This Document Contains Chapters 9 to 10 CHAPTER 9 Modern Principles of Economics: International Trade Facts and Tools 1. The Japanese people currently pay about four times the world price for rice. If Japan removed its trade barriers so that Japanese consumers could buy rice at the world price, who would be better off and who would be worse off: Japanese consumers or Japanese rice farmers? If we added all the gains and losses to the Japanese, would there be a net gain or net loss? Who would make a greater effort lobbying for or against this reduction in trade barriers: Japanese consumers or Japanese rice farmers? Solution 1. Japanese consumers would be better off and Japanese rice farmers would be worse off. The theory of trade tells us that Japanese consumers would be better off by more than Japanese producers would be worse off so the net gains would be positive. The theory of politics, however, tells us that Japanese rice farmers would probably spend more effort and money opposing the reduction in trade barriers than consumers would spend favoring the reduction in barriers. The gains to consumers would be small per consumer but the losses to producers would be concentrated so the producers have a greater incentive and ability to oppose reductions in trade barriers. 2. The supply curve for rice in Japan slopes upward, just like any normal supply curve. If Japan eliminated its trade barriers to rice, what would happen to the number of workers employed in the rice-producing industry in Japan: Would it rise or fall? What would these workers probably do over the next year or so? Will they ever work again? Solution 2. The number of rice farmers would fall. They would search for new work over the next year or so, but as we saw in our discussion of job creation and destruction, the vast majority would find new employment fairly rapidly. 3. In Figure 9.3, consider triangles B and C. One of these could be labeled “Workers and machines who could be better used in another sector of the economy,” while the other could be labeled “Consumers who have to pay more than necessary for their product.” Which is which? Solution 3. Triangle C is “Consumers who have to pay more”; Triangle B is “Workers and ma¬chines who could be better used.” 4. In his book The Choice, economist Russ Roberts asks how voters would feel about a machine that could convert wheat into automobiles. a. Do you think that voters would complain that this machine should be banned, since it would destroy jobs in the auto industry? b. Would this machine, in fact, destroy jobs in the auto industry? If so, would roughly the same number of jobs eventually be created in other industries? c. Here is Roberts’s punch line: If voters were told that the wonder machine was in fact just a cargo ship that exported wheat and imported autos from a foreign country, how would voters’ attitudes toward this machine change? Solution 4. a. This is a matter of opinion, but most people would probably be excited about such an interesting device, at least in the technology-hungry United States. b. Yes, it would destroy jobs in the short run, but as we’ve seen, market economies tend to create new jobs. The market reconsiders a “vacuum” of unemployed workers. c. For some reason, people get more upset about foreign workers taking jobs than about new technology eliminating the need for particular jobs. Historically, Americans tend to be pro-technological growth, although there is some worry about machines taking human jobs, but they are less pro-foreign trade. Why this is so, when the example indicates that foreign trade can be considered as a type of technology, would make for a good class discussion. 5. Spend some time driving in Detroit, Michigan—the Motor City—and you’re sure to see bumper stickers with messages like “Buy American” or “Out of a job yet? Keep buying foreign!” or “Hungry? Eat your foreign car!” Explain these bumper stickers in light of what you’ve learned in this chapter. Who is hurt by imported automobiles? Who benefits? Solution 5. These bumper stickers are voicing support for protectionism. Domestic auto companies are potentially hurt by imported automobiles. Many workers identify with the plight of their company because they recognize that if the domestic auto industry shrinks in response to imported autos, they may lose their jobs. The workers at the foreign auto companies benefit when Americans import automobiles because their industry grows larger. Domestic buyers benefit from the downward pressure that imports may place on auto prices. These lower auto prices benefit others in the economy, not just auto buyers, because the money that those households save on buying lower-priced automobiles, they spend on other goods and services in the economy. So while the domestic auto industry may shrink as a result of imported autos, it is quite possible that other domestic industries could grow, because of increases in sales. 6. This chapter pointed out that trade restrictions on sugar cause U.S. consumers to pay more than twice the going world price for sugar. However, you are very unlikely to ever encounter bumper stickers that say things like “Out of money yet? Keep taxing foreign sugar!” or “Hungry? It’s probably because domestic sugar is so expensive!” Why do you think it is that these bumper stickers are not popular? Solution 6. Though domestic buyers of sugar are hurt by sugar tariffs, one is unlikely to find vocal opposition to these tariffs because the costs of the tariffs are relatively small (according to the chapter, about 11 cents per pound of sugar) and spread out among many, many people. 