Managerial Economics
IIM BANGALORE
PROBLEM SET 4
TOPIC: Externalities
1. A well-maintained waterfront property that is enjoyed by other property owners is an
example of
a) a positive consumption externality.
b) a negative consumption externality.
c) a negative production externality.
d) a positive production externality.an inefficient allocation of resources.
2. Smoking tobacco creates a externality.
a) positive consumption
b) negative consumption
c) negative production
d) positive production
e) none of the above
3. When negative externalities are present the market equilibrium output level will be:
a) too low for society.
b) too high for society.
c) socially optimal/efficient.
d) at the intersection of demand and marginal social cost
e) at the point that minimizes the marginal external cost
4. The marginal cost at a plant making aerosol cans of hair spray is MC= 2 + 0.01Q, but
because the use of aerosol spray destroys the earth's ozone layer, the marginal social
cost is given by MSC = 2 + 0.5Q, where Q is cans of hair spray per month. The demand
curve faced by firm is perfectly elastic at $4 per can. What is the efficient level of output?
a) 0
b) 2
c) 4
d) 20
e) 200
5. The Coase Theorem states that:
a) regardless of how property rights are assigned, the market outcome will be efficient
if transaction costs (cost of reaching an agreement) of bargaining are zero.
b) if property rights are assigned to the party imposing a negative externality on
society, an efficient outcome is achievable.
c) with incomplete information, standards are more efficient than emissions fees.
d) None of the above is correct.
6. A chemical factory and a fishing club share a lake. Producing chemicals creates water
pollution that harms the fish. Initially the lake is owned by no one. Keeping in mind the
Coase Theorem, suppose transaction costs are low and the chemical factory is given
ownership of the lake. Compared to the situation with no property rights, the quantity
of chemicals produced
a) increases.
b) decreases.
c) changes but the direction of the change is unknown.
d) decreases only if the marginal external benefit decreases.
e) stays the same.
7. Which of the following illustrates the concept of external cost?
a) Smoking harms the health of the smoker.
b) Bad weather reduces the size of the wheat crop.
c) A reduction in the size of the wheat crop causes the income of wheat farmers to
fall.
d) Smoking harms the health of nearby nonsmokers.
e) Public health services reduce the transmission of disease.
8. Each of the following provides incentives to reduce a negative externality except:
a) a merger with affected firms.
b) subsidizing consumption of the good being produced.
c) bargaining among firms.
d) taxation of externality.
9. Suppose an emissions tax is imposed on all dairy farms. This tax would have the effect
of:
a) encouraging the dairy farmers to lower prices.
b) increasing the level of emissions.
c) reducing the supply of milk.
d) increasing the supply of milk.
10. If the marginal social benefit received from pollution is less than its marginal social
cost, then:
a) society's well-being can be improved if the quantity of pollution increases.
b) society's well-being can be improved if the quantity of pollution decreases.
c) society has achieved its socially optimal level of pollution.
d) the market is producing too little pollution.
11. Figure below shows the marginal private cost curve, marginal social cost curve, and
marginal social benefit curve for raising goats on a common pasture. If property rights
to the pasture are granted to a farmer so that the farmer owns the pasture, the farmer
raises:
a) 0 goats
b) 35 goats
c) 50 goats.
d) 40 goats
e) 55 goats.
12. If government officials set an emissions tax too low:
a) there will be too little pollution.
b) there will be too much pollution.
c) the marginal social cost of pollution will be less than the marginal social benefit of
pollution.
d) there could be either too much or too little pollution.
13. Which of the following is an example of a positive externality?
a) Sam dug a pond so he could go fishing, but the pond has contributed to an explosion
of mosquitoes in your neighborhood.
b) Sam has dozens of cats and they come into your yard to hunt the birds that come to
your bird bath.
c) Sam buys a dilapidated house, renovates it, and increases the property values of all
houses in the neighborhood.
d) Liquid waste from Sam's chicken farm flows into a neighbor's well water.
NUMERICALS
1. The Styrofoam cup industry produces at a constant marginal cost of $4. The market
demand for its product is given by P =22 - Q.
a) What output will the industry choose to produce? What is the sum of consumer
surplus and producer surplus at this quantity?
b) This industry produces air pollution along with Styrofoam cups. These pollution costs
are represented by the marginal external cost function, MEC = 0.2Q. From an
efficiency standpoint (i.e., society's standpoint), how many Styrofoam cups should
be produced?
c) The Environmental Protection Agency, concerned about the pollution problem,
requires this industry to adopt a new, lower pollution production technology that
raises the marginal cost of production to MC= $10. Given this new technology, what
output level will the industry choose? What is the sum of CS and PS at this point?
d) Illustrate your answers to parts a) through c) using a Price vs. Quantity graph.
e) A consulting firm estimates the total benefits of reducing pollution using this new
technology at $80. Is the reduction in pollution worth the loss in surplus to the
producers and consumers of Styrofoam cups?
2. In a market for dry cleaning, the inverse market demand function is given by P = 100 -
Q and the (private) marginal cost of production for the aggregation of all dry-cleaning
firms is given by MC = 10 + Q. Finally, the pollution generated by the dry-cleaning
process creates external damage given by the marginal external cost curve MEC = Q.
a) Calculate the output and price of dry cleaning if it is produced under competitive
conditions (i.e., free market equilibrium) absent regulation.
b) Determine the socially efficient price and output of dry cleaning.
c) Determine the tax that would result in a competitive market equilibrium (i.e., market
equilibrium) producing the socially efficient output.
