SELECTED ANSWERS: QUESTIONS ON ENVIRONMENTAL ECONOMICS AND PUBLIC GOODS

5. Why do factories dump chemicals into the air and water and not on people’s lawns or in their houses or cars? What does your answer suggest about ways to tackle problems of pollution?

They pollute because they are not responsible for taking into account all the consequences of their own actions.  If they tried to dump chemicals on someone's lawn or car, the owner of that lawn or car would have an incentive to stop them!  Pollution occurs because the resource that gets polluted (such as the air, water, etc.) is not someone's private property. If it were, then polluters would be forced by the owners to take into account all the consequences of their actions.  This suggests that one way to tackle problems of pollution would be to create private property rights in resources that are subject to pollution (such as common resources).
 

6.  What does the phrase internalize an externality mean?

Internalizing an externality means changing private costs or benefits so that they equal social costs or benefits -- so that people take into account all the consequences of their own actions.
 

8. What determines who makes side payments to whom (i.e., the direction of side payments)?
If an externality is internalized through side payments, then the direction of side payments depends on how an economically efficient situation compares with people's legal rights to take actions that create externalities.  For example, if the law allows a polluter to choose a level of pollution that exceeds the economically efficient level, then people harmed by the pollution would make side payments to the polluter to reduce pollution.  In contrast, if the law allows people potentially harmed by pollution to force a potential polluter to choose a level of pollution below the economically efficient level, then the potential polluter would make side payments to people harmed by the pollution.
 

9.  After the Quantum Corporation example so that Quantum could eliminate the television interference at the hotel by spending only $4,000.
(a) What happens if Quantum Corporation has a legal right to use its equipment despite the reception problems it causes at the hotel?
(b) What happens if Quantum has no legal right to cause this problem for the hotel?

(a) The hotel pays $4,000 to eliminate the interference.
(b) Quantum pays $4,000 to take care of the problem.
 

10. Explain the Coase theorem.

The Coase theorem states that when transactions costs are sufficiently low, the equilibrium is economically efficient regardless of whether firms have the right to pollute, though the law affects who makes side payment to whom. With high transactions costs, however, laws and property rights affect the equilibrium quantity, and the equilibrium may not be economically efficient.
 

13. What would be the effect on the amount of chocolate sold and the price of chocolate if chocolate manufacturers were made legally liable for increases in dental bills as a result of consumption of chocolate? (Assume that it is easy to figure out how much of each dental bill is due to eating chocolate, and assume that the law does not affect the frequency of tooth brushing or flossing.)

The price of chocolate would increase to reflect the producer's cost of assumiong the legal liability associated with the increased dental bills of chocolate consumers.  If dental bills were the same regardless of whether dentists are paid by consumers or chocolate manufacturers, then the equilibrium quantity of chocolate would not change -- buyers would pay more for chocolate, but they would spend that much less of dental bills, so their total spending on chocolate and dental bills together would not change.
 

16. Consider the Lake Ness Example in the text. Recall that a private owner of the lake earned a $1,200 profit by choosing a $300 fee, which  made use of the lake economically efficient (four people fished). Show that the owner's profits would be lower if she charged a fee of $200, or $500, or $600. (In each case, use Table 1 in the chapter to find the number of people who would pay the fee and fish, and then calculate the owner's profit.)

With a $200 fee, 5 people will fish, each catching 200 fish and selling them for $400. After paying the $200 fee, each person has $200 left over. The owner of the lake earns $1.000.

With a $500 fee, 2 people will fish. The owner of the lake earns $1,000.

With a $600 fee, 1 person will fish, and the owner gets $600.
 

17. Many of the world's rain forests are common resources. If governments were to make the rain forests private property and give private property rights to certain people, who would gain and who would lose? Would it be possible to compensate any losers so that everyone would gain from creating private property rights in the rain forests?

Private ownership of a resource can internalize externalities and eliminate the tragedy of the commons. The owner has a strong incentive to care for the rain forest, particularly since it is renewable if properly managed. Current and future generations would gain while those who profit from deforestation would lose.
 

20. Well-attended parties are more fun than poorly attended parties. Explain the application of this observation to this chapter.

People attending parties create positive externalities for other people at the party -- "the more, the merrier."

21. A movie company sues people who made and sold pirated (unauthorized) copies of a movie on videotape. The movie originally cost $100 million to make and appeared at theaters last year. Draw a graph to show the marginal cost and average cost of providing the movie to a person on videotape. Would the courts promote economic efficiency by allowing people to make copies of videotapes (a) for their own use, (b) to lend to their friends, (c) to sell? How is this problem related to natural monopoly?

