5 MARKET FAILURE

5 MARKET FAILURE

Ragan Chapters 16 and 17

Externalities

Markets create an efficiency loss because people ignore external costs and benefits

1. Identify four types of externalities. Figure 16-1 shows two.

a. Show the efficiency loss for each diagram.

b. Identify the common relationship between the private outcome and the cooperative outcome.

2. Discuss solutions to the externalities problem noting the benefits and disadvantages of each solution

a. Property Rights: The Coase Theorem

b. Merger

c. Quotas

d. Taxes and Subsidies

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Pigouvian Taxes

3. A firm with C = 10Q + 0.5Q2 creates social damages of D = 15Q + 0.5Q2. Demand is P = 100 − Q.

a. Compute and compare output Q under the private (non-cooperative) solution and optimal (cooperative) solution.

b. Calculate and illustrate the efficiency loss. Find CS = Benefits – Expenditure and PS = Revenue – Cost.

c. Show how a per-unit tax can be used to induce the cooperative solution.

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Pigouvian Subsidies for Vaccination

4. An externality has marginal benefits MB = 48 – 2Q, marginal social benefits MSB = 48 – Q and marginal costs MC = 12 + Q.

a. Illustrate and quantify the cooperative and noncooperative equilibria in this market.

b. Illustrate and quantify the efficiency loss.

c. The externality problem could be corrected with a per-unit subsidy equal to __________ dollars.

d. Update your diagram to show the impact of the subsidy.

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Public Goods

5. Roommates A, B and C can purchase paintings at $20 each for their apartment. Marginal benefits are MBA = 10 – 2Q, MBB

= 20 – Q and MBC = 30 – 2Q.

a. What are the two properties of a Public Good? [Figure 16-2]

b. Explain the Free-Rider problem.

c. Aggregate the demand curves (vertical sum).

d. Why are there kinks in the market demand curve?

e. Calculate and illustrate the optimal quantity for this good.

f. How should the costs of purchasing this quantity be allocated between the buyers?

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Common Goods

Non-cooperative congestion

6. 60 commuters much travel from Mississauga to Toronto. The GO Train takes 20 minutes. The AVERAGE time for a

commuter to reach downtown when driving on the QEW is t = 10 + 0.5D and it depends on the number of drivers D on the

road. [Table 16-1]

a. Provide a labelled diagram to compare the non-cooperative solution to the cooperative solution. Label the

efficiency loss. The MARGINAL time of commuting t’ = 10 + D is twice as steep with the same vertical intercepts as

the average time of commuting t = 10 + 0.5D.

b. What is the total time for all 60 commuters if they behave non-cooperatively? What is the total time if the behave

cooperatively?

c. Use your diagram to show how a highway toll (per-unit tax) could be used to correct this efficiency loss.

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7. The amount that a beggar outside the Toronto Stock Exchange Building can collect in AVERAGE revenues depends

negatively on the number of beggars; r = 100 − 2n. A beggar has the alternative of standing in line to receive welfare

benefits of 20 dollars.

a. Discuss, graph and determine the noncooperative solution and the cooperative solution. Show the efficiency loss.

b. Illustrate how the cooperative solution could be achieved if the government introduced a per-unit tax on the

revenues of each beggar.

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Information

8. Discuss [pages 372-374] why p ≠ p*

a. Lemons and Plums

b. Principal Agent

c. Adverse Selection

d. Moral Hazard

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Optimal pollution is not zero

9. Pollution is a negative externality. Define E = emissions and A = abatement. The transfer function is E = 100 – 2A.

Abatement costs are C = 20A + A2 while the benefits are B = 100A – A2. Calculate optimal pollution and provide a diagram.

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Permit trading

A scheme developed by Professor Dales (U of T Economics)

10. Polluters firm 1 with C1 = 10A1 + A12 and firm 2 with C2 = 20A2 + 0.5A22 have transfer functions E1 = 10 – A1 and E2 = 10 – A2.

The government has determined that society should have E = 12 units of pollution.

a. Performance standards require each firm to do units of abatement. Calculate C1 + C2.

b. Each firm is issued E1 = 6 and E2 = 6 permits which would require A1 = 4 and A2 = 4. They are permitted to trade the

permits. Calculate the equilibrium price for these permits. Calculate C1 + C2. Discuss.

c. What will happen if Green Peace enters the market and purchases 3 permits?

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Tutorial Questions

11. Roommates A and B plan to purchase public good. Their marginal benefits from consuming this public good are mbA = 4 –

0.5q and mbB = 2 – 0.5q. The price is p = 3. Calculate the total amount that these roommates should spend on the public

good. Provide a diagram to illustrate this calculation.

