Chapter 7

Externalities

Exercise 7.1
“Smoke from a factory dirties the local housing and poisons crops.” Identify
the nature of the externalities in this statement.
Solution 7.1
There are two externalities in the statement. The smoke dirtying the local
housing is a negative consumption externality. The smoke that poisons the crops
is a negative production externality.

Exercise 7.2
How would you describe the production function of a laundry polluted by a
factory?
Solution 7.2
If the laundry is polluted by a factory there is a negative production exter-
nality. The output of the laundry will be reduced for any given level of inputs
for the laundry. Assume the laundry uses two inputs in quantities z1 and z2 .
Denote the output of the factory by yf and the output of the laundry by y� .
The general form of production function for the laundry would be
y� = f (z1 , z2 , yf ) , (7.1)
with
∂f
< 0. (7.2)
∂yf

� �
A particular example could be
1
y� = z1α z2β log . (7.3)
yf

Exercise 7.3
Let U = [x1 ]α [x2 y]1−α , where y is an externality. Is this externality positive
or negative? How does it affect the demand for good 1 relative to the demand
for good 2?

117
118 CHAPTER 7. EXTERNALITIES

Solution 7.3
The marginal effect of the externality is given by

= [1 − α]
α 1−α
∂U [x1 ] [x2 y]
> 0. (7.4)
∂y y
The externality is positive.
To see how it affects relative demand, consider a consumer who solves the
problem
max [x1 ]α [x2 y]1−α s.t. M = p1 x1 + p2 x2 .
{x1 ,x2 }
(7.5)

The first-order conditions are

− λp1
[x1 ]α [x2 y]1−α
α = 0, (7.6)
x1

[1 − α] − λp2
[x1 ]α [x2 y]1−α
= 0. (7.7)
x2
Dividing the first of these by the second

1 − α x1
α x2 p1
= . (7.8)
p2
The externality does not affect the demand for good 1 relative to good 2.

� �α � 1 2 �1−α
� 2 �α � 2 1 �1−α
Exercise 7.4
If the two consumers in the economy have preferences U1 = x11 x2 x1
and U2 = x1 x2 x1 , show that the equilibrium is efficient despite the
externality. Explain this conclusion.
Solution 7.4

� 1 �α � 1 2 �1−α
The marginal utility of good 1 for consumer 1 is

∂U1 x1 x2 x1
= α , (7.9)
∂x11 x11

� 1 �α � 1 2 �1−α
and the marginal utility of good 2 is

= [1 − α] 1
∂U1 x x2 x1
. (7.10)
∂x12 x12

� � 1
From these the marginal rate of substitution for consumer 1 is

1 − α x11
1 α x2
MRS1,2 = . (7.11)

� � 2
Similar calculations for consumer 2 give

1 − α x21
2 α x2
MRS1,2 = . (7.12)
 119

Notice that each of the marginal rates of substitution is independent of the

externality effect. Each consumer equates their MRS to the price ratio which
ensures that the marginal rates of substitution are equal. Therefore the exter-
nality does not affect the fact that the equilibrium is efficient.
This conclusion holds because the externality does not affect the proportions
in which the two consumers purchase the goods. (Observe that the externality
effect can be factored out of the utility functions as a constant.) The same
equilibrium is reached with the externality as it is without. Such externalities
are called “Pareto irrelevant”.

Exercise 7.5
Consider a group of n students. Suppose that each student i puts in hi hours
h2

�
of work on her classes which involves a disutility of 2i . Her benefits depend on
how she performs relative to her peers and take the form u( hhi ) for all i, where
h = ( n1 ) i hi denotes the average number of hours put in by all students in the
class and u(·) is an increasing and concave function.
(a) Calculate the symmetric Nash equilibrium.
(b) Calculate the Pareto-efficient level of effort.
(b) Explain why the equilibrium involves too much effort compared to the
Pareto-efficient outcome.
Solution 7.5
(a) At a Nash equilibrium the choice of each individual student maximizes
utility given the actions of the other students. Let the sum of the choices of
the students other than j be given by H. Then h = ( n1 ) [hj + H] . Using this

� �
notation benefit less disutility is

− i
h2

� �
hj
U = u
h 2

− i.
hj h2
= u 1 (7.13)
n (hj + H)
2

� � � �
The first-order condition for the choice of hj is

n (hj + H) − n hj
�1 �2 − hj = 0.
�
1 1
∂U hj
= u 1 (7.14)
∂hj (hj + H) n (hj + H)