Draw a graph with a horizontal straight-line marginal cost curve at about $1, which is about the cost of making a copy of a videotape of a movie.  That curve shows that the marginal cost of providing a copy of the movie to one more person is about $1.  The average cost curve, however, is downward sloping -- since the movie cost $100 million to make, the following table shows the average cost:
 

Courts would promote economic efficiency if they could interpret laws to allow anyone to copy a tape (paying the cost of $1 to make the copy) either for their own use, or to lend or sell, AND, AT THE SAME TIME, not interfere with the incentives of film producers to make more movies in the future.  The problem is that efficient use of the product conflicts with efficient incentives to invest in creating more movies in the future.  That is, the average cost of providing a movie to people decreases as the number of people increases, just as average cost decreases in a natural monopoly.  Economically efficient use of the product, in the absence of problems providing incentives to create future products, would require that the price equal marginal cost, or about $1.  However, average cost exceeds marginal cost.  In other words, if the price were $1, film makers would not recoup their fixed costs of making films, and this would eliminate their incentives to make future films.  Consequently, economic efficiency requires a balance between (1) the losses today from policies that keep the cost of viewing the film high, and (2) the future losses that would occur if producers chose not to produce as many movies because policies that allow copying of tapes keep their revenues low.
 

22. Governments usually limit the hunting seasons for most animals. What does this policy have to do with common resources?

The animal population for hunters are common resources, which generally creates a problem of overuse (overkill, in this case). Allowing hunting only in certain seasons reduces overkill of the animal population.
 

23. Explain, with a graph, why subsidizing the production of goods that generate positive externalities can eliminate a deadweight social loss and create economic efficiency in situations with high transactions costs.

Draw a graph with a subsidy (see chapters 8 and 9), showing that it raises the equilibrium quantity.  Because equilibrium production is below the economically efficient level when there are positive externalities, a subsidy can bring it closer (or all the way) to the efficient level, reducing (or eliminating) the deadweight social loss.
 

24 Suppose that the owners of a company have no legal liability for paying hospital bills, sick-leave, etc. for their employees who are injured on the job. Do the owners have an incentive to invest in equipment and programs that reduce the probability and severity of accidents on the job?

Yes.  The owners of a company have an incentive to invest in equipment and programs that reduce the probability and severity of accidents on the job because doing so reduces their total labor costs.  The company would have to pay higher wages to attract as many workers (of the same quality) if the company spent less to reduce accidents on the job.  In that sense, a low chance of accidents is one form of pay for workers -- just as other aspects of good working conditions are like one form of pay.
 

25. A dentist and a writer live next door to each other, and each has her office at home. Screams of pain from the patients in the dentist's office interfere with the writer's creativity, causing her to write inferior novels and lose $800 per year in income. It would cost $600 for the dentist to install sound-absorbing material on her office walls, and this material would have to be replaced each year. (it is a rowdy dentist office.) The writer sues the dentist. The court can rule in favor of the author and require the dentist to soundproof her walls, or it can rule in favor of the dentist and dismiss the case. Explain what would happen under each ruling if:
  a. The dentist and the writer are on speaking terms (small transactions cost, ignoring court fees).
  b. They are not speaking to each other under any circumstances (large transactions costs).

Suppose that the lawyer and dentist are on speaking terms (i.e. transactions costs are small).  If the court rules in favor of the dentist, then the writer could pay the dentist some amount between $600 and $800 to soundproof her office, and both the dentist and writer would be better off.  So that payment will occur, and the office will get
soundproofed.  If the court rules in favor of the writer, then the office will get soundproofed.  The only difference in these two cases is the distribution of wealth: if the court rules in favor of the dentist, then the dentist is better off and the writer is worse off.  But the allocation of resources is unaffected by the court ruling: the office is soundproofed in either case.  So this illustrates the Coase theorum with low transactions costs.

Now suppose that the dentist and writer hate each other, and never speak (even through representatives).  This means that transactions costs for them are high (at least in dealing with each other).  If the court rules in favor
of the dentist, she will not soundproof her office.  But if the court rules in favor of the writer, the office will get soundproofed.   So, with high transactions costs, not only the distribution of wealth but also the
allocation of resources is affected by the rights assigned by the law.
 

26. Turkeys run wild on Turkey Island. The island is not the property of anyone, in particular, and people are free to hunt turkeys there and sell them to food wholesalers. Turkey Island is fairly small, though, and several hunters at once tend to scare away the turkeys, leaving fewer to shoot. One hunter alone can shoot 20 turkeys on an average day, two hunters hunting at once can each get 15 turkeys, on average. If three hunters are on the island at once, each will get 12 turkeys, on average. Each of four hunters will get 9 turkeys on an average day. With more than four hunters, no one gets any turkeys. All of the people who live in the vicinity of Turkey Island (those who might come to the island to hunt) could earn $80 in a day if they were not turkey hunting. (of course, this $80 reflects the social value of the goods they would produce if they were not hunting turkeys). If they go turkey hunting, they can sell the turkey hunting, they can sell the turkeys that they shoot for $10 each. Assume that turkeys reproduce adequately to eliminate any danger of extinction, and that all of the numbers stated above stay the same over time.
  a. In long-run equilibrium, how many people would hunt turkeys on Turkey Island when anyone could freely do so? Why?

