Chapter 11 — Exercises
Section A — Identifying externalities
A1. For each of the following activities, identify whether it produces a negative externality, a positive externality, both, or neither. For each externality you identify, describe who bears the cost or receives the benefit. - (a) A factory emitting sulfur dioxide into the air - (b) A homeowner mowing their lawn at 7 a.m. on Saturday - (c) A student getting a college education - (d) A driver using a congested highway - (e) A beekeeper whose bees pollinate a neighbor's orchard - (f) A person getting a flu vaccine - (g) A construction company building a skyscraper that blocks your view - (h) A musician practicing in their apartment
A2. Smoking produces both a negative externality (second-hand smoke) and a consumption externality (health costs that are partly borne by public insurance). Distinguish these two types. Which is easier to address with policy?
A3. Education produces positive externalities. List three specific spillover benefits that accrue to people other than the person being educated. For each, explain why the benefit is "external" (i.e., not captured by the educated person).
Section B — The social-cost graph
B1. Suppose a market has private supply: P = 10 + Q and demand: P = 50 − Q. The external cost is $6 per unit (constant). Find: - (a) The market equilibrium (where private supply = demand) - (b) The social cost curve - (c) The socially optimal equilibrium (where social cost = demand) - (d) The overproduction (market quantity − optimal quantity) - (e) The deadweight loss from the externality
B2. Now suppose the external cost rises to $12 per unit. Redo the calculation. How does the deadweight loss change?
B3. Draw a diagram for a positive externality. The social benefit curve is above the demand curve by $4 per unit. Show that the market produces less than the socially optimal quantity.
Section C — Solutions
C1. For the market in B1, calculate the Pigouvian tax that would achieve the socially optimal outcome. Show that after the tax, the market produces the optimal quantity.
C2. For the same market, design a cap-and-trade system. How many permits should be issued? If the permit price equals the Pigouvian tax, show that the outcomes are equivalent.
C3. Compare the Pigouvian tax and the cap-and-trade system in terms of: - (a) What is certain: the price of pollution or the quantity of pollution? - (b) What happens when demand unexpectedly rises? - (c) What happens when the external cost changes?
C4. "Regulation is simpler than cap-and-trade but usually more expensive per unit of pollution reduction." Explain why.
C5. Apply the Coase theorem to a dispute between two neighboring firms — one produces noise, the other needs quiet. The noisy firm's profit is $100,000/year. The quiet firm would gain $150,000/year if the noise stopped. The cost of soundproofing is $80,000. What happens under Coase bargaining? Does the initial assignment of property rights affect who pays? Does it affect whether the noise stops?
Section D — The Walden Creek case
D1. Which of the four solutions (Pigouvian tax, cap-and-trade, regulation, Coase bargaining) was most appropriate for the Walden Creek case? Justify your answer.
D2. Suppose the Walden Creek Fishing Association is unable to organize a Coase-style bargaining effort because its 300 members can't agree on how much to pay. What kind of transaction cost is this? How does it undermine the Coase solution?
D3. The case study described a $2/gallon Pigouvian tax that led the company to install filtration. Suppose the external cost were actually $4/gallon (higher than the estimated $2). What would happen? Would the tax still achieve the optimal outcome?
Section E — Climate change preview
E1. Why can't the Coase theorem solve climate change? List three specific reasons related to transaction costs, number of parties, and property rights.
E2. About 90% of surveyed economists support some form of carbon pricing. Why is this consensus so strong? What is the minority 10% likely concerned about?
E3. The EU Emissions Trading System had early problems with too many free permits. Explain why too many permits would keep the carbon price too low and reduce the effectiveness of the system.
E4. A common objection to carbon taxes is that they are "regressive" (they burden lower-income households more). Use the language of tax incidence from Chapter 6 and Chapter 7 to evaluate this claim. Is it correct? If so, can it be addressed?
Section F — Behavioral lens
F1. Why do people react more strongly to visible, local pollution (a smelly factory) than to invisible, global pollution (CO₂ emissions)? Use loss aversion and salience bias.
F2. Climate change is a classic present-bias problem. Explain why, using the language of hyperbolic discounting from Chapter 10.
F3. "Carbon tax" is unpopular. "Carbon dividend" (same tax, revenue returned to citizens) is more popular. Why does framing matter here? Is the economic substance different?
F4. Could nudges help address externalities? For example, could default settings on electricity contracts (green energy as the default) reduce carbon emissions? Design a specific nudge and predict its effect.
Section G — Data lookup
G1. Find the U.S. EPA's estimate of the social cost of carbon (the dollar value of damage caused by one additional ton of CO₂). What is the current estimate? How has it changed over time?
G2. Look up the EU Emissions Trading System carbon price on a financial data source. What is the current price per ton of CO₂? How does it compare to the EPA's social cost of carbon?
G3. Look up the reduction in U.S. sulfur dioxide emissions since the 1990 Clean Air Act Amendments. How much have emissions fallen? What mechanism (cap-and-trade) drove the reduction?
Section H — Policy debate
H1. "We should just ban all pollution." Use the externality framework to explain why this is almost certainly not the efficient policy. What is the efficient level of pollution?
H2. "Market-based solutions to pollution (taxes, cap-and-trade) are better than regulation." Make the strongest case for and against this claim.
H3. "If property rights were clearly defined, we wouldn't need environmental regulation at all." Evaluate using the Coase theorem. Where does this claim hold, and where does it fail?
Section I — Reflection
- Before this chapter, did you think of pollution as a "market failure"? How has the framing changed your view?
- Which of the four solutions to externalities do you find most appealing? Why?
- The chapter argues that climate change is the largest externality in human history. Do you agree? What other candidates might there be?
Selected answers in appendices/answers-to-selected.md.