At a symmetric equilibrium hj = h all j and H = [n − 1] h. Solving the first-

n

n−1 �
u (1) − h = 0,
order conditions
(7.15)
nh
or
u� (1) =
nh2
n−1
. (7.16)

� �
(b) The Pareto-efficient level of effort maximizes the sum of utility levels.
Invoking symmetry, the Pareto-efficient effort level solves

max nU = n u(1) −
h2
{h}
. (7.17)
2
120 CHAPTER 7. EXTERNALITIES

The derivative of nU with respect to h is

= −h < 0.
∂ (nU)
(7.18)
∂h
The derivative is negative for any positive value of h, so the Pareto-efficient level
is h = 0.
(c) This exercise is an example of a rat race. A gain for an individual comes
through exerting relatively more effort than the other students. But more effort
is costly so if all students exert more effort all will lose. It is therefore Pareto-
efficient to exert no effort.

Exercise 7.6
There is a large number of commuters who decide to use either their car
or the tube. Commuting by train takes 70 minutes whatever the number of

where x is the proportion of commuters taking their car, 0 ≤ x ≤ 1.

commuters taking the train. Commuting by car takes C(x) = 20+60x minutes,

(a) Plot the curves of the commuting time by car and the commuting time
by train as a function of the proportion of car users.
(b) What is the proportion of commuters who will take their car if every-
one is taking her decision freely and independently so as to minimize her own
commuting time?
(c) What is the proportion of car users that minimizes the total commuting
time?
(d) Compare this with your answer given in part (b). Interpret the difference.
How large is the deadweight loss from the externality?
(e) Explain how a toll could achieve the efficient allocation of commuters
between train and car and be beneficial for everyone.
Solution 7.6
(a) The commuting times are shown in figure 7.1. The time by tube is
constant but the time taken by car increases as car use increases.
(b) The proportion of car users if independent choices are made will be such
that the times of travel by tube and by car are equated
70 = 20 + 60xm . (7.19)
Solving for xm gives
5
xm = . (7.20)
6
This solution corresponds to the intersection point of the two commuting time

(c) The total commuting time is (20 + 60x) x + 70 (1 − x), where x is the
curves.

proportion of car users. Setting the derivative with respect to x equal to zero

120xo − 50 = 0.
gives
(7.21)
Solving for xo the time-minimizing car use is
5
xo = . (7.22)
12
 121

Commuting
time

Proportion
of car users

Figure 7.1: Commuting times

(d) The free market outcome for the proportion of car users is greater than
the socially optimal outcome because the individual commuters do not take
into account the negative externality generated by car travel, i.e. the traffic
congestion. The deadweight loss from the externality is the difference between
the total commuting times. Using the earlier results
5 1 245
Tm = 20 + 60 + 70 = , (7.23)
6 6 3
and
5 7 515
To = 20 + 60 + 70s = . (7.24)
12 12 6

Tm − T0 =
The difference is
25
. (7.25)
6
(e) If the commuters attach monetary value to their travel time then a toll
may induce them to switch from car to tube if the amount of the toll exceeds
the benefits of shorter travel time. Given information on the monetary value
of travel time the amount of the toll can be computed so that the proportion
of commuters that still find it beneficial to travel by car is exactly equal to the
socially optimal level.

Exercise 7.7
Re-do the previous problem by replacing the train by a bus and assuming
that commuting time by bus is increasing with the proportion of commuters
using car (traffic congestion). Let the commuting time by bus be B(x) = 40+20x
122 CHAPTER 7. EXTERNALITIES

Commuting
time

Proportion
of car users

Figure 7.2: Commuting by car and bus

of commuters taking their car, 0 ≤ x ≤ 1.

and the commuting time by car be C(x) = 20 + 60x, where x is the proportion

Solution 7.7
(a) The commuting times are shown in figure 7.2. The time by bus is in-
creasing as car use increases.
(b) The proportion will be such that it equates the times of travel by bus
and by car,
40 + 20xm = 20 + 60xm , (7.26)
so
1
xm = . (7.27)
2
This solution corresponds to the point where the two curves of commuting time

(c) The total commuting time is (20 + 60x) x + (40 + 20x) (1 − x), where x
intersect.

