Externalities Revision Questions

1. Which of the following statements about negative externalities is/are TRUE?
   I. At the social-surplus maximizing level of output, external costs equal zero.
   II. At the unregulated competitive equilibrium, marginal social cost is greater than marginal social benefit.
   III. At any output level, social costs are greater than private (market) costs.
   a) I, II, and III.
   b) II only.
   c) III only.
   d) II and III.
2. Which of the following statements about external costs is TRUE?
   a) Economics uses the term “external cost” to describe a spillover effect from market activity that is too small to matter to society.
   b) Economics ignores the environmental impact of market activities by calling such impact an “external cost.”
   c) Economics does not provide guidance for environmental policy since its treats any environmental cost as an “external cost”.
   d) None of the above statements are true.
3. If a competitive market is characterized by a negative externality, then which of the following statements is true?
   a) Social surplus is greater than market surplus.
   b) Social surplus is less than market surplus.
   c) Social surplus is equal to market surplus.
   d) Social surplus may be greater than or less than market surplus, depending on the size of the externality.
   The following TWO questions refer to the diagram below, which illustrates the market for a good whose production results in a negative externality.
4. If there is no regulation in place to correct the externality, which area represents MARKET surplus?
   a) a.
   b) a – d.
   c) a + b.
   d) a + b + e.
5. If there is no regulation in place to correct the externality, which area represents SOCIAL surplus?
   a) a.
   b) a – d.
   c) a + b.
   d) a + b + e.
6. Suppose that each kilowatt-hour (kwh) of electricity produced using natural gas results in 0.2Kgs of carbon dioxide emissions. If each ton of carbon dioxide emissions results in environmental costs of $360, then the marginal external cost per kwh of electricity produced is equal to (0.2Kg is equal to about 0.000220462 tons):
   a) 10 cents.
   b) 8 cents.
   c) 4 cents.
   d) 2 cents.
   The following THREE question refer to the diagram below, which illustrates the marginal private cost, marginal social cost, and marginal social benefits for a goods whose production results in a negative externality.
7. Which are represents the deadweight loss due to the externality?
   a) j.
   b) h.
   c) h+j.
   d) There is no deadweight loss.
8. Which are represents external costs at the unregulated competitive equilibrium?
   a) g + h + j + m + k.
   b) g + h + j.
   c) g + m.
   d) g.
9. Which are represents social surplus at the unregulated competitive equilibrium?
   a) f – j.
   b) f.
   c) f + g + h.
   d) f + g + h – j.

Exercise 5.2

1. If the government introduces a per unit tax equal to the marginal external cost, what area represents the change in social surplus?
   a) j; a decrease.
   b) j; an increase.
   c) h; a decrease.
   d) h; an increase.
2. Which area represents external costs at the social-surplus-maximizing quantity of output?
   a) External costs are zero.
   b) g + h + j.
   c) g + h.
   d) g.
   The following TWO questions refer to the diagram below, which illustrates the supply and demand curves for a perfectly competitive market. Assume that each unit of output results in a marginal external cost of $5.
3. In the absence of government intervention, what will the deadweight loss equal? a) $0.
   b) $30.
   c) $60.
   d) There is insufficient information to determine the size of the deadweight loss.
4. If a tax of $5 per unit is introduced in the market illustrated above, then the price that consumers pay will be and the price that producer receive (net of the tax) will
   be .
   a) $9; $4.
   b) $8; $5.
   c) $7; $6.
   d) $6; $1.

Exercise 5.3

1. If the marginal private cost of pollution is zero for each firm then, in the absence of regulation, pollution levels will be:
   a) P1 = 100, P2 = 100.
   b) P1 = 50, P2 = 100.
   c) P1 = 50, P2 = 50.
   d) P1 = 100, P2 = 50.
2. If a pollution tax of $6 per unit is introduced, pollution levels will be: a) P1 = 60, P2 = 10.
   b) P1 = 70, P2 = 20.
   c) P1 = 80, P2 = 30.
   d) P1 = 90, P2 = 40.
3. Suppose a cap and trade program is introduced to reduce aggregate emissions. If each firm receives HALF the permits in the initial allocation, then which firm will sell permits and which firm will buy?
   a) Firm 1 Will sell permits and firm 2 WILL buy permits.
   b) Firm 1 Will buy permits and firm 2 WILL sell permits.
   c) We need to know the number of permits in total, in order to figure out who will sell

and who will buy.
d) We need to know the equilibrium price of permits, in order to figure out who will sell and who will buy.
The following THREE questions refer to the diagram below, which illustrates the marginal abatement cost curve for two firms. Assume these are the only two emitters of pollution.

