Chapter 05 Market Failures Public Goods And Externalities

chapter 05 - market failures: public goods and externalities chapter 05 market failures: public goods and externalities questions 1.

Chapter 05 - Market Failures: Public Goods and Externalities
Chapter 05 Market Failures: Public Goods and Externalities
QUESTIONS
1. Explain the two causes of market failures. Given their definitions,
could a market be affected by both types of market failures
simultaneously? LO1
Answer: A public good is one where consumption in non-rival and
non-excludable. Private goods are not profitable because of the free
rider problem. If we want to set off fireworks and charge for the
event, we probably wouldn't generate much revenue. We can't keep
people from watching the fireworks outside the event
(non-excludability) and the fireworks display can be watched by all
(non-rival: If one person watches the fireworks display this does not
reduce or eliminate the someone else's ability to see the same
fireworks display). This is the first type of market failure.
The second potential market failure is the presence of an externality.
Externalities occur when the costs or benefits accrue to someone other
than the buyer or seller (third parties). For example, an individual
may fully internalize the cost of smoking a cigarette (price, health,
etc...), but he or she does not internalize the negative health
effects that the cigarette may have on others (a third party). This
will result in overconsumption (and production).
ANSWER 1: Yes, it is possible for both to occur if an individual
values the good, such as fireworks, even if the free-rider problem is
present. For example, I would like to set off a fireworks display and
charge for the event so it can be larger than the display I would pay
for myself. However, since everyone free-rides on my display I only
set off a small one (the public good is underprovided). Now if my
fireworks display causes pollution (noise and smoke) or potential fire
damage a negative externality may be present.
ANSWER 2: No, because if the free-rider problem is present firms will
not produce any of the good. Since no goods are produced or consumed
there cannot be an externality.
2. Draw a supply and demand graph and identify the areas of consumer
surplus and producer surplus. Given the demand curve, what impact will
an increase in supply have on the amount of consumer surplus shown in
your diagram? Explain why. LO2
Answer:

An increase in supply will lower the price and increase the amount of
consumer surplus for a given demand curve. Any individual that was
receiving consumer surplus before the change in supply will realize an
increase in consumer surplus as the price falls and the difference
between their maximum willingness to pay and the market price widens.
3. Use the ideas of consumer surplus and producer surplus to explain
why economists say competitive markets are efficient. Why are below-
or above-equilibrium levels of output inefficient, according to these
two sets of ideas? LO2
Answer: When the consumers’ utility exceeds the price paid, consumer
surplus is generated. Likewise, when producers receive a price greater
than marginal cost, producer surplus is created. By producing up to
the point where MB = MC, the maximum potential consumer surplus and
producer surplus is generated. Producing less than the equilibrium
level means that potential surplus is left unrealized. Overproduction
subtracts from the surplus because society values the use of the
additional resources in other pursuits more than it values them in
consumption of that good.
4. What are the two characteristics of public goods? Explain the
significance of each for public provision as opposed to private
provision. What is the free-rider problem as it relates to public
goods? Is U.S. border patrol a public good or a private good? Why? How
about satellite TV? Explain. LO3
Answer: Public goods are nonrival (one person’s consumption does not
prevent consumption by another) and nonexcludable (once the goods are
produced nobody—including free riders—can be excluded from the goods’
benefits). If goods are nonrival, there is less incentive for private
firms to produce them – those purchasing the good could simply allow
others the use without compensation. Similarly, if goods are
nonexcludable, private firms are unlikely to produce them as the
potential for profit is low. The free-rider problem occurs when people
benefit from the public good without contributing to the cost (tax
revenue proportionate to the benefit received). The U.S. border patrol
is a public good – my use and benefit does not prevent yours.
Satellite TV is a private good – if the dish, receiver, and service go
to my residence it can’t go to my neighbors. The fact that I could
invite my neighbor over to watch does not change its status from being
a private good.
5. Draw a production possibilities curve with public goods on the
vertical axis and private goods on the horizontal axis. Assuming the
economy is initially operating on the curve, indicate how the
production of public goods might be increased. How might the output of
public goods be increased if the economy is initially operating at a
point inside the curve? LO3
Answer: On the curve, the only way to obtain more public goods is to
reduce the production of private goods (from C to B).
An economy operating inside the curve can expand the production of
public goods without sacrificing private goods (say, from A to B) by
making use of unemployed resources.