7. Of the three conditions that explain why a free market is efficient (from Chapter 4), which condition or conditions cease to hold in the case of a tariff on imported goods? Which condition or conditions continue to hold even in the case of a tariff on imports? Solution 7. The two conditions violated when a tariff is imposed on otherwise free trade are the following: The supply of goods is sold by the sellers with the lowest cost and there are no unexploited gains or wasteful trades. The tariff causes non–lowest-cost producers (domestic producers) to enter the market and begin producing, even though foreign producers have lower costs. Likewise, the tariff reduces the number of trades made by raising the price that buyers face and driving some of the buyers out of the market. The condition that continues to hold is that the supply of goods is purchased by the buyers who place the highest value on the goods. This is still the case; however, fewer of these buyers continue to buy. Thinking and Problem Solving 8. a. Just to review: Back in Chapter 8 on price ceilings and floors, we illustrated price ceilings with a horizontal line below the equilibrium price. Did price ceilings create surpluses or shortages? b. The horizontal line in Figure 9.1 doesn’t represent a surplus or a shortage. What does it represent? c. Figure 9.1 considers the case of a country that can buy as many semiconduc¬tors as it wants at the same world price. Why do people in this country only buy QdFree trade units? Why don’t they buy more of this inexpensive product? Solution 8. a. A price ceiling creates a shortage. b. It represents the price at which the good can be supplied by the outside world. Thus, the distance between QdFree trade and QsFree trade is not shortage but imports. c. They don’t buy more because the small country’s demand curve slopes down¬ward, and at some point people are satiated at that particular world price. Still, there are people who would buy the good if it were cheaper; at the world price, however, they’ll still sit on the sidelines, spending their money on other products. 9. Figure 9.1 looks at a case in which the world price is below the domestic no-trade price. Let’s look at the case in which the world price is above the domestic no-trade price. We’ll work with the market for airplanes shown in the following figure: a. In the figure, use the Quantity axis to label QsFree trade and QdFree trade. This is some¬what similar to Figure 9.1. b. What would you call the gap between QsFree trade and QdFree trade? c. Also following Figure 9.1, label “Domestic consumption” and “Domestic production.” d. Will domestic airplane buyers—airlines and delivery companies like FedEx—have to pay a higher or a lower price under free trade compared with the no-trade alternative? Will domestic airplane buyers purchase a higher or a lower quantity of planes if there’s free trade in planes? e. Based on your answer to part d, would you expect domestic airplane demanders to support free trade in planes or oppose it? Solution 9. a. b. This gap is exports. c. QdFree Trade is domestic consumption; QsFree Trade is domestic production. d. Domestic buyers have to pay more for airplanes in a free-trade world. In essence, free trade in exports allows foreign buyers to compete with domestic buyers, which pushes up the domestic price. If foreign buyers were prevented from competing with domestic buyers (e.g., with a tax on exports), the domestic price would fall. Notice, however, that without exports the domestic industry would shrink. The ambitious may wish to show that if exports were prevented, the loss in producer surplus would exceed the gain in consumer surplus. e. Airlines and delivery companies are likely to oppose free trade in a case like this: They don’t want competition from foreign buyers. 10. In the text, we discuss sugar farmers in Florida who use unusually large amounts of fertilizer to produce their crops; they do so because their land isn’t all that great for sugar production. If we translate this into the language of the supply curve, would these Florida sugar farms be those on the lower-left part of a supply curve, or those along the upper right of the supply curve? Why? Solution 10. The Florida producers will be in the upper-right part of the supply curve. Going back to Chapter 3, these are the producers with the highest opportunity cost of producing sugar: It costs them a lot to get into this business, and they only enter it when the price of sugar is high. 11. Many people will tell you that, whenever possible, you should always buy U.S.-made goods. Some will go further and tell you to spend your money on goods produced in your own state whenever possible. (Just do a simple Google search for “Buy [any state]” and you’ll find a Web site encouraging this kind of thinking.) The idea is that if you spend money in your state, you help the economy of your state, rather than the economy of some other state. By the same logic, shouldn’t one buy only goods produced in one’s own city? Or on one’s own street? Where does this thinking lead to? And how does it relate to Big Idea Five from Chapter 1? Solution 11. Taken to its extreme, this thinking will lead us to consume only goods that we our¬selves can produce, so we ourselves will reap all of the benefits of our own “purchases.” This leads us to the self-sufficiency mentioned in Chapter 1. Just like each of us cannot produce all that we need on our own, and we benefit from specialization and trade with others, trade between cities or states or countries leads to increasing opportunities for specialization and the benefits that derive from that specialization. When we limit the people with whom we are willing to trade, we may be ignoring some potentially beneficial trades. 