Exercises: Positive and Negative Externalities

A paper mill on a river in Wisconsin dumps waste into the water, and the fishing businesses downstream lose income as a result. The mill does not pay for this damage. Define the term negative externality in your own words, and identify who the third parties are in this example.

Classify each situation as a positive externality or a negative externality, and write one sentence explaining each choice:

(a) Aaliyah gets a flu shot, so her classmates are less likely to catch the flu.

(b) A nightclub in downtown Chicago plays loud music until 3 a.m., and neighbors cannot sleep.

(c) A homeowner in Denver plants a beautiful garden that raises the value of nearby houses.

In a market with a negative externality in production, the marginal social cost (MSC) curve is related to the marginal private cost (MPC) curve. Describe where the MSC curve lies compared with the MPC curve, and name what the vertical distance between them represents.

A chemical plant in Houston produces fertilizer. The market demand is $P = 100 - Q$ and the marginal private cost is $MPC = 20 + Q$, where $Q$ is in thousands of tons and $P$ is in dollars per ton. Each ton produced also causes a constant external cost of $\$20$ per ton.

(a) Find the market equilibrium quantity and price.

(b) Write the marginal social cost curve and find the socially optimal quantity.

(c) Does the market overproduce or underproduce? By how many thousand tons?

The government of a state wants to correct the overproduction in the fertilizer market from the previous situation, where the external cost is $\$20$ per ton. It considers a per-unit tax on producers.

(a) What tax per ton would lead the market to produce the socially optimal quantity?

(b) Explain, using the supply curve, how the tax changes the producers' marginal cost.

(c) Explain why this tax is called a corrective (Pigouvian) tax.

Marcus's town offers a program that pays part of the cost of installing rooftop solar panels. A study finds that each household's panels give neighbors and the community cleaner air worth about $\$300$ per household per year, beyond what the owner gets.

(a) Is this a positive or negative externality? Explain.

(b) Without a subsidy, will the market quantity of solar panels be above or below the socially optimal quantity? Why?

(c) Explain how a subsidy of the right size could fix the problem.

A competitive market for steel has demand $P = 120 - 2Q$ and marginal private cost $MPC = 20 + Q$, with $Q$ in thousands of tons and $P$ in dollars per ton. Producing steel creates pollution that costs society an additional $\$12$ per ton, so $MSC = 32 + Q$.

(a) Find the market equilibrium quantity and the socially optimal quantity.

(b) Calculate the deadweight loss of the unregulated market. (Hint: it is a triangle between the MSC and demand curves, over the units that should not be produced.)

(c) Find the per-unit tax that eliminates the deadweight loss. Find the price consumers pay and the price producers receive after the tax.

(d) Explain why a tax set higher than $\$12$ per ton would create a new deadweight loss.

A city in California considers two policies to reduce traffic pollution from cars: (i) a tax per gallon of gas equal to the external cost, and (ii) a flat rule limiting every driver to the same number of miles per year, regardless of how much each driver values driving.

Compare the two policies. In your answer:

(a) Explain how each policy affects the quantity of driving.

(b) Explain which drivers keep driving under the tax, and which ones stop.

(c) Argue which policy is more efficient, and explain why the tax gives drivers an incentive that the flat rule does not.

(d) Name one reason a policymaker might still prefer the rule.