is the proportion of car users. Setting the derivative with respect to x equal to

80xo − 20 = 0.
zero gives
(7.28)
Solving
1
xo = . (7.29)
4
(d) The free-market outcome for the proportion of car users is greater than
the socially optimal outcome because the individual commuters do not take
into account the negative externality generated by car travel, i.e., the traffic
 123

congestion. The deadweight loss from the externality is the difference between
the total commuting times
1 1
Tm = 20 + 60 + 40 + 20 = 100, (7.30)
2 2
and
1 1
To = 20 + 60 + 40 + 20 = 80. (7.31)
4 4

Tm − T0 = 20.
The difference is
(7.32)
(e) If the commuters attach monetary value to their travel time then a toll
may induce them to switch from car to bus if the amount of the toll exceeds
the benefit of shorter travel time. Given the information on the monetary value
of travel time the amount of toll can be computed so that the proportion of
commuters that still find it beneficial to travel by car is exactly equal to the
socially optimal level.

Exercise 7.8
Consider a binary choice to allow or not the emission of pollutants. The
cost to consumers of allowing the pollution is C = 2, 000 but this cost is only
observable to the consumers. The benefit for the polluter of allowing the exter-
nality is B = 2, 300 and only the polluter knows this benefit. Clearly optimality
requires this externality is allowed since B > C. However the final decision must
be based on what each party chooses to reveal.
(a) Construct a tax-subsidy revelation scheme such that it is a dominant
strategy for each party to report truthfully their private information.
(b) Show that this revelation scheme induces the optimal production of the
externality.
(c) Show that this revelation scheme is unbalanced in the sense that given
the equilibrium reports the tax to be paid by the polluter is less than the subsidy
paid to the pollutee.
Solution 7.8
(a) The scheme should be as follows: (i) allow the pollution if the cost
announced by the consumers is below or equal to the benefits announced by the
producer, do not allow otherwise; (ii) if the pollution is allowed pay each party
the amount announced by the other party, if the pollution is not allowed pay
nothing.

is Uc = 0 if the externality is not allowed and Uc = Ba − C if the externality

Given announcement Ba of the producer the net payoff of the consumers

is allowed. If Ba > C the consumers receive Uc = 0 for announcing Ca ≥

Ba , and Uc = Ba − C > 0 for any announcement Ca < Ba (including the
truthful announcement Ca = C). If Ba ≤ C, the consumers receive Uc = 0 for
announcing Ca ≥ Ba (including Ca = C), and Uc = Ba − C < 0 for announcing
Ca < Ba . Hence, announcing truthfully is a (weakly) dominant strategy for the
consumers.
124 CHAPTER 7. EXTERNALITIES

producer is Up = 0 if the externality is not allowed and Up = B − Ca if the

Similarly, given announcement Ca of the consumer the net payoff of the

Ba ≤ Ca , and Up = Ba − Ca > 0 for announcing Ba > Ca (including the

externality is allowed. If Ca < B the producer receives Up = 0 for announcing

truthful announcement Ba = B). If Ca ≥ B, the producer receives Up = 0 for

announcing Ba ≤ Ca (including Ba = B), and Up = Ba − C ≤ 0 for announcing
Ba > Ca . Hence, announcing truthfully is a (weakly) dominant strategy for the
consumers.
(b) Because the players will play dominant strategies, in the equilibrium the
externality will be produced, which is the socially optimal outcome.
(c) By construction, this scheme requires payment to each party equal to the
amount announced by the other party. Because each party will make truthful
announcement, the subsidy to the pollutee (the consumers) equals the benefit
received by the producer, B = 2300, and in this problem it is greater than the
cost to the consumers, C = 2000, which is the tax to be paid by the polluter
(the producer).

Exercise 7.9
How can licences be used to resolve the tragedy of the commons?
Solution 7.9
The tragedy of the commons is an example of a negative externality. A
group of agents have a common right of access to a resource and in the market
equilibrium the aggregate quantity of the resource used by the agents exceeds
the optimal level. The government can regulate the quantity by issuing licenses
that permit usage of the resource up to a certain limit. The government can then
set the licensed amount so that the aggregate usage equals the optimal level.
In the example with fishing boats, the government can calculate the optimal
number of fishing boats, B o , and issue exactly B o licenses for fishing. This
policy must be enforced by, say, prosecution and penalty for the fishing boats
that operate without licenses.