6. Use the distinction between the characteristics of private and
public goods to determine whether the following should be produced
through the market system or provided by government: (a) French fries,
(b) airport screening, (c) court systems, (d) mail delivery, and (e)
medical care. State why you answered as you did in each case. LO3
Answers:
(a) French fries—market system (rival and excludable)
(b) airport screening—government (nonrival and nonexcludable)
(c) court systems—government (nonrival and nonexcludable)
(d) mail delivery—government, as long as the law gives postal service
a monopoly (although services such as package delivery have private
competition)
(e) medical care—combined market and government; the mix of private
and public production is a controversial topic addressed in the
chapter on the economics of health care
7. What divergences arise between equilibrium output and efficient
output when (a) negative externalities and (b) positive externalities
are present? How might government correct these divergences? Cite an
example (other than the text examples) of an external cost and an
external benefit. LO4
Answers:
(a) When negative externalities are present, the equilibrium output
will be greater than the efficient output. This is because the
producer, who is not bearing the full cost of production, will be able
to produce more at a lower price than the efficient level, which would
exist if true costs were reflected in the production decision.
(b) When positive externalities are present, the equilibrium output
will be smaller than the efficient output because the consumer is
willing to pay a price equal to the consumer’s individual marginal
benefit, but no more. Since social benefits exist in addition to the
private benefit, the government must either aid the producer to
encourage more output or engage in its own production of the item with
the external benefits.
Government might correct external costs through regulation, which
requires firms to internalize these external costs, or it might tax
the externality until it becomes too expensive for the firm to incur
these costs. This effectively shifts the supply curve to the left as
costs of production rise, and the new equilibrium output will be less
and closer to the efficient level. External benefits can be encouraged
by government subsidies to the producers of these products or by
government production. In either case, the supply curve shifts to the
right which lowers the equilibrium price and leads to a greater
equilibrium output level.
Other examples of external costs might include secondhand smoke, noise
from the stereo down the hall, or road congestion. External benefits
might be generated from outdoor Christmas lights, music from the
stereo down the hall, or attractive landscaping in the neighborhood.
8. Why are spillover costs and spillover benefits also called negative
and positive externalities? Show graphically how a tax can correct for
a negative externality and how a subsidy to producers can correct for
a positive externality. How does a subsidy to consumers differ from a
subsidy to producers in correcting for a positive externality? LO4
Answers: Spillover costs are called negative externalities because
they are external to the participants in the transaction and reduce
the utility of affected third parties (thus “negative”). Spillover
benefits are called positive externalities because they are external
to the participants in the transaction and increase the utility of
affected third parties (thus “positive”). To show how taxes and
subsidies can correct externalities, see Figures 5.7 and 5.8. Compare
(b) and (c) in Figure 5.8.
9. An apple grower’s orchard provides nectar to a neighbor’s bees,
while the beekeeper’s bees help the apple grower by pollinating his
apple blossoms. Use Figure 5.6b to explain why this situation of dual
positive externalities might lead to an underallocation of resources
to both apple growing and beekeeping. How might this underallocation
get resolved via the means suggested by the Coase theorem? LO4
Answers: Using Figure 5.6b in the text the following can be said: The
market demand curves for apples and honey, Da and Dh, would not
include the spillover benefits accruing to the production of the other
good. The total benefits associated with the consumption and
production of each good could be shown by Dat or Dht and the optimal
outputs for each good would be Qao and Qho. Both of these outputs are
greater than equilibrium outputs, Qae and Qhe, leading to an
underallocation of resources to both apple‑growing and beekeeping.
Using the Coase theorem, we note that it will be to the advantage of
individual apple growers and beekeepers to negotiate so that
beekeepers (whose hives can be moved) locate their production in or
near orchards. This negotiation will occur as long as property
ownership is well defined, only a few people are involved, and