12. Some people argue for protectionism by pointing out that other countries with whom we trade engage in “unfair trade practices,” and that we should retaliate with our own protectionist measures. One such policy is the policy of some countries to subsidize exporting industries. India, for example, subsidizes its steel industry. Obviously, U.S. steel producers are hurt by this policy and would like to restrict imported steel from India. Is this a good reason to place tariffs on Indian steel? Why or why not? Solution 12. Indian steel subsidies can reduce steel prices that American buyers face, while reduc¬ing the producer surplus for American steel companies. However, the benefit to buyers exceeds the detriment to sellers. Essentially, an Indian steel subsidy constitutes a payment from the Indian government to American steel customers. Taxing Indian steel would just eliminate this payment to domestic buyers, and the net benefit of the cheaper steel. 13. In March 2002, then President George W. Bush put a tariff on imported steel as a means of protecting the domestic steel industry. In February, before the tariff went into effect, the United States produced 7.4 million metric tons of crude steel and imported about 2.8 million metric tons of steel products at an average price of $363 per metric ton. Two months later, after the tariff was in effect, U.S. production increased to 7.9 million metric tons. The volume of imported steel fell to about 1.7 million metric tons, but the price of the imported steel rose to about $448 per metric ton. The supply and demand diagram below shows this situation (along with an estimated no-trade domestic equilibrium at a price of $625 per metric ton and a quantity of 8.9 million metric tons). Determine which areas on the graph represent each of the following: a. The increase in producer surplus gained by U.S. steel producers as a result of the tariff b. The loss in consumer surplus suffered by U.S. steel consumers as a result of the tariff c. The revenue earned by the government because of the tariff d. The wasted resources and lost gains from trade (deadweight loss) created by the tariff Solution 13. a. Area C b. Area C + D + E + F + G c. Area E + F d. Areas D and G 14. For each of the four parts of question 13, calculate the values of these areas in dollars. How much of the deadweight loss is due to the overproduction of steel by higher-cost U.S. steel producers, and how much is due to the underconsumption of steel by U.S. steel consumers? Solution 14. a. $650,250,000 b. $841,500,000 c. $144,500,000 d. The deadweight loss is $46,750,000: $21,250,000 from overproduction and $25,500,000 from underconsumption. Challenges 15. In the chapter, we focused on a sugar tariff that eliminated all imports. Let’s now take a look at the case where the sugar tariff eliminates some but not all imports. We will also examine the closely related case of a quota on sugar imports. The figure shows a tariff on sugar that raises the U.S. price to 20 cents per pound but at that price some sugar is imported even after the tariff. a. Label the free trade equilibrium, the tariff equilibrium, wasted resources, lost gains from trade, and tariff revenues. b. Now imagine that instead of a tariff, the U.S. government uses a quota that forbids imports of sugar greater than 6 billion pounds. (Equivalently, imagine a tariff that is zero on the first 6 billion pounds of imports but then jumps to a prohibitive level after that quantity of imports—this is closer to how the system works in practice.) Under the quota system what does area D represent? Would importers of sugar prefer a tariff or a quota? c. The sugar quota is allocated to importing countries based on imports from these countries between 1975 and 1981 (with some subsequent adjustments). For ex¬ample, in 2015 Australia was given the right to export 87 thousand metric tons of sugar to the United States at a very low tariff rate and Belize was given the right to export 11.5 thousand metric tons of sugar to the United States at a very low tariff rate. How do you think these rights are allocated to firms within the sugar-exporting countries? d. Discuss how the quota and the way it is allocated could create a misallocation of resources that would further reduce efficiency relative to a tariff that resulted in the same quantity of imports. Solution 15. a. Area B is wasted resources, area C is lost gains from trade, area D is the tariff rate times the quantity of imports so it is equal to tariff revenues. The diagram should look like this: b. Under the quota system, 6 billion pounds of sugar are allowed to enter the Unit¬ed States at a zero tariff rate. Since the world suppliers who manage to import this sugar have costs of 9 and are allowed to sell in the United States at a price of 20, area D represents additional profits (producer