Exercise 7.10
If insufficient abatement is very costly, which of taxation or licences is prefer-
able?
Solution 7.10
With a licence scheme the level of pollution abatement will be sure — there
is no uncertainty about the outcome. With a tax, the level of abatement will
depend upon the realized level of cost since the firm chooses after this is known.
Therefore if the cost turns out to be low the firm will choose a high abatement
level. If the cost is high, a low abatement level is chosen. Two observations
follow from this. Firstly, licences and taxation will not be equivalent when
there is uncertainty. Secondly, when the cost of abatement is realized to be low,
taxation leads to excessive abatement. The converse holds when cost is high
and there is insufficient abatement. Therefore when insufficient abatement is
very costly licences will be preferred because of the certainty of the outcome.
 125

Exercise 7.11
Are the following statements true or false? Explain why.
(a) If your consumption of cigarettes produces negative externalities for your
partner (which you ignore), then you are consuming more cigarettes than is
Pareto-efficient.
(b) It is generally efficient to set an emission standard allowing zero pollution.
(c) A tax on cigarettes induces the market for cigarettes to perform more
efficiently.
(d) A ban on smoking is necessarily efficient.
(e) A competitive market with a negative externality produces more output
than is efficient.
(f) A snob effect is a negative (network) externality from consumption.
Solution 7.11
(a) True. With negative externalities the market equilibrium quantity in
general exceeds the Pareto-efficient level.
(b) False. If some production process generates a non-zero level of pollution
but the benefits exceed the cost then this production is socially optimal and
should be allowed. Hence, the emission standards should allow for a certain
non-zero pollution level.
(c) True. Smoking generates negative externalities, and the market outcome
is inefficient.
(d) False. A ban on smoking reduces the utility of the smokers and the prof-
its of the cigarette-makers. Although the utility of non-smokers and the profits
of the producers of substitute goods (e.g., chewing tobacco) would increase, the
aggregate welfare function may change either way.
(e) True. A snob effect is a negative network externality. The snob effect
refers to the desire to own exclusive or unique goods. The quantity demanded
of a “snob” good is higher the fewer the people who own it.

Exercise 7.12

� � � �
Consider two consumers with utility functions

U = log(x1 ) + x2 − log(x1 ), U = log(x1 ) + x2 −

A A A 1 B B B B 1
log(xA
1 ).
2 2

Both consumers have income M and the (pre-tax) price of both goods is 1.
(a) Calculate the market equilibrium.
(b) Calculate the social optimum for a utilitarian social welfare function.
(c) Show that the optimum can be sustained by a tax placed on good 1
(so the post-tax price becomes 1 + t) with the revenue returned equally to the
consumers in a lump-sum manner.
(d) Assume now that preferences are given by

1 ) + x2 − 1 ), U = ρ log(x1 ) + x2 −
1 1
U A = ρA log(xA A
log(xB B B B B
log(xA
1 ).
2 2
Calculate the taxes necessary to decentralize the optimum.
126 CHAPTER 7. EXTERNALITIES

(e) For preferences of part (d) and income M = 20, contrast the outcome
when taxes can and cannot be differentiated between consumers.
Solution 7.12
(a) Consumer A solves

1 ,x2 }
{xA
max U A s.t. xA A
1 + x2 = M. (7.33)
A

� � � � � �
The Lagrangian for this optimization problem is

L = log xA
1 + x2 − M − xA
1 − x2 ,
A 1 A
log xB
1 +λ
A
(7.34)
2
and from the first-order conditions

− λ = 0,
∂L 1
= (7.35)
∂xA
1 xA
1

= 1 − λA = 0,
∂L
(7.36)
∂xA
2

= M − xA
1 − x2 = 0,
∂L A
(7.37)
∂λ
we find his optimal consumption:

xA
1 = 1, 2 = M − 1.
xA (7.38)

2 = M − 1.
Similarly,
xB
1 = 1, xB (7.39)
(b) A utilitarian welfare function is defined as the sum of the individual
utility functions, in general, with individual weights. Here we assume a sym-
metric utilitarian welfare function, i.e., W = U A + U B . The socially-optimal
consumption in this case solves