bargaining costs are low. For example, an apple grower who owns an
orchard could allow a beekeeper to use a portion of his or her land,
charging below‑market rents so that both parties gain from the
agreement.
10. The Lojack car recovery system allows the police to track stolen
cars. As a result, they not only recover 90% of Lojack-equipped cars
that are stolen but also arrest many auto thieves and shut down many
“chop shops” that take apart stolen vehicles to get at their used
parts. Thus, Lojack provides both private benefits and positive
externalities. Should the government consider subsidizing Lojack
purchases? LO4
Answers: If the government were to subsidize Lojack purchases, this
would reduce the private cost of the anti-theft devices. This
reduction in the private cost would, in-turn, increase the purchase of
the Lojack system. The fact that this good was under-utilized in the
private sector without the subsidy because part of the benefit accrued
to society, not the individual, in the form of reduced crime (shutting
down "chop shops") implies this subsidy is appropriate. Yes, the
government should consider subsidizing Lojack purchases.
11. Explain the following statement, using the MB curve in Figure 5.9
to illustrate: “The optimal amount of pollution abatement for some
substances, say, dirty water from storm drains, is very low; the
optimal amount of abatement for other substances, say, cyanide poison,
is close to 100 percent.” LO5
Answers: Reducing water flow from storm drains has a low marginal
benefit, meaning the MB curve would be located far to the left of
where it is in the text diagram. It will intersect the MC curve at a
low amount of pollution abatement, indicating the optimal amount of
pollution abatement (where MB = MC) is low. Any cyanide in public
water sources could be deadly. Therefore, the marginal benefit of
reducing cyanide is extremely high and the MB curve in the figure
would be located to the extreme right where it would intersect the MC
curve at or near 100 percent.
12. Explain why zoning laws, which allow certain land uses only in
specific locations, might be justified in dealing with a problem of
negative externalities. Explain why in areas where buildings sit close
together tax breaks to property owners for installing extra fire
prevention equipment might be justified in view of positive
externalities. Explain why excise taxes on beer might be justified in
dealing with a problem of external costs. LO5
Answers: Zoning could force businesses producing negative
externalities to locate in regions where these costs would not spill
over onto third parties, or where such costs would at least be
reduced. Businesses wanting to locate in regions where external costs
would cause the most damage (but where zoning restricts their
location) would be forced to eliminate or reduce those external costs.
In either case, a more efficient allocation of resources would result.
Tax breaks to property owners who install fire prevention equipment
reduces the potential of fire spreading to nearby buildings. Thus, the
fire prevention equipment will have positive externalities because of
the additional benefit to the community. At the individual level the
building owners take into account the benefits for their own business,
which implies that fire prevention equipment will be underutilized
without the tax break (which reduces direct cost).
13. LAST WORD Distinguish between a carbon-tax and a cap-and-trade
strategy for reducing carbon dioxide and other so-called greenhouse
gases (that are believed by many scientists to be causing global
warming). Which of the two strategies do you think would have the most
political support in an election in your home state? Explain your
thinking.
Answers: Scientific evidence suggests that carbon dioxide and other
gas emissions are accumulating and causing the average temperature of
the atmosphere to increase. In the Kyoto Protocol, the industrialized
nations agreed to cut emissions 6 to 8 percent below 1990 by 2012.
Flooding may occur in some regions, thus decreasing the land upon
which the population lives, whereas temperatures in the northern parts
of the globe may moderate and make these areas more habitable. (Al
Gore’s film An Inconvenient Truth illustrates this effectively.)
A carbon-tax affects each polluting firm by charging them for
emissions. The cap-and-trade strategy would allow more efficient firms
to sell their permits to the less efficient firms resulting in greater
efficiency (Heavier polluters must pay more to maintain the same level
of production).
PROBLEMS
1. Refer to Table 5.1. If the six people listed in the table are the
only consumers in the market and the equilibrium price is $11 (not the
$8 shown), how much consumer surplus will the market generate? LO2
Answer: $3
Feedback: Consider the following table as an example:

