Answers to Questions in Chapter 11



Answers to Questions in Chapter 12

Note: No. before ( indicates a page number

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268 ( Do you agree that, if some people gain and if no one loses, then this will be an ‘improvement’ in the well-being of society?

Assuming that there really is a ‘gain’ and that no-one loses at all in any way whatsoever, then most people would probably agree that there has been an improvement in the well-being of society. It is virtually true by definition.

There is a major problem in reality, however, that people are unlikely to agree as to what constitutes a ‘gain’ or ‘no loss’. For example, if a person has a substantial increase in income, he or she at the time may regard this as a gain. However, other people may claim that it made the person more miserable and selfish, and the person may end up being less happy not more. The question here is whether people are the best judge as to whether they are actually gaining or losing.

Then there is the question of distributive justice. If the rich get richer and the poor stay the same, then could this be said to be an improvement in the well-being of society, even if the poor feel themselves to be no worse off?

270 ( Assume that the price of the good falls. How will an ‘efficient’ level of consumption be restored?

The fall in the price will cause MU to be above P. Consumers will buy more. But as they do so, the MU will fall (diminishing marginal utility) until P = MU: until the ‘efficient’ level of consumption has been restored.

271 ( On a diagram like Figure 12.2 demonstrate that there will be a less than optimum level of consumption where there are external benefits in consumption.

The MSB curve will above the MU curve. The actual level of consumption (where MU = P) will thus be below the optimum level (where MSB = P).

271 ( 1. Give other examples of each of the four types of externality.

(a) External costs of production (MSC > MC)

The pollution of rivers and streams by slurry and nitrate run-off from farms; road congestion near a factory.

(b) External benefits of production (MSC < MC)

Beneficial spin-offs from the development of new products (for example, the various space programmes in the USA, the USSR and Europe have contributed to advances in medicine, materials technology, etc.); where the opening of a new environmentally friendly factory results in less output from factories that pollute.

(c) External costs of consumption (MSB < MB)

The effect of CFC aerosols on the ozone layer; the unpleasant sight of satellite dishes.

(d) External benefits of consumption (MSB > MB)

People decorating the outside of their houses or making their gardens look attractive benefits neighbours and passers-by.

281 ( 2. Redraw Figures 12.1 and 12.2, only this time assume that the producer (in the first diagram) or the consumer (in the second) has economic power and is thus not a price taker. How does power affect the relationship between the private and the social optimum positions?

The firm in Diagram 12.1 has market power and thus faces a downward-sloping demand curve and marginal revenue curve. It produces Q1 at a price of P1. (If the industry had been under perfect competition, it would have produced Q0 at a price P0.) The effect of monopoly power is thus to reduce output. With external costs in production, the optimum output will be at Q2 at a price P2, where MSB=MSC. This is below the perfectly competitive output (Q0), but may be above, below or the same as the monopoly output (Q1). The way it is drawn in Diagram 12.1, it is the same as Q1. Thus in this case the socially disadvantageous effects of external costs and monopoly power tend to cancel each other out!

The consumer in Diagram 12.2 has monopsony power and thus faces an up-sloping supply curve (average cost of consumption) and a marginal cost of consumption curve (MC) which is above it and steeper. [This is the same analysis as in the case of a firm with monopsony power (see Figure 9.7 on page 217).] Consumption will be at Q1 at a price of P1. This is below the perfectly competitive level of Q0, P0. With external costs of consumption, the optimum consumption will be at Q2 at a price of P2, where MSB = MSC. This is below the perfectly competitive level of consumption (Q0), but may be above, below or the same as the monopsony level consumption (Q1). Thus, as in the above case, the socially disadvantageous effects of external costs and monopsony power tend to cancel each other out.

Had there been external benefits rather than external costs in either case, the socially disadvantageous effects of this and the market power would have reinforced each other. They would both have led to production or consumption below the socially optimum level.

271 ( If monopoly power existed in an industry, would production be above or below the socially efficient level (assuming no externalities)? Which would be greater, MSB or P?

Below. (See Figure 12.3 on page 274.) A firm with monopoly power produces at Q1, where MR = MC. But this is below the socially efficient level of output (Q2) where P = MC.

MSB will still equal P. Consumption still takes place along the demand curve, which gives MSB (assuming no consumption externalities).

272 ( (Box 12.2) Can you think of other examples of external costs of production arising in one country being imposed on residents of other countries?