{xA }
max U A + U B s. t. xA,B
1 + xA,B
2 = M. (7.40)
,xA ,xB ,xB
1 2 1 2

� � 1 � �
The Lagrangian for the social planner’s problem is

L =
� � � �
1
log xA
1 + log xB A B
1 + x2 + x2

+λA M − xA1 − x2 + λ M − xA 1 − x2 .
2 2
A B A
(7.41)

From the first-order conditions we find the socially optimal consumption profile:

2 =M − ,
1 1
xA
1 = , xA (7.42)
2 2
x2 = M − .
1 1
xB
1 = , B
(7.43)
2 2
 127

� �
(c) With tax tA placed on good 1 and with lump-sum transfer T A consumer
A solves

{x1 ,x2 }
max U A s. t. 1 + tA xA A A
1 + x2 = M + T . (7.44)
A A

� � � � � � � �
The Lagrangian for this optimization problem is

L = log xA 1 + x2 − M + T A − 1 + tA xA 1 − x2 ,
A 1 A
log xB1 +λ
A
(7.45)
2

� �
and from the first-order conditions

− λA 1 + tA = 0,
∂L 1
A
= A
(7.46)
∂x1 x1

= 1 − λA = 0,
∂L

� �
(7.47)
∂xA2

= M + T A − 1 + tA xA 1 − x2 = 0,
∂L A
(7.48)
∂λ
we find his optimal consumption:

2 =M +T −
1 1
xA
1 = , xA A
. (7.49)
1 + tA 1 + tA
Similarly we find the optimal consumption of consumer B who pays tax tB on
good 1 and receives T B as a lump-sum transfer:

2 =M +T −
1 1
xB
1 = , xB B
. (7.50)
1 + tB 1 + tB
Comparing the optimum consumption levels with the market outcome we find
the set of taxes and transfers that decentralizes the socially optimal outcome:
tA,B = 1, (7.51)
1
T A,B = . (7.52)
2

� �
(d) With tax tA placed on good 1 and with lump-sum transfer T A consumer
A solves

{x1 ,x2 }
max U A s. t. 1 + tA xA A A
1 + x2 = M + T . (7.53)
A A

� � � B� � � � �
The Lagrangian for this optimization problem is

L = ρA log xA1 + x2 − log x1 + λ M + T A − 1 + tA xA1 − x2 ,

A 1 A A
(7.54)
2

� �
and from the first-order conditions

− λA 1 + tA = 0,
∂L ρA
A
= A
(7.55)
∂x1 x1

= 1 − λA = 0,
∂L

� �
(7.56)
∂xA2

= M + T A − 1 + tA xA 1 − x2 = 0,
∂L A
(7.57)
∂λ
128 CHAPTER 7. EXTERNALITIES

we find his optimal consumption:

2 =M +T −
ρA ρA
xA
1 = , xA A
. (7.58)
1 + tA 1 + tA

Similarly we find the optimal consumption of consumer B who pays tax tB on

good 1 and receives T B as a lump-sum transfer:

2 =M +T −
ρB ρB
xB
1 = , xB B
. (7.59)
1 + tB 1 + tB

The socially-optimal consumption for a (symmetric) utilitarian welfare function

solves

1 ,x2 ,x1 ,x2 }

{xA
max U A + U B s.t. xA,B
1 + x2A,B = M + T A,B . (7.60)
A B B

� � � �
� A� � �
The Lagrangian for the social planner’s problem is

L = ρ − log x1 + ρ −
� � � �
A 1 B 1
log xB A B
1 + x 2 + x2
2 2
+λA M − xA 1 − x2 + λ M − xA 1 − x2 .
A B A
(7.61)

From the first-order conditions we find the socially optimal consumption profile:

= ρA − , 2 =M −ρ + ,
1 1
xA
1 xA A
(7.62)
2 2
= ρB − , 2 =M −ρ + .
1 1
xB
1 xB B
(7.63)
2 2
Comparing these with the market outcome we find the set of taxes and transfers
that decentralizes the socially optimal outcome:

2ρA,B − 1
1
tA,B = , (7.64)
1
T A,B = . (7.65)
2
(e) Taxes can only achieve efficiency, i.e., the effect of externality can be
completely removed, if the consumers can be differentiated. If it is not possible
to levy individual tax rates on individual consumers, a uniform tax rate can be
used which will reduce the effect of the externality. Suppose, ρA = 3/2, ρB = 1,
M = 20, the tax rate is set to t = 3/4 for both consumers, and the tax revenues
are divided equally. Without taxes the market equilibrium outcome would be