Using the values above, and assuming an equilibrium price of $11 (not
the $8 shown), we first note that an individual will only purchase the
good if his or her "maximum price willing to pay" is greater than or
equal to the price of the product ($11). This implies that only Bob,
Barb, and Bill are willing to purchase the good at the price of $11.
Now we can calculate the consumer surplus by adding up the difference
between the "maximum price willing to pay" and the actual price paid.
Bob's consumer surplus is $2 (= $13 - $11)
Barb's consumer surplus is $1 (= $12 - $11)
Bob's consumer surplus is $0 (= $11 - $11)
Thus, the total consumer surplus equals $3 (= $2 + $1 + $0)
2. Refer to Table 5.2. If the six people listed in the table are the
only producers in the market and the equilibrium price is $6 (not the
$8 shown), how much producer surplus will the market generate? LO2
Answer: $6
Feedback: Consider the following table as an example:

Using the values above, and assuming an equilibrium price of $6 (not
the $8 shown), we first note that an individual will only sell the
good if his or her "minimum acceptable price" is less than or equal to
the price of the product ($6). This implies that only Carlos,
Courtney, Chuck, and Cindy are willing to sell the good at the price
of $6.
Now we can calculate the producer surplus by adding up the difference
between the actual (equilibrium) price and the "minimum acceptable
price".
Carlos's producer surplus is $3 (= $6 - $3)
Courtney's producer surplus is $2 (= $6 - $4)
Chuck's producer surplus is $1 (= $6 - $5)
Cindy's Producer surplus is $0 (= $6 - $6)
Thus, the total producer surplus equals $6 (=$3 + $2 + $1 + $0)
3. Look at Tables 5.1 and 5.2 together. What is the total surplus if
Bob buys a unit from Carlos? If Barb buys a unit from Courtney? If Bob
buys a unit from Chad? If you match up pairs of buyers and sellers so
as to maximize the total surplus of all transactions, what is the
largest total surplus that can be achieved? LO2
Answers: $10 (= $13 - $3); $8 (= $12 - $4); $5 = ($13 - $8); $30.
Feedback: Consider the following tables as an example:


If Bob buys a unit of the good from Carlos, then the economic surplus
is the difference between Bob's "maximum price willing to pay" and
Carlos's the "minimum acceptable price." The economic surplus is $10
(= $13- $3)
If Barb buys a unit form Courtney, then the economic surplus equals $8
(= $12 - $4).
If Bob buys a unit form Chad, then the economic surplus is $5 (= $13 -
$8).
If we match up buyers and sellers to maximize the total economic
surplus then we need to choose the pairs with the largest gap between
"maximum price willing to pay" and the "minimum acceptable price."
This implies the following pairs (Bob, Carlos) with an economic
surplus of $10, (Barb, Courtney) with an economic surplus of $8,
(Bill, Chuck) with an economic surplus of $6, (Bart, Cindy) with an
economic surplus of $4, (Brent, Craig) with an economic surplus of $2,
and (Betty, Chad) with an economic surplus of $0. Adding this up
across all pairs gives us a total economic surplus of $30.
4. ADVANCED ANALYSIS Assume the following values for Figures 5.4a and
5.4b. Q1 = 20 bags. Q2 = 15 bags. Q3 = 27 bags. The market equilibrium
price is $45 per bag. The price at a is $85 per bag. The price at c is
$5 per bag. The price at f is $59 per bag. The price at g is $31 per
bag. Apply the formula for the area of a triangle (Area = ½ x Base x
Height) to answer the following questions. LO2
a. What is the dollar value of the total surplus (producer surplus
plus consumer surplus) when the allocatively efficient output level is
being produced? How large is the dollar value of the consumer surplus
at that output level?
b. What is the dollar value of the deadweight loss when output level Q2
is being produced? What is the total surplus when output level Q2 is
being produced?
c. What is the dollar value of the deadweight loss when output level Q3
is produced? What is the dollar value of the total surplus when output
level Q3 is produced?
Answers: (a) At output level Q1, total surplus is $800; consumer
surplus at Q1 is $400.
(b) The deadweight loss at Q2 is $50; the total surplus at Q2 is $750.
(c) The deadweight loss at Q3 is $98; the dollar value of the total
surplus at Q3 is $702.
Feedback: To answer this question, let us first find the mathematical
representation of the supply and demand schedules. To help us
accomplish this objective we us the following figures.