Four hunters: it is worthwhile since they would each get 9 turkeys and so earn $90 a day, better than their alternative of $80 a day.  No one ELSE would hunt turkeys because with a fifth person no one gets ANY turkeys.

  b. What is the economically efficient number of hunters on the island? Why? Does the island have overhunting, underhunting, or the economically efficient amount of hunting?

The economically efficient number of hunters on the island is two hunters: altogether they get 30 turkeys.  3 hunters is not efficient because a third hunter brings the total to 36, so that third hunter creates a gain of 6 turkeys, which are worth $10 each.  So the social gain from a third hunter would be only $60, while the social loss is the value of his production elsewhere in the economy, which is $80.  One hunter alone is not efficient because the social value of a second hunter is 10 turkeys, or $100, which is more than the social cost of that second hunter ($80).
 So there is OVERhunting in equilibrium when the island is a common resource.

  c. Suppose that the island were owned by someone interested in earning the largest profit possible. What is the maximum price that someone would be willing to pay to hunt turkeys on the island for a day if he were the only hunter allowed?

$120

What is the maximum price per day that someone would pay to hunt on the island if one other person were also allowed to hunt?

$70

What is the maximum price per day a person would pay if two other hunters were allowed on the island?

$40

Three others?

$10

d. How many hunters would an owner of the island allow to maximize his own profits from owning the island?

2 hunters

How much profit would he make?

$140

If the island were owned, would overhunting, underhunting, or the economically efficient amount of hunting occur?

the economically efficient amount
 

27. A geneticist who specializes in recombinant DNA research invents a new bacteria that is harmless and unnoticeable to humans, but obnoxious to insects that feed on farm crops. The bacteria can be easily spread on farmland along with seed. The scientist obtains a patent on this new bacteria and sets up a company to sell it to farmers. The research that led to the discovery cost thousands of dollars, but enough bacteria to protect one acre of farmland cost only 3¢ now that the scientist has perfected the technique. The scientist's company is the only company allowed to sell the product, because of the patent.
  a. Draw a graph to illustrate the forces that determine the equilibrium price and quantity sold of the bacteria.

(Draw a graph with a perfectly elastic MC curve at 3 cents per unit of bacteria.  Draw a demand curve and calculate the MR curve.  Like any monopoly (that cannot price discriminate), the firm chooses to produce a quantity at which the MC and MR curves intersect, and charges the price shown by the demand curve at that quantity.)

  b. Is the marginal social cost of the bacteria, now that it has been invented )or discovered) equal to, less than, or greater than 3¢? Why?

The social marginal cost is 3 cents per unit -- because that is all it costs to produce another unit.

  c. Illustrate on your graph the economically efficient amount of bacteria to be produced and sold, now that it has been invented.

The economically efficient quantity is the quantity at which the MC and demand curves intersect.

  d. If the government were to force the scientist's company to produce and sell the economically efficient amount of the product (assuming that the government could determine this number exactly), would the company make a profit or suffer a loss?

The company would make a loss -- the situation is similar to the "natural monopoly" graph on page 331 the book.

  e. Does a conflict emerge between the economically efficient use of a product that has already been invented and the economically efficient amount of research on new inventions and discoveries?

Yes, there is a conflict.  Economically efficient use of a product that has already been invented requires a price equal to marginal cost -- but that can mean that the firm producing the product cannot recover the (sunk) costs of research and development.  Obviously, that would give no incentive for firms to spend money on research and development in the future.  To provide such an incentive, the firm must be able to charge a price higher than marginal cost after the product is developed.  But that creates inefficient use of the product.  So there is a conflict between the economically efficient use of a product that has already been invented and the economically efficient amount of research on new inventions and discoveries.
 

28. Suppose that someone builds a house near an airport and later complains about noise from the planes. Does an externality arise in this case? Does it matter if the homeowner was aware of the airport before building the house?

The airport noise creates an externality.  However, the person losing from this externality may NOT be the homeowner -- because if the homeowner had been aware of the airport before buying the land and building the house (or buying the house from a previous owner), then the airport noise would have led to a lower price for that land (or that house).  The person who loses from the externality would be the person who owns the land (or house) when the airport is first built (or first planned) -- because that lowered the value of the property immediately.
 

29. Many, though not all, scientists believe that carbon dioxide emissions will lead to global warming, with average temperatures rising 2 to 9 degrees Fahrenheit within the next century. Assume that this possibility could be prevented by reducing carbon dioxide emissions. How would an economist determine whether it would be more economically efficient to reduce the emissions (at a cost that the U.S. government calculates to be in excess of $100 billion per year) or to spend the resources on irrigation, dikes, and air conditioning to help reduce negative effects of global warming?

An economist would estimate the expected costs and benefits of using each method. The method, or comibination of methods, that maximizes net benefit would provide the efficient response to the problem.