In 1986 a nuclear power station at Chernobyl in Russia exploded causing a ‘cloud’ of nuclear waste being carried by wind across much of Western Europe. There are numerous other examples of air and water pollution created by one country affection others.

273 ( Is it likely that the MSB curve will be parallel to the MU curve? Explain your reasoning.

No. It is likely that the marginal external costs of consumption will increase as more is consumed, and thus the curves will get further apart (making the MSB curve steeper than the MU = MB curve). For example, the marginal pollution costs of cars gets progressively greater as more and more cars come onto the roads and the environment becomes less and less able to absorb the additional quantities of pollutants.

274 ( Why will Pareto optimality not be achieved in markets where there are substantial economies of scale in production?

Because such markets are incompatible with perfect competition. Once a firm gets large enough to experience the full economies of scale, it would also be large enough to charge prices above MC and hence to produce an output below the Pareto optimal level.

274 ( Which of the following have the property of non-rivalry: (a) a can of drink; (b) public transport; (c) a commercial radio broadcast; (d) the sight of flowers in a public park?

(c) and (d)

275 ( (Box 12.3) The following table gives the costs and benefits of an imaginary firm operating under perfect competition whose activities create a certain amount of pollution. (It is assumed that the costs of this pollution to society can be accurately measured.)

| | |Marginal (private) costs|Marginal external |Marginal social costs |

|Output (units) |Price per unit (MSB)|to the firm (MC) |(pollution) costs (MEC) |(MSC=MC+MEC) ($) |

| |($) |($) |($) | |

|1 |100 |30 |20 |50 |

|2 |100 |30 |22 |52 |

|3 |100 |35 |25 |60 |

|4 |100 |45 |30 |72 |

|5 |100 |60 |40 |100 |

|6 |100 |78 |55 |133 |

|7 |100 |100 |77 |177 |

|8 |100 |130 |110 |240 |

(a) What is the profit-maximizing level of output for this firm?

(b) What is the socially efficient level of output?

(c) Why might the marginal pollution costs increase in the way illustrated in this example?

(a) 7 units (where marginal revenue (= P) equals marginal cost).

(b) 5 units (where marginal social benefit (= P) equals marginal social cost.

(c) Because the environment becomes ever less able to cope with additional amounts of pollution.

276 ( 1. Give some other examples of public goods. Does the provider of these goods (the government or local authority) charge for their use. If so is the method of charging based on the amount of the good people use? Is it a good method of charging? Could you suggest a better method?

Two examples are: national defence; urban roads. In both cases the user is not directly charged. The funding comes from taxation. In the case of roads, part of the funding comes from road users generally (in the form of taxes on petrol and road licences) and part from general or local taxation. Only in the case of petrol tax is the charging related to the amount that people use the public good. It encourages people to use the roads less, and thus takes into account the marginal cost (i.e. repairs and maintenance) of road provision. In this sense, however, roads are not a pure public good because using them does create a small amount of wear and tear on them (although a significant portion of road maintenance costs are due simply to deterioration through time).

If the marginal cost of provision is zero (as is the case with a pure public good) then charging people according to how much they use it will not cause an efficient allocation of resources: with a zero marginal cost, the price should be zero. Charging people according to how much they use it, however, could be regarded as fair according to the benefit principle – but not according to the principle of vertical equity.

276 ( 2. Name some goods or services provided by the government or local authorities that are not public goods.

Education, health, libraries, state retirement homes.

276 ( (Box 12.4) 1. The police charge football clubs for policing inside football matches. Do you think this is a good idea?

In this case the benefits of the policing are largely confined to those attending the match. Although it is still a ‘public good’ in the sense that the benefits to individual consumers cannot be separated, it could be regarded as fair that only those benefiting ought to pay. This is achieved by charging the club, which then passes it on to the consumer in terms of higher entrance fees.

The method could be criticised, however, if the policing is seen to benefit the wider community by leading to the apprehension of people who would commit crimes outside the ground at some other time.

276 ( (Box 12.4) 2. Some roads could be regarded as a public good, but some could be provided by the market. Which types of road could be provided by the market? Why? Would it be a good idea?

Roads where there are relatively few access points and where therefore it would be practical to charge tolls. Charges could be regarded as a useful means of restricting use of the roads in question, or, by charging more at peak times, of encouraging people to travel at off-peak times. Such as system, however, could be regarded as unfair by those using the toll roads, and might merely divert congestion onto the non-toll roads.