Now consider the following values as an example. Assume the following
values for Figures 5.4a and 5.4b: The equilibrium quantity Q1 = 20,
the market equilibrium price is $45 per bag, the price at a is $85 per
bag, the price at c is $5 per bag.
To derive the demand schedule (inverse demand schedule), we use the
following ordered pairs: (20,45) equilibrium and (0,85) point a.
We know the form of the demand schedule will be P=C1 + C2Q where C1
and C2 are unknown constants. The intercept, C1, can be found by
setting Q equal to zero. This is point a, so C1 equals 85. To find the
slope, C2, we divide the change in quantity by the change in price
using our two ordered pairs above (rise-over-run). This implies C2
equals (20 - 0) / (45 - 85) = -2.
Thus, we have the following demand schedule: P = 85 - 2Q
To derive the supply schedule (inverse supply schedule), we use the
following ordered pairs: (20,45) equilibrium and (0,5) point c.
We know the form of the supply schedule will also be P = C1 + C2Q
where C1 and C2 are once again unknown constants. The intercept, C1,
can be found by setting Q equal to zero. This is point c, so C1 equals
5. To find the slope, C2, we divide the change in quantity by the
change in price using our two ordered pairs above (rise-over-run).
This implies C2 equals (20 - 0) / (45 - 5) = 2.
Thus, we have the following supply schedule: P = 5 + 2Q
With these schedules we can now answer the following questions:
Part (a): What is the dollar value of the total surplus (producer
surplus plus consumer surplus) when the allocatively efficient output
level is being produced? How large is the dollar value of the consumer
surplus at that output level?
To calculate total surplus we use the following formula for the area
of a triangle (Area = ½ (Base x Height)).
The area between the demand schedule P = 85 - 2Q and the supply
schedule P = 5 + 2Q for the quantity ranging from 0 to 20 is the total
economic surplus. This is a triangle with a base of 80 (the price
difference at Q = 0, or points a and c) and a height of 20 (the number
of units purchased in equilibrium). Using these values we have a total
surplus = (1/2) x 80 x 20 = 800.
The consumer surplus is the area between the demand curve and the
equilibrium price line. Here we have a base of 40 (the price
difference between the demand schedule price at Q = 0, which is $85,
and the equilibrium price of $45). The height of the triangle is once
again 20 (the number of units purchased in equilibrium). Using these
values we have a consumer surplus = (1/2) x 40 x 20 = 400.
Consider the following additional values for the figures above: Q2 =
15 bags. Q3 = 27 bags, the price at f is $59 per bag, and the price at
g is $31 per bag.
Part (b): What is the dollar value of the deadweight loss when output
level Q2 is being produced? What is the total surplus when output
level Q2 is being produced?
The first thing we need to do is calculate the price at Q2 = 15 for
the supply and demand schedules. The price on the supply schedule is P
= 5 + 2 x 15 = 35. The price on the demand schedule is P = 85 – 2 x 15
= 55. The difference between these two prices is our base, which
equals 20. The height is the quantity difference between the
equilibrium quantity Q1 = 20 and the underproduction quantity Q2 = 15
(= 5). Thus, the deadweight loss from underproduction is (1/2) x 20 x
5 = 50.
The total surplus can be found by subtracting the deadweight loss from
the original total surplus that maximized efficiency. This is 800
(maximum total surplus) - 50 (deadweight loss) = 750.
Part (c): What is the dollar value of the deadweight loss when output
level Q3 is produced? What is the dollar value of the total surplus
when output level Q3 is produced?
Here we follow the same procedure. We are given the price at point f
is $59 and the price at point g is $31 (we do not need to calculate
these prices using the demand and supply schedule). The quantity Q =27
represents over production (the marginal cost to society exceeds the
marginal benefit to society) of 7 units. To calculate the deadweight
loss from this overproduction we use the price difference as the base,
which is 28 (= 59 - 31), and the amount of overproduction as the
height, which is 7 (= 27 - 20). This results in a deadweight loss of
98 (= (1/2) x 28 x 7).
The total surplus can be found by subtracting the deadweight loss from
the original total surplus that maximized efficiency. This is 800
(maximum total surplus) - 98 (deadweight loss) = 702. Note here that
we capture all of the surplus from producing the equilibrium quantity,
but we lose surplus from overproduction (inefficient use of
resources).
5. On the basis of the three individual demand schedules below, and
assuming these three people are the only ones in the society,
determine (a) the market demand schedule on the assumption that the
good is a private good and (b) the collective demand schedule on the
assumption that the good is a public good. LO3