surplus) that flow to import¬ers. Thus, importers would much prefer a quota to a tariff. Notice that with the quota there are no tariff revenues so, all else equal, a tariff is better for the U.S. government. c. As we saw in part b, the right to export sugar to the United States at a low tariff rate is very valuable; so, within Australia or Belize there is a political process to determine which firms get the right to export sugar to the United States. d. The way the sugar quota is allocated around the world could result in consid¬erable wasted resources. First, resources will be wasted in Australia, Belize, and other exporting countries in the political process as firms lobby to be given the right to import sugar into the United States at the low tariff rate. Economists call this a rent-seeking cost. The idea of rent seeking was first discussed in Tullock, Gordon. 1967. The welfare costs of tariffs, monopolies, and theft. Western Eco¬nomic Journal 5 (3): 224–232; and was discussed (and named) in the context of tariffs and quotas in Krueger, Anne. 1974. The political economy of the rent-seeking society. American Economic Review 64 (3): 291–303. In addition, there is no guarantee that the lowest-cost firm will be the one to win the quota. Nor is it likely that the countries that were the low-cost produc¬ers of sugar in 1975–1981 (and thus which get a big chunk of today’s import quota) are today’s low-cost producers of sugar. With free trade, for example, Aus¬tralia would probably export a smaller share of world sugar production than it did in 1975–1981 since other countries have a greater comparative advantage in sugar production today. As a result, the sugar producers who get the quota probably have costs greater than 9 cents per pound, which means that under the quota, resources are wasted (these resources would not be wasted under a tariff that allowed any country to export sugar to the United States so long as the tariff was paid). 16. In a 2005 Washington Post article (“The road to riches is called K Street”), Jeffrey Birnbaum noted that there were 35,000 registered lobbyists in Washington, D.C., people whose primary job is asking the federal government for something. A lobbyist who comes with long experience as an aide to a powerful politician will earn at least $200,000 per year. Many lobbyists (not all) are attempting to restrict trade in order to turn consumer surplus into producer surplus. a. Let’s focus just on the lobbyists who are restricting trade. If the United States were to amend the Constitution to permanently ban all tariffs and trade restric¬tions, these lobbyists would lose their jobs, and they’d have to leave Washington to get “real jobs.” Would this job change raise U.S. productivity or lower it? b. Would most of these lobbyists likely earn more after the amendment was enacted or less? c. How can you reconcile your answers to parts a and b? Solution 16. a. This would raise productivity, since they are currently (by assumption) just redis-tributing income, not producing output. b. They would probably earn less, not more. c. Lobbyists in Washington, D.C., are paid to shift revenue from some people (most¬ly consumers) to other people (mostly firms): Although this can be profitable to the lobbyists, it doesn’t increase output. If the lobbyists found private-sector employment outside the lobbying industry, their own wages would fall but many of them would produce valuable output that would increase consumer surplus— thus shifting lobbyists from lobbying to, say, cookie making would increase total output and national welfare. Note that some lobbyists do lobby to have the government produce public goods and others lobby for laws and regulations that increase efficiency, so not all lobbyists reduce national welfare. 17. One of the assumptions made in this chapter was that the U.S. market for sugar was small relative to the overall world market for sugar, so that when the United States entered the world market for sugar, and U.S. buyers began to buy imported sugar, the price did not change. If we relax this assumption, how do you think that would affect Figure 9.1? How would the outcome differ from the outcome under the assumption of the relatively small market? Solution 17. In this case, the world price would be an upward-sloping world supply curve rather than a horizontal line. The more the domestic buyers want to import, the higher the price would go. In this case, it might look like the diagram below. Though some of the specifics might change (domestic producers might produce more, domestic buyers might import less and at a higher price), the overall result is the same: Consumer surplus increases as a result of trade; producer surplus decreases as a result of trade; and the net impact of trade is positive, because the increase in con¬sumer surplus is greater than the decrease in producer surplus. 18. The following tables show the domestic supply and demand schedules for bushels of flaxseed (used as an edible oil and a nutrition supplement) in the United States and Kazakhstan, with prices measured in U.S. dollars and quantities measured in millions of bushels. a. In which country is flaxseed cheaper to produce? In which country do the con¬sumers of flaxseed value it more? b. Complete the bottom table by describing each nation’s willingness to import or export flaxseed at each price. One row has been done for you as an example.
