Eco 402 – Public Finance Sample Quiz 1: Externalities
1. Suppose a positive externality is associated with education.
a. On the next page, carefully graph the following for this situation being sure to label
i. Marginal social cost (MSC)
ii. Marginal private benefit (MPB)
iii. Marginal social benefit (MSB)
b. Label the following on your graph:
iv. Private level of output (Qp)
v. Socially optimal level of output (Qs)
c. Would a tax or subsidy be used to internalize the externality? (2)
d. Graph the area representing the total amount of the subsidy or tax necessary to
internalize the externality. (3)
NOTE: YOUR GRAPH MUST BE NEATLY DRAWN AND CLEAR.
Similar to the Cassanova problem from class (Rosen text, page 108, #2)
2. The table below shows the total private costs (TPC) to a chemical producer from producing
various quantities of chemicals. The total external costs thrust upon a small community of
20 people downstream from the chemical producer's water pollution (TEC) is also given.
Total private benefits (TPB) and total external benefits (TEB) of chemical production are
Q TPC TEC TPB TEB
0 0 0 0 0
1 5 0 10 0
2 10 0 19 0
3 15 0 27 0
4 20 0 34 0
5 25 1 40 0
6 30 3 45 0
7 40 12 49 0
8 52 27 52 0
a. What is the private equilibrium output level?
QP=6 (MPC = $5 MSB = $5)
b. What is the socially optimal output level?
Qso=5 (MSC = $6 MSB = $6)
c. Assume ownership of the stream has been assigned to the small community, who
receives zero benefits from the manufacture of chemicals. What is the output level,
given the community owns the stream and assuming no bargaining occurs?
QP<4 (MPC = $0 MSB = $0)
d. Answer "c" assuming bargaining occurs (that is, what is the output level given the
community owns the stream and bargaining occurs?) Who is likely to end up with
an income gain and why?
The output would be the socially optimal level of Qso=5 (MSC = $6 MSB = $6)
If they are producing Q=4, the MEB to the community of producing one extra unit is $0 and the
MEC is $1. For the Chemical producer, the MPC of producing one extra unit is $5 and the MPB is
$6. The Chemical producer would be willing to pay the community up < $1 to produce one extra
unit and the community would be willing to allow it for a payment > $1.
Thus the community will end up with the income gain.
3. Efficiency can correspond to more than one distribution of well-being. Can the efficiency
criterion by used to rank one distribution over another? Explain.
This applies to to the welfare function (the one looking like a production possibilities frontier – see
page 44 in Rosen text) I drew when I first discussed the Efficiency criterion. We can say that a
point inside the welfare function is an inefficient allocation of resources and thus inferior to one on
the function, but we can’t say that one point on the curve is better than another point on the curve.
Both are good from an efficiency point of view.
4 Common Property Goods. See chapters 25 & 27 in the Miller, Benjamin, North book.
a. Define common property goods and given an example (besides national/state parks).
b. What are the externalities associated with common property goods (that is, from a
public finance economist perspective, why do these goods cause problems?)
c. Provide a market-based solution to the problem associated with common property
goods. Use an example in your answer.
d. The National Park Service could set the price of admission to Yellowstone at a rate
high enough to eliminate the overcrowding problem. Why don’t they do this?
5. If we assume that vocational training bestows proportionately more benefits on individuals
as opposed to society, compared to a liberal arts education, what effect does this have on
how education is funded – private vs. public. Explain.
Since vocation training results in less positive externalities compared to a liberal arts education, less
government subsidies should go to vocational training, meaning more of the cost of a vocational
education should be borne by the individual (privately).
6. Does marketing the right to pollute mean that we are allowing too much destruction of our
environment? In other words, is zero pollution an efficient goal? Explain.