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1. What is the difference between an external cost and an external benefit? An external cost is a cost of a transaction that must be paid by some party not in the transaction. An external benefit is similar, but it is a benefit from a transaction that is received by some party not involved in a transaction. 2. Why are markets with externalities inefficient? Markets with externalities can either produce too much or too little. When there is an external cost, the marginal private cost is below the marginal social cost; thus, the firm produces more than is socially optimal. When there is an external benefit, the marginal private benefit is below the marginal social benefit, and thus, the firm produces too little. For efficiency, the MC of society must equal the MR. 3. What is the difference between using taxes to solve an externality problem and using the Coase theorem? When taxes are used to solve an externality problem, the government must directly assess the marginal damage cost and impose it on the firm. The Coase solution is to assign a clear right to the firm or the party who is bearing the cost. Then let the two negotiate a solution. There is no need to assess damage or have any government intervention. 4. Would an economist favor the banning of all pollution? Why? No. Economists recognize that pollution is an unfortunate byproduct of production. The relevant question for an economist is how much pollution is socially optimal? To find out, the firm should compare the marginal damage cost (as part of the marginal social cost) to the marginal benefit people get from the consumption of the good. 5. How do public goods differ from other goods. Public goods are nonrival in consumption, meaning that one person’s consumption does not exclude another person’s consumption. Public goods are also nonexcludable, meaning that you cannot exclude someone from consuming the good who wanted to consume the good.
6. How should the government provide public goods, according to Samuelson? What are the problems with this solution? Samuelson argued that you find the market demand for the public good by adding up each person’s willingness to pay for each quantity. You then find where the market demand curve intersects the marginal cost curve. The problem with this strategy is that it relies on the government being accurately able to determine each person’s willingness to pay. 7. How do people "vote with their feet?" People reveal their willingness to pay for certain public goods by paying taxes or buying a house in order to live in a particular community that has a certain level of public good provision. 8. What are some solutions to the moral hazard and adverse selection problems? The moral hazard problem can be partially solved by making the party that takes the action bear some of the costs of their behavior; for example, a deductible on your insurance policy. Researching the good that you are about to purchase solves the adverse selection problem. The government also provides information and protects against false advertisement. 9. What does the impossibility theorem have to say about using the majority rule for making social choices? The impossibility theorem says that any system (including majority rule) has the potential to provide inconsistent results when used to make decisions that represent the will of a large number of people.
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