At a price of… The U.S. would be willing to… And Kazakhstan would be willing to…
$2 Import 12 million bushels Import 4 million bushels
$4
$6
$8
$10
$12
$14
$16
$18
$20
c. If the United States and Kazakhstan entered into free trade with only one another, what would be the price of flaxseed, and what quantity of flaxseed would be traded? d. For each of the following four constituent groups, determine whether free trade between the United States and Kazakhstan would help or harm the members of that group. Calculate the change in consumer or producer surplus in each coun¬try as necessary to support your claim. i. The buyers of flaxseed in Kazakhstan ii. The sellers of flaxseed in Kazakhstan iii. The buyers of flaxseed in the United States iv. The sellers of flaxseed in the United States e. Suppose the sellers of flaxseed in the importing country successfully lobby for protection in the form of a $4 tariff per bushel of flaxseed. Describe the impact of this tariff on flaxseed trade and on the consumer and producer surpluses you calculated in part d. How much deadweight loss does this tariff generate? Solution 18. a. Kazakhstan produces more flaxseed at any price than does the United States, so it must be cheaper to produce in Kazakhstan. The United States demands more flaxseed at any price, so it must be more highly valued in the United States. b. The table should look like this: c. It can be seen in the table that at a price of $10, the amount of flaxseed that the United States is willing to import is equal to the amount of flaxseed that Kazakhstan is willing to export. Therefore, the price at which they trade will be $10/bushel and the quantity traded will be 4 million bushels. d. In each case, the change in surplus will be equal to (change in price) × (aver¬age of pre-trade quantity and post-trade quantity), which is the area formula for a trapezoid. Most of your students will need to break it up into a rectangle and a triangle. Drawing the figures will help. The answers are: i. The buyers of flaxseed in Kazakhstan are hurt by this trade. Their consumer surplus falls by ($4) × ([4.5 + 3.5]/2) = $4 × 4 million = $16 million. ii. The sellers of flaxseed in Kazakhstan benefit from this trade. Their producer surplus rises by ($4) × ([4.5 + 7.5]/2) = $4 × 6 million = $24 million. iii. The buyers of flaxseed in the United States benefit from this trade. Their consumer surplus rises by ($4) × ([6 + 8]/2) = $4 × 7 million = $28 million. iv. The sellers of flaxseed in the United States are hurt by this trade. Their pro¬ducer surplus falls by ($4) × ([6 + 4]/2) = $4 × 5 million = $20 million. e. The tariff reduces the amount traded to only 2 million bushels. Kazakhstan will produce and sell flaxseed for $8 per bushel, but U.S. buyers will pay $12 per bushel for it. The benefits and losses of restricted trade (versus no trade) are smaller than for free trade: −$8.5 million, +$10.5 million, +$13 million, and −$11 million, compared to the numbers in i through iv. The deadweight loss of the tariff is the net reduction in surplus caused by the tariff. Free trade provides net benefits of $16 million versus no trade, and restricted trade provides net benefits of $4 million versus no trade. So the tariff creates $12 million in dead¬weight loss. CHAPTER 10 Modern Principles of Economics: Externalities: When the Price Is Not Right Facts and Tools 1. Let’s sort the following eight items into private costs, external costs, private benefits, or external benefits. There’s only one correct answer for each of questions a–h. a. The price you pay for an iTunes download b. The benefit your neighbor receives from hearing you play your pleasant music c. The annoyance of your neighbor because she doesn’t like your achingly conventional music d. The pleasure you receive from listening to your iTunes download e. The price you pay for a security system for your home f. The safety you enjoy as a result of having the security system g. The crime that is more likely to occur to your neighbor once a criminal sees a “Protected by alarm” sticker on your window h. The extra safety your neighbor might experience because criminals tend to stay away from neighborhoods that have a lot of burglar alarms Solution 1. Private cost = PC; External cost = EC; Private benefit = PB; External benefit = EB a. PC, b. EB, c. EC, d. PB, e. PC, f. PB, g. EC, h. EB 2. If the students at your school started saying “thank you” to friends who got flu shots, would this tend to reduce the undersupply of people who get flu shots? Why or why not? Solution 2. People sometimes do things to get approval from their friends, so people might be more likely to get flu shots if they knew they’d get a thank you from someone they cared about. And it’s reasonable to thank people who get flu shots: They’re reducing the chance you’ll get sick this winter! Alex has suggested (on Marginal Revolution) three possible buttons to give people who get a flu shot: • Kiss me, I’m vaccinated. • Take one for the herd! • Get a flu shot. The life you save may not be your own. 3. a. Consider a factory, located in the middle of nowhere, producing a nasty smell. As long as no one is around to experience the unpleasant odor, are any externalities produced? b. Suppose that a family moves in next door to the smelly factory. Do we now have an externalities problem? If so, who is causing it: the factory by producing the smell, the family by moving in next door, or both? c. Suppose that the family clearly possesses the right to a pleasant-smelling environment. Does this mean that the factory will be required to stop producing the bad smell? What could happen instead? There are many right answers. (Hint: Think about the Coase theorem. Actually, it’s always a good idea to think about the Coase theorem, whether the topic is smelly factories, labor–management disputes, international peace negotiations, or divorce settlements.) Solution 3. a. No. b. Yes, there is now an externalities problem. It is caused jointly by the factory and the family. c. The family could demand that the factory shut down or use a less-smelly technology, but there are other possibilities. The factory could pay the family to move away and continue to produce the bad smell. The factory could just pay the family a fixed monthly fee for the right to keep producing the smell. The factory could buy the family lovely-smelling flowers for their home. That’s the nature of the Coase theorem: There are usually many possible win-win outcomes, and if the parties can calmly negotiate, there’s a good chance they’ll find an option that‘s better, in this case, than just shutting down the factory. 4. Considering what we’ve learned about externalities, should human-caused global warming be completely stopped? Explain, using the language of social benefits and social costs. Solution 4. It’s probably not efficient to stop human-made global warming completely. The social benefits that manifest as a result of creating a lot of carbon dioxide and other greenhouse gases probably outweighs the social costs of such action. The socially optimal amount of human-made carbon dioxide is likely less than today’s amount, but it’s likely far more than zero. In supply and demand terms, the social cost curve is to the left of the supply curve, but not radically so far to the left that the socially optimal quantity is zero. 5. In the following cases, the markets are in equilibrium, but there are externalities. In each case, determine whether there is an external benefit or cost and estimate its size. Finally, decide between a tax or a subsidy as a simple way to compensate for the externality. Fill out the table that follows with your answers. a. In the market for automobiles, the private benefit of one more small SUV is $20,000 and the social cost of one more small SUV is $30,000. b. In the market for fashionable clothes, the marginal social benefit of one more dress per person is $100, and the marginal private benefit is $500. Bonus: Can you tell an externality story that makes sense of these numbers? c. In the market for really good ideas, ideas that will dramatically change the world for the better, the private benefit of one more really good idea (from speaker’s fees, book sales, patents, etc.) is $1 million. The marginal social benefit is $1 billion. Solution 5. See the following table:
Case External Cost or Benefit? Size of External Benefit (or cost if negative) Tax It or Subsidize it?
