thieves will not attempt
to steal a car with The Club visibly in place. This means that they will move on to another car.
The Lojack system conveys a positive externality because thieves do not know which cars have
this technology. Therefore, they are less likely to steal any car. Policy implications include a
subsidy for car owners that use the Lojack technology and a tax on those who use the Club.
2. a. The statement, "The benefits of Pigovian taxes as a way to reduce pollution have to be
weighed against the deadweight losses that these taxes cause," is false. In fact,
Pigovian taxes reduce the inefficiency of pollution by reducing the quantity of the good
being produced that has pollution as a by-product. So, Pigovian taxes reduce
deadweight loss, they do not increase it.
b. The statement, "When deciding whether to levy a Pigouvian tax on consumers or
producers, the government should be careful to levy the tax on the side of the market
generating the externality" is inaccurate. It does not matter on whom the tax is
imposedthe incidence of the tax will be identical. So whether the externality is caused
by the seller or the buyer of a good, a tax on either producers or consumers will lead to
the same reduction of quantity and change in the prices producers receive or consumers
3. a. Fire extinguishers exhibit positive externalities because even though people buy them for
their own use, they prevent any fire from damaging the property of others.
b. Figure 2 illustrates the positive externality from fire extinguishers. Notice that the social
value curve is above the demand curve and the social cost curve is the same as the
190 191 ✦ Chapter 10/Externalities
c. The market equilibrium level of output is denoted Q marketnd the efficient level of output
is denoted Q . The quantities differ because in deciding to buy fire extinguishers,
people don't account for the benefits they provide to other people.
d. A government policy that would result in the efficient outcome would be to subsidize
people $10 for every fire extinguisher they buy. This would shift the demand curve up to
the social value curve, and the market quantity would increase to the optimum quantity.
4. a. The externality is noise pollution. Ringo’s consumption of rock and roll music affects
Luciano, but Ringo does not take that into account in deciding how loud he plays his
b. The landlord could impose a rule that music could not be played above a certain decibel
level. This could be inefficient because there would be no harm done by Ringo playing
his music loud if Luciano is not home.
c. Ringo and Luciano could negotiate an agreement that might, for example, allow Ringo to
play his music loud at certain times of the day. 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.
5. If the Swiss government subsidizes cattle farming, it must be because there are externalities
associated with it. Since tourists come to Switzerland to see the beautiful countryside,
encouraging farms, as opposed to industrial development, is important to maintaining the tourist
industry. Thu,s farms produce a positive externality by keeping the land beautiful and unspoiled
by development. The government's subsidy, thus, helps the market provide the optimal amount
6. a. The market for alcohol is shown in Figure 3. The social value curve is below the demand
curve because of the negative externality from increased motor vehicle accidents caused
by those who drink and drive. The free-market equilibrium level of output is Q marketnd
the efficient level of output is Q .
optimum Chapter 10/Externalities ✦ 192
b. The shaded area shows the amount by which social costs exceed social value for the
quantity of alcohol consumption beyond the efficient level.
7. a. It is efficient to have different amounts of pollution reduction at different firms because
the costs of reducing pollution differ across firms. If they were all made to reduce
pollution by the same amount, the costs would be low at some firms and prohibitive at
others, imposing a greater burden overall.
b. Command-and-control approaches that rely on uniform pollution reduction among firms
give the firms no incentive to reduce pollution beyond the mandated amount. Instead,
every firm will reduce pollution by just the amount required and no more.
c. Pigovian taxes or tradable pollution rights give firms greater incentives to reduce
pollution. Firms are rewarded by paying lower taxes or spending less on permits if they
find methods to reduce pollution, so they have the incentive to engage in research on
pollution control. The government does not have to figure out which firms can reduce
pollution the mostit lets the market give firms the incentive to reduce pollution on their
8. a. If the government knew the cost of reduction at each firm, it would have Acme eliminate
all its pollution (at a cost of $10 per tonne times 100 tonnes = $1,000) and have Creative
eliminate half of its pollution (at a cost of $100 per tonne times 50 tonnes = $5,000).
This minimizes the total cost ($6,000) of reducing the remaining pollution to 50 tonnes.
b. If each firm had to reduce pollution to 25 tonnes (so each had to reduce pollution by 75
tonnes), the cost to Acme would be 75 x $10 = $750 and the cost to Creative would be
75 x $100 = $7,500. The total cost would be $8,250. 193 ✦ Chapter 10/Externalities
c. In part a, it costs $6,000 to reduce total pollution to 50 tonnes, but in part b it costs
$8,250. So it is definitely less costly to have Acme reduce all of its pollution and have
Creative cut its pollution in half. Even without knowing the costs of pollution reduction,
the government could achieve the same result by auctioning off pollution permits that
would allow only 50 tonnes of pollution. This would ensure that Acme reduced its
pollution to zero (since Creative would outbid it for the permits) and Creative would then
reduce its pollution to 50 tonnes.
9. a. An improvement in the technology for controlling pollution would reduce the demand for
pollution rights, shifting the demand curve to the left. Figure 4 illustrates what would
happen if there were a Pigovian tax, while Figure 5 shows the impact if there were a
fixed supply of pollution permits. In both figures, the curve labeled D is1the original
demand for pollution rights and the curve labeled D is 2he new demand for pollution
rights after the improvement in technology.
b. With a Pigovian tax, the price of pollution remains unchanged and the quantity of
pollution declines, as Figure 4 shows. With pollution permits, the price of pollution
declines and the quantity of pollution is unchanged, as Figure 5 illustrates. Chapter 10/Externalities ✦ 194
10. a. In terms of economic efficiency in the market for pollution, it does not matter if the
government distributes the permits or auctions them off, as long as firms can sell the
permits to each oth