3 1
xA
1 = , xA2 = 18 , (7.66)
2 2
xB
1 = 1, xB
2 = 19. (7.67)
 129

The first-best socially optimal outcome is

xA
1 = 1, xA
2 = 19, (7.68)
1 1
xB
1 = , xB
2 = 19 . (7.69)
2 2
The socially optimal outcome can be achieved with

1 1
tA = , tB = 1, T A,B = . (7.70)
2 2
3
With the uniform tax rate t = 4 the outcome is

6 1
xA
1 = , xA
2 = 19 , (7.71)
7 28
4 15

� �
xB
1 = , xB
2 = 19 . (7.72)
7 28

(total tax revenue is t xA B

1 + x1 = 15/14, so that each consumer receives
T A,B = 15/28). Aggregate welfare without taxes is W0m = 37.90, aggregate
welfare with the uniform tax is Wtm = 38.13, and the social optimum has
W o = 38.15.

Exercise 7.13
A competitive refining industry releases one unit of waste into the atmosphere

product is pd = 20 − q, which represents the marginal benefit curve where q is

for each unit of refined product. The inverse demand function for the refined

the quantity consumed when the consumers pay price pd . The inverse supply
curve for refining is MP C = 2 + q which represents the marginal private cost
curve when the industry produces q units. The marginal external cost curve
is MEC = 0.5q, where MEC is the marginal external cost when the industry
releases q units of waste. Marginal social cost is given by MSC = MP C +M EC.
(a) What are the equilibrium price and quantity for the refined product when
there is no correction for the externality?
(b) How much of the chemical should the market supply at the social opti-
mum?
(c) How large is the deadweight loss from the externality?
(d) Suppose the government imposes an emission fee of T per unit of emis-
sions. How large must the emission fee be if the market is to produce the socially-
efficient amount of the refined product?
Solution 7.13
(a) The equilibrium price and quantity without correction for the externality
equate the inverse demand and the marginal private cost:

2 + qm = 20 − q m , (7.73)
qm = 9, pm = 11. (7.74)
130 CHAPTER 7. EXTERNALITIES

Price/
cost
MSC

MPC+T
MPC

po
pm

MPB
qo qm
Quantity

Figure 7.3: Use of an emissions fee

(b) At the social optimum the inverse demand equals the marginal social
cost:

2 + q o + 0.5q o = 20 − qo , (7.75)
qo = 7.2, po = 12.5. (7.76)

(c) The deadweight loss from the externality is the difference between the
welfare level at the social optimum (the sum of the consumer surplus and the
producer surplus) and the welfare level at the market equilibrium (the sum of
the consumer surplus, the producer surplus, and the difference between the total

� �
� �
social cost and the total private cost):

MSC (q) − pd (q) dq = [(2 + 1.5q) − (20 − q)] dq

qm 9

� 9
DW L =
qo 7.2

= (2.5q − 18) dq = 4.05. (7.77)

7.2

(d) With the emission fee the market equilibrium is determined by

2+q+T = 20 − q (7.78)
= 9− .
T
q (7.79)
2
This quantity equals the socially optimal level, qo = 7.2, when T = 3.6.
These results are summarized in figure 7.3.

Exercise 7.14
 131

Discuss the following statement: “A tax is a fine for doing something right.
A fine is a tax for doing something wrong”.
Solution 7.14
The imposition of a tax or a fine for undertaking an economic activity raises
the relative cost of the activity and, in general, will reduce the degree to which
it is undertaken. In this respect the two are identical from an economic per-
spective. Where taxes and fines differ is in the degree of certainty of payment.
If taxes are paid honestly then there is certainty in the price of the activity. In
contrast if something “wrong” is done there may be a probability of not being
detected and avoiding any fine. The imposition of a fine becomes a random
event and the price of the activity is uncertain. This highlights the economic
distinction between choosing under certainty when taxes are paid, and choosing
with risk when there is the potential for a fine. The analysis of pollution permits
with uncertainty shows how the choices can differ between cases of certainty and
uncertainty, and that real economic differences in outcomes can arise.