a. SUVs External cost −$10,000 Tax
b. Fashionable clothes External cost (or negative external benefit) −$400 Tax
c. Ideas External benefit + $999,000,000 Subsidize
Bonus for part b: Fashion is a relative game. If one person is more fashionable, that makes other people less fashionable by comparison, so the private benefits of being fashionable (signaling wealth, attractiveness, social status, and so on) may exceed the social benefits. 6. In which cases are the Coase theorem’s assumptions likely to be true? In other words, when will the parties be likely to strike an efficient bargain? How do you know? a. My neighbor wants me to cut down an ugly shrub in my front yard. The ugly shrub, of course, imposes an external cost on him and on his property value. b. My neighbors all would love for me to get that broken-down Willies Jeep off my front lawn. It’s been years now, after all. And would it be too much for me to paint the house and fill up that 6-foot deep ditch in the front yard? The whole neighborhood is just annoyed. c. A coal-fired electricity plant dumps its leftover hot water into the nearby lake, killing the naturally occurring fish. Thousands of homes line the banks of the lake. d. A coal-fired electricity plant dumps its leftover hot water into the nearby river, killing the naturally occurring fish downstream. There is one large fishery 1 mile downstream affected by this. After that, the water cools enough so it’s not a problem. Solution 6. In all cases, it’s a simple question of whether you need to negotiate with one party or with many parties. This is an easy way to illustrate low versus high transaction costs. a and d. One party is annoyed, so the injuring party can probably work something out with the injured party. The neighbor can chip in half the cost of getting the shrub removed, and the fishery can pay for the coal-fired plant to cool off the water first. Or, if the fishery has the right to cool water, then the power plant can pay for the right to heat the river—it might even pay the fishery to shut down completely. b and c. It’s too hard to negotiate with thousands of lake dwellers or dozens of neighbors. The few neighbors who care most probably can’t come up with enough money to convince me to clean up my yard—though every once in a while it might work out. 7. With electricity, we saw that it was important to tax the pollutant rather than the final product itself. In the following cases, will the proposed taxes actually hit at the source of the external cost, or will they only land an inefficient glancing blow? What kind of tax might be better? a. Gas-guzzling cars create more pollution, so the government should tax big SUVs at a higher rate. b. All-night liquor stores seem to generate unruly behavior in nearby neighborhoods, so owners of all-night liquor stores should pay higher property taxes. c. Bell-bottom jeans insist on coming back every few years, and their ugliness cre¬ates external costs for all who see them. Therefore, bell-bottom jeans should be taxed heavily. d. American parents are worried about their children seeing too much profanity on television. Congress decides to tax TV shows based on the number of profane words used on the shows. Solution 7. a. It’s possible for SUVs to be fuel-efficient. They could run on electricity alone, they could be hybrids, or they could run on hydrogen fuel cells charged by nuclear power plants. An extra tax on all big SUVs would discourage people from driving these cars. Moreover, it’s not just miles-per-gallon that matters but how far people drive. An SUV used occasionally is less polluting than a car driven many thousands of miles a year in congested traffic. A tax on gasoline would hit at the source of the problem more directly, and a tax on carbon emissions from all sources would be better yet. b. This sounds like the best one can hope for. You could imagine fining the unruly drunks, but police can already go after them for being drunk and disorderly. The transaction costs of finding and fining the drunks sounds extremely high. It’s probably better to discourage more liquor stores. c. Yes. This reasoning is flawless. The bell bottoms themselves are the problem. But what is less clear is whether people who wear bell bottoms should be taxed or whether they should be paid not to wear them. The latter case might be more just, since most people think that people have a right to commit fashion crimes no matter how heinous, but then everyone might try to claim the subsidy. d. A tax would discourage profanity but this would harm adults who like to watch realistic, “gritty” shows. The government only needs to tax (or fine, the same thing) the shows that are on when children watch TV. There’s little need to tax late-night profanity, since few children are up at those hours. Even better is the V-chip, which lets parents limit the type of television shows that children watch without limiting the types of shows that are produced. This chip allows individual families—especially parents—to choose what is acceptable or permitted within their households, rather than allowing Congress or some other authority to decide what is best for everyone. 8. When the government expands the number of pollution allowances, does that increase the cost of polluting or cut it? What about when the number of pollution allowances is cut back? Solution 8. Pollution allowances work just like a supply curve: If the government creates more of them, supply shifts out, so demanders bid down the price of an allowance, which reduces the marginal cost of polluting. Conversely, a smaller supply increases the price of an allowance, which increases the price of polluting. 