277 ( How do merit goods differ from public goods?

They could be provided by the market (albeit with too little consumed). The problem of non-excludability does not apply.

278 ( Summarise the economic policies of the major political parties. (If it is near an election you could refer to their manifestos.) How far can an economist go in assessing these policies?

You will need to look at the current policies. Economists in their role as economists cannot challenge fundamental normative issues – such as whether it is desirable to have a much more substantial redistribution of income from the rich to the poor. They can, however, examine whether the factual claims of the parties are correct, and whether the policies they advocate will bring the effects they claim.

279 ( (Box 12.5) Does this argument also apply to food and other basic goods?

To some extent, but the problem is more acute in the case of health care. The expenditure on food is relatively constant per week, and therefore can more easily be budgeted for. For those unable to afford an adequate diet, cash benefits (such as family credit) could be argued to be better than the provision of free food as a means of tackling the problem. In the case of health care, because many people only require occasional treatment, but when they do, it can be very expensive, and because the needs of people differ so hugely, a fixed cash benefit per week related to income would be quite inappropriate, unless it had to be spent on some type of health insurance.

280 ( (Box 12.5) 1. Does the presence of external benefits from health care suggest that health care should be provided free?

This alone does not suggest that health care ought to be provided free, merely that it ought to be provided at a price below the marginal private cost of provision: a price that leads to consumption at the point where MSB = MSC. In some circumstances, if the external benefits are large, this could be a zero price, or even a negative price (e.g. paying people to be vaccinated).

280 ( (Box 12.5) 2. If health care is provided free, the demand is likely to be high. How is this high demand dealt with? Is this a good way of dealing with it?

It is dealt with by a system of queuing. Emergency cases are usually dealt with immediately, or at least very quickly, but non-emergency cases may have to wait weeks, months or even years for treatment.

Many people would argue that for reasons of equity, and the special nature of health, it is better to solve the problem of waiting lists by diverting more resources into health care, rather than by using a system of charging people. Except where there are initially idle resources or inefficiencies, this approach will result in a lower provision of other publicly provided goods or services, or higher taxes.

280 ( (Box 12.5) 3. Go through each of the market failings identified in this box. In each case consider what alternative policies are open to a government to tackle them. What are the advantages and disadvantages of these alternatives?

1. People may not be able to afford treatment.

– Cash benefits.

– Free health care for those below a certain income.

Advantages: less costly to taxpayers.

Disadvantages: people just above threshold may have difficulty in affording treatment; given the problems of externalities and patient ignorance, the consumption of health care may be below the social optimum.

Medical insurance (see discussion in the text).

2. Difficulty for people in predicting their future medical needs.

– Medical insurance: (see discussion in the text).

3. Externalities.

– Subsidies for treatments where there are substantial external benefits.

Advantages: less costly than comprehensive free health care, encourages the authorities to focus on the whole question of externalities

Disadvantages: difficult to measure externalities, administratively complex.

4. Patient ignorance.

– Health education.

Advantages: can encourage people to detect early symptoms, can encourage people to take preventative measures.

Disadvantages: few (except if it makes people believe that they are better at diagnosis than they really are!)

5. Oligopoly.

– Encouraging competition by attacking restrictive practices, by devolving budgets, etc.

Advantages: competition may reduce prices and improve quality.

Disadvantages: quality of provision may suffer in an attempt to cut the price of treatment, difficult for the consumer to make rational decisions given patient ignorance.

281 ( 1. Why is it easier to use taxes and subsidies to tackle the problem of car exhaust pollution than to tackle the problem of peak-time traffic congestion in cities?

Because with car exhaust pollution, a single tax can apply to all motorists: e.g. so many pence per litre of petrol. This encourages people to drive less and to buy cars with high fuel economy. With peak-time congestion in cities, however, if people were not to be discouraged from using cars at other times, differential taxes would have to be used: e.g. meters fitted to cars that would be triggered by roadside devices at peak times, (such schemes are being tried in many cities throughout the world: see Box 10.7). Subsidies for public transport are easier to administer, but would probably have to be combined with a system of bus lanes and other ‘anti-car’ measures in order to encourage sufficient people to switch to public transport (unless the subsidies were very large).

281 ( 2. If the precise environmental costs of CFCs in fridges (becoming a pollutant when old fridges are broken up) were known, would the tax solution be a suitable remedy for the problem?

