Chapter 9
Externalities and Public Goods
Questions
1. Why are externalities called market failures? Are pecuniary externalities also an example of market
failure?
Answer: Externalities are called market failures because the market allocates resources without
considering the costs and benefits of externalities. Since firms and individuals do not consider
externalities when they make choices, the market fails to arrive at a socially efficient outcome.
Pecuniary externalities are not market failures because they do not result in market inefficiencies.
Pecuniary externalities exist when market transactions affect third parties, but only through the
market price. The market price will then correctly reflect the society-wide impact of market
transactions and therefore pecuniary externalities are not market failures.
2. Explain whether the following are examples of externalities.
a. Alisha did not sleep well because her neighbor was playing loud music.
b. Rochelle was late for a job interview because her alarm did not go off.
c. José, who is allergic to pollen, is sick from the flowers that grow in his garden.
Answer:
a. This is an example of a negative externality. Loud music played by her neighbor has a
spillover effect on Alisha as she is unable to sleep.
b. This is not an example of an externality. Rochelle was late because her alarm did not go off.
There is no spillover cost here that is affecting someone who is not involved in the activity.
c. This is not an example of an externality. Since José is sick from the flowers that grow in his
own garden, he is directly engaged in the activity. Note that if his neighbor got sick, then it
would qualify as an externality.
3. Education is considered as a consumer good with positive externality in that an educated person tends
to also benefit other parties in the society who are the non-consumers. Why does the invisible hand
fail to generate the social efficient outcome in the education market?
Answer: The marginal social benefit of education with positive externality is greater than its marginal
private benefit given by the market demand curve. Since buyers and sellers only consider the
marginal private benefit, the invisible hand will drive the quantity towards market equilibrium
quantity where marginal private benefit equals marginal cost which is less than the socially efficient
quantity where marginal social benefit equals marginal cost.
4. What does it mean to say that an individual or a firm has internalized an externality?
Answer: Externalities are external costs or benefits that firms or consumers do not consider when
making decisions. When incentives are altered such that an externality is taken into account, firms
and individuals are said to have internalized the externality. So, for example, suppose I raise bees
next door to your apple orchard. The bees pollinate your tress and so there is an externality. The
externality will be internalized if I buy your orchard.
© 2015 Pearson Education, Inc.
, Chapter 9 | Externalities and Public Goods 102
5. What is the Coase Theorem? Under what conditions will the Coase Theorem break down?
Answer: The Coase Theorem predicts that, when there are externalities, negotiation between the
individuals involved leads to the efficient outcome regardless of who has the legal property right.
This means that government intervention is not necessary to solve externality problems.
The Coase Theorem will not hold if transaction costs of negotiating are too high. This cost could
include direct expenditures like legal fees and time and also the cost of an awkward situation: it may
be difficult to bargain with neighbors and others. The number of agents on each side of the bargaining
table also matters; bargaining may not work when there are many people involved. Additionally, it’s
important for the property right to be clearly defined; in many cases, the law is not clear on who holds
the property rights.
6. How does a command-and-control policy differ from a market-based policy?
Answer: Governments sometimes use a mix of policies to encourage firms and consumers to
internalize externalities. Command-and-control is a centralized system of controlling production in
which an authority decides the allocation of resources. Here, the government directly regulates the
allocation of resources (for example, the government bans smoking in restaurants). Market-based
policies are those where the government provides incentives for private organizations to internalize
the externality. Market-based policies include Pigouvian taxes or subsidies and markets for pollution
rights.
7. What are Pigouvian taxes and subsidies? How do governments decide when to levy a tax or provide a
subsidy?
Answer: Governments address externalities through Pigouvian taxes or subsidies, named after the
economist Arthur Pigou. Taxes and subsidies are levied to ensure that firms internalize externalities.
Consider a good with negative externalities. The marginal social cost of the good is greater than its
marginal private cost. The government will levy a tax on the good, which is equal to the external cost
of the good. This tax makes firms take into account the external damage from the good when it makes
its production decisions. Similarly, for a good with positive externalities, the government provides a
subsidy to a firm or consumer that is equal to the external benefits from the good. The Pigouvian
subsidy raises the individual’s marginal benefits of consumption by an amount equal to the external
benefits its consumption causes, exactly aligning the individual’s benefits with society’s benefits.
8. To provide national security to a country, the supplier needs to hire soldiers and also acquire weapons
and other military equipments. Do you think it is possible that a private firm is able to supply
national security efficiently?
Answer: National security is non-rival and non-excludable. Even if a private firm is able to hire
professional soldiers and purchase weapons and military equipments, it will not be able to collect
sufficient revenues from the consumers. Consumers know that national security is non-
excludable and hence they will have no incentive to pay for it. The private firm will not be able to
cover its cost and hence it will not be able to provide national security efficiently.
9. Compare and contrast between a private good and a club good.
Answer: A private good is both rival and excludable. This means that the consumption of a private
good by one consumer reduced the quantity available to others. Also, the purchaser, who is the
rightful owner of the private good, can prevent or exclude others from consuming the good. In
contrast, a club good is non-rival but excludable. This means the consumption of a club good by one
consumer will not reduce the quantity available to others.
© 2015 Pearson Education, Inc.