9. Maxicon is opening a new coal-fired power plant, but the government wants to keep pollution down. a. Based on what we’ve seen in this chapter, which way is a more efficient way to reduce pollution: commanding Maxicon to use one particular air-scrubbing technology that will reduce pollution by 25% or commanding Maxicon to re¬duce pollution by 25%? b. If a corrupt government just grants Maxicon all of the (tradable) pollution permits in the entire nation (even though there are many energy companies), does this guarantee that Maxicon will engage in an enormous amount of pollution? Why or why not? Solution 9. a. It’s better to command a low level of pollution than a particular method to reduce pollution. Maxicon could at least look around for a more efficient way to hold pollution down. One size rarely fits all, especially in a technology-driven field like energy. One issue, however, is that if the government commands Maxicon to reduce pollution by 25%, they will need some method of monitor¬ing Maxicon’s pollution output. b. If the permits are tradable, other companies might bid up the price of the permits so high that Maxicon would rather cut back on polluting itself and sell the permits rather than hold on to the permits. The high permit price would convince Maxicon to sell some of its right to pollute. In other words, a benefit of tradable permits is that they will tend to flow to the high demanders (those with the highest costs of reducing pollution). Thinking and Problem Solving 10. When someone is sick, the patient’s decision to take an antibiotic imposes costs on others—it helps bacteria evolve resistance faster. But it also gives free benefits to others: It may slow down the spread of infectious disease the same way that vaccinations do. Thus, antibiotics can create external costs as well as external benefits. In theory, these could cancel each other out, so that just the right amount of antibiotics is being used. But economists think that, on balance, there is overuse of antibiotics, not underuse. Why? (Hint: Think on the margin!) Solution 10. Let’s compare the external costs and external benefits of adding a little bit more antibiotic use on top of the amount that patients would choose anyway. If most people with serious infections would be prescribed antibiotics anyway, then on the margin the external benefit of more antibiotic use will be small. On the other hand, the external cost may be large. Imagine, for example, that antibiotics were free. Then people will use them until the private marginal benefits are zero. At this point the external benefits would be zero as well (if the antibiotics aren’t doing anything to reduce your infection then they won’t stop the spread of the disease either). On the other hand, with so much private use, the external costs at this point would be very large. Since antibiotics are relatively cheap, economists think the external costs outweigh the external benefits. And, of course, many infections for which antibiotics are prescribed do not pose a risk to others. 11. A flu shot typically costs about $25–$50 but some firms offer their employees free flu shots. Why might a firm prefer to offer its employees free flu shots if the alternative is an equally costly wage increase? Solution 11. Two reasons. First, the firm doesn’t want to lose workers because of sick days: Fewer workers mean less productivity. And the company hates losing work time because of illness, especially if the workers are salary workers (so the company has to pay them whether or not they show up). Second, and more important for this chapter, to the extent that flu spreads from person to person within a firm, the flu shot is worth more to the firm than to the employee. A flu shot given to one employee, for example, may prevent two employees from getting the flu! Thus, the firm internalizes more of the externality than does the employee. 12. “The environment is priceless.” What evidence do you have that this statement is incorrect? Solution 12. This was a major theme in the chapter: Polluting the environment has a very real cost, but it’s not an infinite cost, at least according to the way most people see things. For example, you probably don’t clean up every piece of litter you see and you certainly don’t spend all your time cleaning up trash along the highway. Even if a benevolent social planner came along to design a society that took everyone’s needs into account, he or she would likely design a society that had some pollution that hurt the environment. Eliminating all pollution would require shrinking the number of humans and the quality of human lives to an unacceptable degree. This question, like the entire chapter, reminds us about the importance of measuring trade-offs accurately. 