12. A market has a Negative Externality. Marginal benefits are MB = 100 – 0.25Q, marginal private costs are MC = 40 + 0.25Q

and marginal social costs are MSC = 40 + 0.75Q. To correct this externality would require a Pigouvian Per-unit Tax equal to

________ dollars. Provide a diagram to illustrate this calculation. Shade in the efficiency loss.

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13. Forty commuters must decide between taking the GO Train and driving on the QEW. A passenger on the GO can reach

downtown in 20 minutes. A driver on the QEW can reach downtown in t = 10 + 0.5D minutes where D is the number of

drivers on the QEW. Compute the noncooperative solution and the cooperative solution. Provide a labelled diagram to

illustrate and quantify your predictions.

14. A market has a positive externality. Marginal benefits are MB = 80 – 0.75Q, social marginal benefits are SMB = 80 – 0.25Q

and marginal costs are MC = 20 + 0.25Q. Calculate the Pigouvian Per-unit Subsidy to correct this positive externality.

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Review Questions

15. A plausible example of market failure due to an externality is

a. The line-ups at the theatre when a good movie is playing.

b. A farmer with an apple orchard who also keeps bees.

c. The cost of building new highways outside of major cities.

d. The despoiling of rivers and lakes by nitrogen run-off from agricultural fertilizers. ✓

16. For a production process that involves a positive externality, it is true that

a. Without government intervention, the market will produce too much of this good.

b. A subsidy to producers could increase production to the socially optimal level. ✓

c. Marginal social cost is more than marginal private cost.

d. Marginal social benefit is less than marginal private benefit.

17. A flu vaccine has an associated ________ externality. In the absence of government intervention, the quantity of flu

vaccines purchased will be ________ the socially optimal quantity.

a. Negative; more than

b. Positive; less than ✓

c. Positive; more than

d. Negative; less than

18. The price charged for access to an uncongested, excludable non-rivalrous good should be ________ because ________.

a. Positive; more than one person can consume this good at the same time.

b. Positive; consumers receive a positive marginal benefit from consuming the good.

c. Zero; it is inefficient to exclude people from consuming this good once it has been supplied. ✓

d. Positive; marginal cost and marginal benefit for this good are both positive.

19. Moral hazard is said to exist when one party to a transaction

a. Is subject to a hostile corporate takeover.

b. Is not able to take advantage of the other party.

c. Purchases insurance because they know they are involved in risky activities.

d. Has the incentive to, and is able to, shift costs to another party in the transaction. ✓

20. Suppose a law firm purchases additional insurance against theft, and as a result, the partners are not very careful about

locking their office doors when they leave. This is an example of

a. Adverse selection.

b. A common property resource.

c. The free-rider problem.

d. Moral hazard. ✓

21. Common Goods are

a. Non-rival and non-excludable.

b. Non-rival and excludable.

c. Rival and non-excludable. ✓

d. Rival and excludable.

22. A good example of a Public Good is

a. Taylor Swift’s concert at Rogers Centre.

b. Light from a lighthouse. ✓

c. A publicly owned subway system.

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d. Subsidized tuition fees at UTM.

23. An example of a Common-property Problem is

a. Light from a lighthouse.

b. A sport-fishing river in BC. ✓

c. A Taylor Swift concert at Rogers Centre.

d. A congested toll highway.

24. An example of Adverse Selection is

a. Purchasing the required homeowner's insurance when you buy a condo.

b. Asking a doctor if you are sick.

c. Asking your lawyer if you should sue your doctor for malpractice.

d. Purchasing more dental insurance when you know your teeth are especially bad. ✓

Price 0 2 4 6 8 10

Angela 10 8 6 4 2 0

Barbara 6 4 2 0 0 0

25. The table above shows quantities demanded by Angela and Barbara at various prices. How many units should be

purchased if this non-rivalrous public good has a marginal cost of 4 dollars?

a. 4

b. 6

c. 8

d. None of these

26. Which of the following roles of the government is most fundamental to a society's ability to function safely and carry on

normal economic and social life?

a. Holder of a monopoly of violence ✓

b. Regulator of free markets

c. Provider of a justice system

d. Provider of health care

e. Provider of education

27. Provincial laws that mandate a minimum drinking age (for alcohol) are an example of government intervention through

a. Regulation. ✓

b. Communism.

c. Merit-goods control.

d. Public provision and price control.