Exercise 7.15
Suppose the government issues tradable pollution permits.
(a) Is it better for economic efficiency to distribute the permits between
polluters or to auction them?
(b) If the government decides to distribute the permits, does the allocation
of permits among firms matter for economic efficiency?
Solution 7.15
The issues at the heart of this question are the success, or otherwise, of
the market in allocating scarce commodities. The government sets a limit on
the total quantity of pollution that can be emitted by limiting the number of
permits. The permits are a scarce resource and economic efficiency requires
that they are used by those who value them the most. The government is
unlikely to be in possession of information on the values placed on permits.
Direct distribution by the government will not succeed in placing the permits
with the correct users. The benefit of an auction is that the permits will go to
the highest bidders who by definition are the users who value them most. If an
auction is not used but the permits are tradeable it does not matter how the
permits are initially distributed provided there is a market for the permits. If
the government distributes a permit to a user who places a low value upon it
then the permit will be sold to a user with a higher valuation. Efficiency is not
affected by the initial distribution but the allocation of income is affected.
There are caveats to the above arguments. The willingness to pay for a
permit reflects the private benefits from owning the permit and not the social
benefit. The essence of externalities is the deviation of private from social
benefits. Selling to the highest bidder will allocate according to private benefit
not social benefit. The argument that trade in permits is necessarily efficient
needs to be judged case-by-case taking account of the nature of the externalities.

Exercise 7.16
132 CHAPTER 7. EXTERNALITIES

A chemical producer dumps toxic waste into a river. The waste reduces the
population of fish, reducing profits for the local fishery industry by $150,000 per
year. The firm could eliminate the waste at a cost of $100,000 per year. The
local fishing industry consists of many small firms.
(a) Apply the Coase Theorem to explain how costless bargaining will lead
to a socially efficient outcome, no matter to whom property rights are assigned
(either to the chemical firm or the fishing industry).
(b) Verify the Coase Theorem if the cost of eliminating the waste is doubled
to $200,000 (with the benefit for the fishing industry unchanged at $150,000).
(c) Discuss the following argument: “A community, held together by ties of
obligation and mutual-interest can manage the local pollution problems”
(d) Why might bargaining not be costless?
Solution 7.16
(a) A socially efficient outcome in this case is to cease the externality, i.e.,
to allow the chemical firm to function after it eliminates the waste. Suppose
the property rights are assigned to the chemical firm, i.e., it has a full right to
produce chemicals, even though the production process involves dumping toxic
waste into a river. Then the fishing industry can pay the chemical firm to have it
install the facilities that would eliminate the waste. Since the cost of eliminating
the waste to the firm ($10,000) is less than the profits to be received by the
fishing industry after the waste is eliminated ($15,000) the fishing industry will
pay the full cost and still make a positive profit. Suppose now that the property
rights are assigned to the fishing industry. The chemical firm will then be forced
to install the waste-refining facilities (and pay their full cost), otherwise the
fishing industry will insist on shutting it down. In an intermediate case the
chemical firm and the fishing industry can bargain over the shares of cost of
the waste-refining facilities. In any case, a socially efficient outcome will be
achieved.
(b) In this case a socially efficient outcome is to continue the externality,
i.e., to allow pollution. Suppose the property rights are assigned to the chemical
firm. The cost of the pollution externality to the fishing industry is now smaller
than the cost of eliminating the waste to the firm. Hence, the fishing industry is
unable to offer the chemical firm enough compensation to have it eliminate the
waste, and the externality will continue. Suppose now that the property rights
are assigned to the fishing industry. Then the firm will be willing to pay the
fishing industry compensation of amount $15,000 and continue its production
without eliminating the waste. In an intermediate case, when both parties have
(limited) property rights, they can bargain over the amount of compensation.
Again, in any case a socially efficient outcome will be achieved.
(c) Bargaining is one solution to the externality problem. An alternative
solution is to internalize the externality. The effect of internalization is to ensure
that all participants face the social benefit and social cost of their actions. If the
chemical firm and the fishing industry are seen as a single community then profit
maximization by the chemical firm will take account of how its choices affect
the fishing industry (and vice versa). “Ties of obligation and mutual-interest”
can be interpreted as channels through which information on external effects
 133

can be communicated and lead to appropriate internalization.

(d) The process of bargaining takes time and resources. While the negotia-
tions are going on either party could be incurring losses, e.g. because of ceased
production or continuing pollution, etc. Because of the legal issues involved
both parties would have to hire lawyers and pay legal expenses.