Externalities and Public Goods
Questions
1. Why are externalities called market failures? Are pecuniary externalities also an example of market
failure?
Answer: Externalities are called market failures because the market allocates resources without
considering the costs and benefits of externalities. Since firms and individuals do not consider
externalities when they make choices, the market fails to arrive at a socially efficient outcome.
Pecuniary externalities are not market failures because they do not result in market inefficiencies.
Pecuniary externalities exist when market transactions affect third parties, but only through the
market price. The market price will then correctly reflect the society-wide impact of market
transactions and therefore pecuniary externalities are not market failures.
2. Explain whether the following are examples of externalities.
a. Alisha did not sleep well because her neighbor was playing loud music.
b. Rochelle was late for a job interview because her alarm did not go off.
c. José, who is allergic to pollen, is sick from the flowers that grow in his garden.
Answer:
a. This is an example of a negative externality. Loud music played by her neighbor has a
spillover effect on Alisha as she is unable to sleep.
b. This is not an example of an externality. Rochelle was late because her alarm did not go off.
There is no spillover cost here that is affecting someone who is not involved in the activity.
c. This is not an example of an externality. Since José is sick from the flowers that grow in his
own garden, he is directly engaged in the activity. Note that if his neighbor got sick, then it
would qualify as an externality.
3. Education is considered as a consumer good with positive externality in that an educated person tends
to also benefit other parties in the society who are the non-consumers. Why does the invisible hand
fail to generate the social efficient outcome in the education market?
Answer: The marginal social benefit of education with positive externality is greater than its marginal
private benefit given by the market demand curve. Since buyers and sellers only consider the
marginal private benefit, the invisible hand will drive the quantity towards market equilibrium
quantity where marginal private benefit equals marginal cost which is less than the socially efficient
quantity where marginal social benefit equals marginal cost.
4. What does it mean to say that an individual or a firm has internalized an externality?
Answer: Externalities are external costs or benefits that firms or consumers do not consider when
making decisions. When incentives are altered such that an externality is taken into account, firms
and individuals are said to have internalized the externality. So, for example, suppose I raise bees
next door to your apple orchard. The bees pollinate your tress and so there is an externality. The
externality will be internalized if I buy your orchard.
© 2015 Pearson Education, Inc.
, Chapter 9 | Externalities and Public Goods 102
5. What is the Coase Theorem? Under what conditions will the Coase Theorem break down?
Answer: The Coase Theorem predicts that, when there are externalities, negotiation between the
individuals involved leads to the efficient outcome regardless of who has the legal property right.
This means that government intervention is not necessary to solve externality problems.
The Coase Theorem will not hold if transaction costs of negotiating are too high. This cost could
include direct expenditures like legal fees and time and also the cost of an awkward situation: it may
be difficult to bargain with neighbors and others. The number of agents on each side of the bargaining
table also matters; bargaining may not work when there are many people involved. Additionally, it’s
important for the property right to be clearly defined; in many cases, the law is not clear on who holds
the property rights.
6. How does a command-and-control policy differ from a market-based policy?
Answer: Governments sometimes use a mix of policies to encourage firms and consumers to
internalize externalities. Command-and-control is a centralized system of controlling production in
which an authority decides the allocation of resources. Here, the government directly regulates the
allocation of resources (for example, the government bans smoking in restaurants). Market-based
policies are those where the government provides incentives for private organizations to internalize
the externality. Market-based policies include Pigouvian taxes or subsidies and markets for pollution
rights.
7. What are Pigouvian taxes and subsidies? How do governments decide when to levy a tax or provide a
subsidy?
Answer: Governments address externalities through Pigouvian taxes or subsidies, named after the
economist Arthur Pigou. Taxes and subsidies are levied to ensure that firms internalize externalities.
Consider a good with negative externalities. The marginal social cost of the good is greater than its
marginal private cost. The government will levy a tax on the good, which is equal to the external cost
of the good. This tax makes firms take into account the external damage from the good when it makes
its production decisions. Similarly, for a good with positive externalities, the government provides a
subsidy to a firm or consumer that is equal to the external benefits from the good. The Pigouvian
subsidy raises the individual’s marginal benefits of consumption by an amount equal to the external
benefits its consumption causes, exactly aligning the individual’s benefits with society’s benefits.
8. To provide national security to a country, the supplier needs to hire soldiers and also acquire weapons
and other military equipments. Do you think it is possible that a private firm is able to supply
national security efficiently?
Answer: National security is non-rival and non-excludable. Even if a private firm is able to hire
professional soldiers and purchase weapons and military equipments, it will not be able to collect
sufficient revenues from the consumers. Consumers know that national security is non-
excludable and hence they will have no incentive to pay for it. The private firm will not be able to
cover its cost and hence it will not be able to provide national security efficiently.
9. Compare and contrast between a private good and a club good.
Answer: A private good is both rival and excludable. This means that the consumption of a private
good by one consumer reduced the quantity available to others. Also, the purchaser, who is the
rightful owner of the private good, can prevent or exclude others from consuming the good. In
contrast, a club good is non-rival but excludable. This means the consumption of a club good by one
consumer will not reduce the quantity available to others.
© 2015 Pearson Education, Inc.