28. The direct resource costs of government intervention include the

a. Opportunity costs of forgone investment.

b. Rent seeking.

c. Increased costs of production arising from compliance with regulations.

d. Salaries of government regulators. ✓

29. The total costs of government intervention in the market economy include

a. Extra costs arising from regulation.

b. Compliance costs.

c. The costs of rent seeking.

d. All the above. ✓

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30. Rent seeking is a problem of

a. Private organizations in which ownership is not identical to management.

b. Pure free-market economies.

c. Centrally planned economies.

d. All economies, given the existence of government. ✓

31. Economists generally agree that government intervention in the economy is appropriate

a. Only when the market fails to provide a socially useful good.

b. Whenever there is a market failure.

c. Whenever the benefits of the correction of the market failure through intervention are greater than the costs of

the intervention itself. ✓

d. Whenever the costs of the intervention are greater than the value of the correction of the market failure.

32. If pollution is associated with the production of some good, then

a. marginal social cost minus marginal private cost is positive. ✓

b. the price of the good is equal to firms’ marginal private cost.

c. marginal social cost minus marginal private cost is negative.

d. the marginal social cost is less than the marginal social benefit.

33. When an external cost associated with the production of some good has been internalized, it means that

a. the consumer is bearing the net social benefits imposed by the producer.

b. the external costs are incorporated into private decision making. ✓

c. the private cost of production is borne by the producer.

d. the firm is ignoring social costs.

34. When a farmer in Manitoba produces fertilizer run-off that pollutes the local water system,

a. the farm should stop producing agricultural products altogether.

b. the amount of farm output produced will not be cost-effective.

c. the amount of farm output produced will be less than the efficient level.

d. the amount of farm output produced will exceed the efficient level. ✓

35. What is the “marginal cost of pollution abatement”?

a. the social cost of producing one additional unit of pollution

b. the private cost of producing one additional unit of pollution

c. the cost of reducing pollution by one additional unit ✓

d. the cost of the last unit of pollution produced

36. When the marginal costs of pollution abatement equal the marginal benefits of pollution abatement,

a. any further reductions in pollution will continue to increase net social benefits.

b. then firms are likely to increase output.

c. any further reductions in pollution will lower net social benefits. ✓

d. pollution has been entirely eliminated.

37. A downward-sloping marginal benefit curve for pollution abatement means that

a. the costs of pollution decrease as further amounts are abated.

b. the marginal cost of pollution reduction will always exceed the marginal benefit.

c. there are decreasing incremental benefits to be realized from additional increments of pollution abatement. ✓

d. it is impossible to know the benefits from additional increments of pollution abatement.

38. An upward-sloping marginal cost curve for pollution abatement means that

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a. the cost of an extra unit of pollution abatement will increase as the total amount of abatement rises. ✓

b. additional increments of pollution abatement will yield decreasing benefits.

c. it is impossible to know the benefits from additional increments of pollution reduction.

d. the marginal benefit of pollution reduction will increase with additional increments of pollution reduction.

39. Zero environmental damage is probably

a. technologically possible but not economically efficient. ✓

b. neither technologically possible nor economically efficient.

c. technologically possible and economically efficient.

d. economically efficient but not technologically possible.

40. Direct pollution controls can be inefficient because, for any given amount of pollution reduction, they

a. create new pollution as they eliminate existing pollution.

b. take into account differing marginal costs among firms.

c. cost too much to enforce.

d. do not minimize the total cost of pollution abatement. ✓

41. Automobile emissions standards are an example of

a. direct pollution controls. ✓

b. a market-based environmental policy.

c. tradable emissions standards.

d. emissions taxes.

42. Consider two firms, A and B, that must engage in pollution abatement. If Firm A has a lower marginal cost of pollution

abatement than Firm B, then

a. reallocating all abatement activity to Firm A will reduce pollution and reduce the total cost of abatement.

b. regardless of costs, it is equitable for both firms to face the same direct controls on their pollution.

c. reallocating some of Firm B’s abatement activity to Firm A can keep total abatement constant but reduce the total

cost of abatement. ✓

d. reallocating some of Firm A’s abatement activity to Firm B will keep total abatement constant but will reduce the

total cost of abatement.

43. Two firms, A and B, are legally required to reduce their toxic emissions. If Firm A’s marginal cost of abatement is $5 and

Firm B’s marginal cost of abatement is $5,

a. their joint total cost of abatement is at a minimum. ✓

b. Firm B should abate more, and Firm A should abate less.

c. their joint total cost of abatement is at a maximum.

d. Firm A should abate more, and Firm B should abate less.

44. If emissions permits are traded freely between profit-maximizing firms in the private market,

a. all firms will use identical pollution abatement technologies.

b. there will be more than the optimal amount of pollution.

c. each firm will face identical costs of pollution abatement.

d. marginal abatement costs will be equalized across firms. ✓

45. Economists often argue that a system of tradable pollution permits is cost-effective because

a. firms facing a high marginal cost of abatement will not abate at all.

b. firms facing a low marginal cost of abatement will not abate at all.

c. firms will choose their abatement so that their marginal cost of abatement equals the price of a permit, which is

the same for all firms. ✓

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d. firms facing a marginal cost of abatement lower than the permit price will not abate at all.