It depends how high the environmental costs were. If they were very high, then the tax would have to be so high that virtually no-one would buy fridges that used CFCs. In which case it might be simpler to ban the use of CFCs in fridges, thus avoiding the costs of administering the tax.

282 ( (Box 12.6) Is it a good idea to use the revenues from green taxes to subsidise green alternatives (e.g. using petrol taxes for subsidising rail transport)?

In terms of strict social efficiency criteria, the answer is no, unless the tax and subsidy were being used as a joint policy to correct one and the same externality: e.g. a charge being imposed on a firm which was then used to clean up the pollution that it had created. In all other cases, charging creators of negative externalities in one part of a country to finance subsidies for activities elsewhere that create positive externalities could be argued to be unfair. Why should the motorist in town A subsidise rail transport between towns B and C? The problem here is that there are redistributive effects as well as allocative ones. To correct for an externality without having any redistributive side effects, subsidies should be paid from general taxation.

The counter-argument that is often used is that it is desirable to redistribute income away from the general category of polluters to the general category of ‘green-minded’ people. There is also the very strong argument that governments, always short of finance, will be more willing to subsidise green activities if they can identify a specific source of new finance (e.g. taxing carbon emissions).

282 ( If the sufferers had no property rights, show how it would still be in their interests to ‘bribe’ the firm to produce the socially efficient level of output.

So long as the cost of the bribe is less than the value of the reduction in suffering, the sufferer will gain by paying the bribe: there is a Pareto improvement. When the marginal suffering has been reduced to the level of the bribe, no more will be paid. The social optimum will have been reached.

282 ( 1. To what extent could property rights (either public or private) be successfully extended and invoked to curb the problem of industrial pollution (a) of the atmosphere; (b) of rivers; (c) by the dumping of toxic waste; (d) by the erection of ugly buildings; (e) by the creation of high levels of noise?

(a) This would be very difficult given that large numbers of people are affected by the pollution. One possible answer would be to legislate such that if specific health problems could be traced to atmospheric pollution, then those affected would have rights to sue.

(b) If tracts of the river were privately owned, then as relatively few owners would be involved, it would be relatively easy to pursue polluters through the courts, provided they could be clearly identified (i.e. it would be easier to pursue factories for specific toxic emissions than individuals for dumping litter).

(c) Again if the dumpers could be identified and the dumping were on private ground, then the owners could use the courts to prevent it. The problem here is that the owners may be quite happy to charge the company for dumping, not caring about the effects on other people of polluting, say, the water table.

(d) This is more difficult, given that the ugly buildings are on land owned by owners of the buildings! The law would have to give people the right to sue for visual pollution. This could be difficult to prove, as it involves aesthetic judgements.

(e) There would have to be laws prohibiting banning noise above a certain level within the hearing of residents. Then it would be a relatively simple case of the affected residents demonstrating to the satisfaction of the courts that a noise offence had been committed. It would be easier if the summons could be brought by an environmental inspectorate.

It should be clear from these answers that the boundaries between legal controls and exercising property rights are rather blurred. The ability of people to exercise property rights depends on the laws of property.

282 ( 2. What protection do private property rights in the real world give to sufferers of noise (a) from neighbours; (b) from traffic; (c) from transistor radios at the seaside?

(a) The noisy neighbours can be reported to the police, who have powers to order the neighbours to be quieter.

(b) Very little if any protection is given, unless your property is damaged by a road accident.

(c) None.

285 ( (Box 12.7) Explain how, by varying the charge debited from the smart card according to the time of day or level of congestion, a socially optimal level of road use can be achieved.

The higher the level of congestion, the higher is the marginal external cost of motoring, and thus the higher must be the charge if the charge is to equal the full marginal social cost. What this means is that if the charge increases with the level of congestion, there is an incentive for people to reschedule their journeys to non-peak times.

285 ( How suitable are legal restrictions in the following cases?

(a) Ensuring adequate vehicle safety.

(b) Reducing traffic congestion.

(c) Preventing noise from aircraft in residential areas.

(d) Preventing noise from transistor radios.

(a) Very suitable, provided that periodic tests and possibly spot checks are carried out.

(b) Good in certain cases: e.g. one-way systems, banning trucks of a certain size from city centres during certain parts of the day, bus lanes.

(c) Good in some cases, e.g. imposing curfews on night flying.

(d) Reasonably suitable in residential areas but not elsewhere (see answers to the question on p.282.)

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Diagram 12.2

Diagram 12.1

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