Answers: (a) Market demand schedule
Quantity Demanded
Price
1
$8
2
$7
4
$6
7
$5
10
$4
13
$3
16
$2
19
$1
(b) Collective demand schedule
Quantity
Amount Society is Willing to Pay
1
$19
2
$16
3
$13
4
$10
5
$7
6
$4
7
$2
8
$1
Feedback: Consider the following table:

Part (a): Derive the market demand schedule on the assumption that the
good is a private good. To accomplish we use the principle of
horizontal summation. That is, we fix price and add up the quantities
demanded by the individuals.
At a price of $8: individual 1 (I1) demands 0, individual 2 (I2)
demands 1, and individual 3 (I3) demands 0. Thus, we have the
following market demand ordered pair (1,8).
At a price of $7: I1 demands 0, I2 demands 2, and I3 demands 0. Thus,
we have the following market demand ordered pair (2,7).
At a price of $6: I1 demands 0, I2 demands 3, and I3 demands 1. Thus,
we have the following market demand ordered pair (4 [=3+1],6).
At a price of $5: I1 demands 1, I2 demands 4, and I3 demands 2. Thus,
we have the following market demand ordered pair (7[=1+4+2],5).
At a price of $4: I1 demands 2, I2 demands 5, and I3 demands 3. Thus,
we have the following market demand ordered pair (10,4).
At a price of $3: I1 demands 3, I2 demands 6, and I3 demands 4. Thus,
we have the following market demand ordered pair (13,3).
At a price of $2: I1 demands 4, I2 demands 7, and I3 demands 5. Thus,
we have the following market demand ordered pair (16,2).
At a price of $1: I1 demands 5, I2 demands 8, and I3 demands 6. Thus,
we have the following market demand ordered pair (19,1).
Part (b): Derive the collective demand schedule on the assumption that
the good is a public good. To accomplish we use the principle of
vertical summation. That is, we fix quantity and add up the price
(willingness to pay) for the individuals. The logic here is that the
individuals (society) can pool resources to purchase a given quantity
because this good will be shared (public good).
At the quantity 1: I1 is willing to pay $5, I2 is willing to pay $8,
and I3 is willing to pay $6. Thus, we have the following collective
demand ordered pair (1,19=5+8+6).
At the quantity 2: I1 is willing to pay $4, I2 is willing to pay $7,
and I3 is willing to pay $5. Thus, we have the following collective
demand ordered pair (2,16).
At the quantity 3: I1 is willing to pay $3, I2 is willing to pay $6,
and I3 is willing to pay $4. Thus, we have the following collective
demand ordered pair (3,13).
At the quantity 4: I1 is willing to pay $2, I2 is willing to pay $5,
and I3 is willing to pay $3. Thus, we have the following collective
demand ordered pair (4,10).
At the quantity 5: I1 is willing to pay $1, I2 is willing to pay $4,
and I3 is willing to pay $2. Thus, we have the following collective
demand ordered pair (5,7).
At the quantity 6: I1 is willing to pay $0, I2 is willing to pay $3,
and I3 is willing to pay $1. Thus, we have the following collective
demand ordered pair (6,4).
At the quantity 7: I1 is willing to pay $0, I2 is willing to pay $2,
and I3 is willing to pay $0. Thus, we have the following collective
demand ordered pair (7,2).
At the quantity 8: I1 is willing to pay $0, I2 is willing to pay $1,
and I3 is willing to pay $0. Thus, we have the following collective
demand ordered pair (8,1).
6. Use your demand schedule for a public good, determined in problem
5, and the following supply schedule to ascertain the optimal quantity
of this public good. LO3

Answer: 4 units
Feedback: From the example table in problem 5, we calculated the
collective demand schedule from the individual demand schedules:

Collective Demand Schedule:
Quantity
Price Society is Willing to Pay
1
$19
2
$16
3
$13
4
$10
5
$7
6
$4
7
$2
8
$1
Combining this collective demand schedule with the following supply
schedule, we can determine the optimal provision (quantity) of the
public good.