4. If a pollution tax of $10 per unit is introduced, then how much will each firm emit in the taxed equilibrium?
   a) Firm 1 Will emit 60 units, firm 2 WILL emit 120 units.
   b) Firm 1 Will emit 80 units, firm 2 WILL emit 160 units.
   c) Firm 1 Will emit 20 units, firm 2 WILL emit 40 units.
   d) Each firm will emit no pollution.
5. If a cap and trade program is introduced in which aggregate emissions are restricted to 120 units, what is the competitive equilibrium price for permits?
   a) $10.
   b) $15.
   c) $20.
   d) We cannot determines the equilibrium price without knowing the initial distribution of permits.
6. Suppose a cap and trade program is introduced, in which firm 1 receives 100 permits and firm 2 receives 120 permits, in the initial allocation. Which of the following statements is true?

a) Given the initial allocation of permits, neither firm will want to buy permits.
b) Given the initial allocation of permits, neither firm will want to sell permits.
c) In equilibrium, firm 1 Will buy permits and firm 2 WILL sell permits.
d) In equilibrium, firm 1 Will sell permits and firm 2 WILL buy permits.

7. Which if the following statements about environmental policy is true?
   I. A cap and trade policy allows the government to directly control the quantity of pollution, but the price of pollution is determined by private agents.
   II. A carbon tax allows the government to directly control the price of pollution, but the quantity of pollution is determined by private agents.
   III. Both carbon taxes and cap and trade programs will result in least-cost abatement.
   a) I only.
   b) II only.
   c) I and II only.
   d) I, II, and III.
   The following two questions refer to the diagram below, which illustrates the marginal abatement cost curve for two polluting firms. Note that in the absence of regulation, each firm will emit 80 units of the pollutant in question, so that aggregate emissions are 160 units.
8. If a pollution tax of $8 per unit is introduced, then what is the percentage decrease in aggregate emissions?
   a) 25%.
   b) 50%.

c) 75%.
d) 100%.

9. If a cap and trade program is introduced in which aggregate emissions are restricted to 100 units, what be the equilibrium price of permits?
   a) $2.
   b) $4.
   c) $6.
   d) $8.

Revision Summary

Externality
a cost or benefit that arises from production that falls on someone other than the producer or a cost or benefit that arises from consumption that falls on someone other than the consumer

Negative Externality
a production or consumption activity that creates an external cost

Positive Externality
a production or consumption activity that creates an external benefit

Marginal Private Cost
the cost of producing an additional unit of a good or service that is borne by the producer of that good or service

Marginal External Cost
the cost of producing an additional unit of a good or service that falls on people other than the producer

Marginal Social Cost
the marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls. It is the sum of the marginal private cost and marginal external cost

Property Rights
legally established titles to the ownership, use, and disposal of production and goods and services that are
enforceable in the courts

Coase Theorem
the proposition that if property rights exist, only a small number of parties are involved, and transactions costs are low, then private transactions are efficient and the outcome is not affected by who is assigned the property right

Transaction Costs
the opportunity costs of conducting a transaction

Marginal Private Benefit
the benefit from an additional unit of a good or service that the consumer of that good or service receives

Marginal External Benefit
the benefit from an additional unit of a good or service that people other than the consumer of the good or service enjoy

Marginal Social Benefit
the marginal benefit enjoyed by society—by the consumers of a good or service and by everyone else who benefits from it. It is the sum of the marginal private benefit and marginal external benefit

Public Provision
The production of a good or service by a public authority that receives most of its revenue from the government

Subsidy
a payment by the government to a producer to cover part of the costs of production

Voucher
A token that the government provides to households that can be used to buy specified goods or services

Intellectual Property Rights
the property rights of the creators of knowledge and other discoveries

Patent/Copyright
a government sanctioned exclusive right granted to the inventor of a good, service, or productive process to produce, use, and sell the invention for a given number of years