46. Consider a coal-fired electric-power plant that is operating under a cap-and trade-system. If its marginal cost of pollution

abatement is $5 per unit and the price of the permit is $3 per unit, this firm will

a. buy permits and abate less pollution. ✓

b. not abate at all.

c. buy permits and abate more pollution.

d. sell permits and abate more pollution.

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47. A paper mill discharges chemicals into a river that washes the shores of a downstream resort area. The private cost, social

cost, and marginal benefit associated with the production of paper are given by the following equations: PMC = 5 + Q, SMC

= 10 + 2Q, and MB = 35 – 0.5Q.

a. Provide a labelled diagram to illustrate how the competitive free market will not produce the socially optimal

amount of output.

b. Illustrate the efficiency loss.

c. Illustrate how a per-unit tax could be used to correct this problem.

48. Three roommates need to purchase candles for their new apartment. Candles are a Public Good. The marginal benefits to

each of the roommates are given by PA = 8 – QA , PB = 4 – QB and PC = 2 – QC. Candles cost $11 each.

a. Provide a fully labelled diagram showing how many should be purchased and how should the costs be shared.

b. Briefly explain how the results would differ if the roommates acted non- cooperatively. How would the Free-Rider

Problem be evident in this question?

Quantity

Price

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49. Production of good X creates a negative externality. Marginal private costs (supply) are MPC = Q and marginal social costs

are MSC = 2Q. Marginal benefits (demand) are MB = 120 − Q.

a. Provide a Supply and Demand diagram to illustrate the fact that private decision-making will over-supply this good.

Show the Efficiency Loss and the Pigouvian Tax that would be required to eliminate the Efficiency Loss.

b. The Efficiency Loss is equal to ____________ and the Pigouvian Tax is _____________.

50. Bicycle paths are public goods which can be supplied at cost MC = 5 + 2Q where Q measures kilometres of bicycle paths.

There are only two people in this city Mr. A and Ms. B. Describe the free rider problem associated with the supply of this

good. Suppose that demand is given by QA = 50 – 0.5p and QB = 25 – p so that MBA = 100 − 2Q and MBB = 25 − Q.

a. Find the efficient quantity of paths. Provide a fully labeled diagram.

b. Calculate the cost of supplying the efficient quantity and suggest how this cost might be recovered from the two

consumers.

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51. The private cost of education at a college near UTM is $300 per course. Graduates of their business program can expect to

earn marginal private benefits of MB = 400 − 20q where q is the number of courses taken. A graduate will create social

benefits so MSB = 400 − 10q.

a. How many courses will a student choose to take?

b. What is the socially optimal number of courses?

c. Illustrate how a per-unit subsidy could be used to correct this problem.

52. Roommates have demand for cleaning PA = 20 – Q, PB = 40 – Q and PC = 40 – 2Q. Cleaning costs C = 60Q so MC = 60.

a. Illustrate and quantify the optimal purchases of this public good.

b. The total cost C = 60Q of this service will be equal to __________ dollars.

c. The best way to divide the total costs of these services would be to have roommate B pay __________ dollars.

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53. Forty commuters must decide between taking the GO Train and driving on the QEW. A passenger on the GO can reach

downtown in 20 minutes. A driver on the QEW can reach downtown in t = 10 + 0.5D minutes where D is the number of

drivers on the QEW.

a. The noncooperative solution predicts that commuters will spend a total of __________ minutes.

b. The cooperative solution predicts that commuters will spend a total of __________ minutes.

c. Provide a labelled diagram to illustrate and quantify your predictions.

54. Automobiles and industrial factories both contribute to air pollution in Toronto. The total cost of abating automobile

emissions is given by CA = YA2 + 8 while the total cost of abating in industry is CI = 2YI2 + 20. The total benefits from

pollution abatement are B = 28Y – 0.5Y2 + 20 where Y = YA + YI is the total amount of abatement.

a. Calculate the socially optimal amount of abatement activity.

b. How much should each sector abate?

55. A firm operates in a perfectly competitive market and receives a price $20 for its output. The marginal cost of production

is given by MC = 4Q. A government study has found that the production process creates pollution and measures the social

marginal cost of production at MSC = 5Q.

a. Provide a fully labeled diagram that shows the private profit maximizing choice of output and the socially optimal

choice of output.

b. Calculate the per- unit Pigouvian tax required to achieve the social optimum. Show the impact of the tax on the

same diagram.