The optimal quantity can be found by finding the price where the
willingness to pay equals price required by the firm to supply that
last unit (basically the price that clears the market). For example,
at $19 society demands one unit but firms are willing to supply 10
units. At $16 society demands 2 units but firms are willing to supply
8 units. This continues until we reach the price of $10 where society
demands 4 units and firms are willing to supply 4 units. Thus, the
optimal quantity is 4 units.
7. Look at Tables 5.1 and 5.2, which show, respectively, the
willingness to pay and willingness to accept of buyers and seller of
bags of oranges. For the following questions, assume that the
equilibrium price and quantity will depend on the indicated changes in
supply and demand. Assume that the only market participants are those
listed by name in the two tables. LO4
a. What is the equilibrium price and quantity for the data displayed
in the two tables?
b. What if instead of bags of oranges, the data in the two tables
dealt with a public good like fireworks displays. If all the buyers
free ride, what will be the quantity supplied by private sellers?
c. Assume that we are back to talking about bags of oranges (a private
good), but that the government has decided that tossed orange peels
impose a negative externality on the public that must be rectified by
imposing a $2-per-bag tax on sellers. What is the new equilibrium
price and quantity? If the new equilibrium quantity is the optimal
quantity, by how many bags were oranges being overproduced before?
Answers: P* = $8 and Q* = 6 bags; Q* = 0; P* = $9 and Q* = 5 bags.
Feedback: Here we consider the tables from Problems 1 and 2.


Part (a): To determine the equilibrium price of oranges, we begin by
comparing the highest willingness to pay with the lowest minimum
acceptable price. Bob is willing to pay $13 and Carlos is willing to
accept at minimum $3. This trade is made because Bob is willing to pay
more than Carlos requires for the sale. We then move on to the trade
between Barb and Courtney. This trade is also made because Barb is
willing to pay $12 and Courtney only requires $4 to make the sale.
This goes on until the "maximum willingness to pay" equals the
"minimum acceptable price". This occurs for the trade between Betty
and Chad. Betty's "maximum willingness to pay" is $8 and Chad's
"minimum acceptable price" is also $8. Since the six purchasers (each
purchases 1 unit) buy the 6 units produced by the six producers (each
produces 1 unit), the equilibrium quantity is 6 at the equilibrium
price of $8.
Part (b): If instead of bags of oranges, the data in the two tables
dealt with a public good like fireworks displays, and all the buyers
free ride, then the quantity supplied will be zero. Everyone will try
to pay a zero price.
Part (c): If the government decides that tossed orange peels impose a
negative externality on the public that must be rectified by imposing
a $2-per-bag tax on sellers, then the "minimum acceptable price" will
increase by the amount of the tax. The reason is that the producers
must now pay an additional $2 on top production costs. This implies
that the "minimum acceptable price" for Carlos is $5(= $3 + $2),
Courtney $6, Chuck $7, Cindy $8, Craig $9, and Chad $10. Comparing
this new "minimum acceptable price" schedule with the original
"maximum willingness to pay" schedule we have the following new
equilibrium.
Bob is willing to pay $13 and Carlos is willing to accept at minimum
$5. This trade is made because Bob is willing to pay more than Carlos
requires for the sale. We then move on to the trade between Barb and
Courtney. This trade is also made because Barb is willing to pay $12
and Courtney only requires $6 to make the sale. This goes on until the
"maximum willingness to pay" equals the "minimum acceptable price".
This occurs for the trade between Brent and Craig now. Brent's
"maximum willingness to pay" is $9 and Craig's "minimum acceptable
price" is also $9. The potential trade between Betty and Chad no
longer takes place. Betty is only willing to pay $8 and Chad requires
$10 to make the sale. Since only five purchasers (each purchases 1
unit) buy the 5 units produced by the five producers (each produces 1
unit), the new equilibrium quantity is 5 at the equilibrium price of
$9.
If this is the optimal quantity, then the market was overproducing by
1 unit before the tax was imposed on orange producers.
5-18
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