Exercise 7.17
It is often used as an objection to market-based policies of pollution abate-
ment that they place a monetary value on cleaning up our environment. Econo-
mists reply that society implicitly places a monetary value on environmental
clean up even under command-and-control policies. Explain why this is true.
Solution 7.17
The objection to placing a monetary value on the environment is usually
one of principle rather than being based on a reasoned claim that the method
fails. Many environmental lobbyists view the environment as something unique
and beyond economic valuation. There are limits to how far this view can be
sustained. For better or worse man is forced to interact with the environment,
and consequently affect the environment, in order to survive. Even for extreme
environmentalists there has to be a point where the judgement is made that
survival is more important than the environment. For less environmentally con-
scious people economic activity takes greater priority over environment. Con-
sequently every economy is bound to place a monetary value on cleaning-up
the environment which reflects some aggregate of the individual valuations. As
for any other economic decision correctly evaluating the benefits and costs of
an action will result in an efficient decision being made. Although no pricing
is apparent when a command-and-control policy is employed the aims of the
policy represent the outcome of a benefit-cost calculation and the policy itself
is equivalent to a tax-based solution (if there is no uncertainty).

Exercise 7.18
Use examples to answer whether the externalities related to common re-
sources are generally positive or negative. Is the free-market use of common
resources greater or less than the socially optimal use?
Solution 7.18
The externalities related to common resources are generally negative. Typi-
cally, an increase in usage of the common resource by an individual hinders the
usage of this resource by everyone else because of congestion and/or depletion.
Because the users do not take this into account they tend to use the common
resource excessively, so that the free-market use of common resource is greater
than the socially-optimal value. An example of externality leading to the de-
pletion of the common resource is the tragedy of commons (unlimited access
to fishing or grazing etc.) — each individual user is concerned only with his
individual profits and does not take into account that, e.g., by catching more
fish he reduces the amount of fish and makes fishing more difficult for others.
An example of an externality leading to the congestion of the common resource
are traffic jams on free public roads — each individual commuter is concerned
134 CHAPTER 7. EXTERNALITIES

only with his own commuting time and does not take into account that his car
contributes to the road congestion and thus makes travel more difficult for other
car users. An example of a positive externality is when a group of people jointly
enjoy socializing during the use of a common resource such as a swimming lake.

Exercise 7.19
Why is there more litter along highways than in people’s yards?
Solution 7.19
One reason may be that litter along highways is removed by the local govern-
ment authorities paid for from tax revenues. The individuals do it excessively,
because they do not take into account that increasing the amount of litter along
highways makes cleaning more expensive and will probably result in an increase
in tax to cover this expense.
An alternative explanation could be that dumping litter on the highway is
a common resource problem. In contrast, the back yard is viewed as a private
resource and not over-exploited.

Exercise 7.20
Evaluate the following statement: “Since pollution is bad, it would be so-
cially optimal to prohibit the use of any production process that creates pollu-
tion”.
Solution 7.20
The statement, in general, is not true. In every case the cost of pollution
must be compared to the benefits from the production that generates this pollu-
tion, and the losses the society may incur if the ban on pollution will cause this
production to stop. Economics focuses on comparing marginal costs to marginal
benefits to guide choices. As long as the benefits and costs are correctly mea-
sured an efficient choice will be made. One important issue with externalities is
that there may be considerable uncertainty about the true costs. (For example,
are we really in a period of man-made global warming and, if so, what will be
its consequences?)

Exercise 7.21
Why is it not generally efficient to set an emissions standard allowing zero
pollution?
Solution 7.21
This is similar to exercise 7.11 part (b). If some production process generates
a non-zero level of pollution but the benefits exceed the cost then this production
is socially optimal and should be allowed. Hence, the emission standards should
allow for a certain non-zero pollution level.

Exercise 7.22
Education is often viewed as a good with positive externalities.
(a) Explain how education might produce positive external effects.
(b) Suggest a possible action of the government to induce the market for
education to perform more efficiently.
 135

Solution 7.22
(a) Education increases labor productivity by raising the skill of the labor
force. In addition, education upholds technical progress through inventive ac-
tivity. Hence, education leads to higher output and higher national income,
from which everyone benefits.
(b) The government may subsidize education for the financially constrained
families, as well as subsidize local public libraries and access to educational
resources in the internet.