13. Cultural influences often create externalities, for good and ill. A happy movie might make people smile more, which improves the lives of people who don’t see the movie. A new fashion trend for tight-fitting clothing might hurt the body image of people who think they won’t look good in the new trendy clothing. Let’s consider the market for one cultural good that unrealistically raises expectations about the opposite sex: the romance novel. In romance novels, men are dangerous yet safe, they are wealthy yet never at work, they ride high-speed motor¬cycles yet never get in terrible accidents, they look fantastic even though they never waste endless hours at the gym, and so on. (Of course, advertising that focuses on sexy female models may also unrealistically raise expectations about the opposite sex, so feel free to change our example as you see best.) a. Consider the following market. Romance novels impose an external cost on men, who have to try to live up to these unrealistic expectations. Illustrate the effect of this external cost in the figure. b. Illustrate in the figure the deadweight loss from the externality, before a tax or other solution is imposed. c. If the government decides to compensate for the externality by putting a tax on romance novels, should the tax be high enough to stop everyone from reading the novels? Why or why not? d. Show graphically how big the tax should be per novel. e. As long as the government spends the money efficiently, does it matter what the government spends the money from the “romance novel tax” on? In other words, could the government just use the money to pay for necessary roads and bridges, or does it need to spend the money to fix the harmful social effects of romance novels? Solution 13. a. and b. See following figure. The shaded area is the deadweight loss: It represents novels with a social cost that was higher than the private cost. c. No, as the figure shows, there should still be some romance novels: As long as there aren’t too many romance novels, the benefit to the readers outweighs the cost to the men. d. See the following figure: e. This is a point that students sometimes overlook. When a tax is reducing the harm from an externality, it doesn’t matter how the government spends the money, as long as it’s spending it efficiently. It doesn’t need to spend the tax dollars on projects directly related to the problem at hand. It can use the money to pay for food stamps or college aid or tax cuts for the rich. As long as some separate argument can show that it’s efficient to spend the money that way, the theory of externalities has nothing to say on the matter. 14. Green Pastures Apartments wants to build a playground to increase demand for its larger-sized apartments but is worried that it will be overcrowded with tenants from the Still Waters Mobile Estates and Twin Pines Townhomes developments nearby. a. What type of externality is the playground: external cost or external benefit? b. What type of compromise might Green Pastures be able to make with Still Waters and Twin Pines so that all three developments will benefit from the playground? More than one answer is possible, but give just one based on reasoning from this chapter. Solution 14. a. External benefit. It will benefit people living in other nearby complexes. b. Here are two possible ideas: The three complexes could agree to share in the costs of the playground. Or Green Pastures could put a fence around the playground, letting in all Green Pastures residents but only the Estates and Townhome residents who paid a small fee. Quite a few parks and recreational areas charge lower fees for residents than nonresidents. 15. In Chapter 6, we said that taxes create deadweight losses. When we tax goods with external costs, should we worry about deadweight losses? Why or why not? Solution 15. No. When governments tax external costs, they are preventing transactions that ought to be prevented. By contrast, when no externalities are present, every trans¬action that is deterred by a tax is a transaction that creates consumer or producer surplus. So losing those transactions means losing valuable consumer or producer surplus. Note, however, that if a tax on an external cost reduces the quantity traded below the efficient quantity because the tax is greater than the externality, then it will create a deadweight loss. 16. Economists have found that increasing the proportion of girls in primary and secondary schools leads to significant improvement in students’ cognitive outcomes (Victor Lavy and Analia Schlosser. 2007. Mechanisms and impacts of gender peer effects at school, NBER Working Paper 13292). One key channel seems to be that on average boys create more trouble in class, which makes it harder for every¬one to learn. In newspaper English, we’d say that “boys are a tax on every child’s education.” a. Using the tools of this chapter, do girls in a classroom provide external costs or benefits? What about boys? b. Just based on this study, if you are a parent of a boy, would you rather your son be in a class with mostly boys or mostly girls? What if you are the parent of a girl? c. Who should be taxed in this situation? Can you see any problems implementing this tax? Solution 16. a. Girls provide neither external costs nor external benefits. Boys provide an exter¬nal cost. b. Either way, whether we have a boy or a girl, we want them in a class with mostly girls, so that he or she can learn more. c. External costs should be taxed, so in this case the standard economic prescription is to tax boys in order to reduce the number of boys in classrooms. Of course, that’s a problem since we want all children to be educated and parents aren’t likely to appreciate boy taxes. Alternative practices would make classes with a large proportion of boys be smaller classes or subsidize girls going to school to increase their numbers in the classroom. More generally, there are values other than maximizing social surplus, such as respecting individual rights or treating people equally, and we might have to sacrifice efficiency for these other values on occasion. See Chapter 20 for more on this topic. 17. In the example of honeybees, we said that the farmers pay the beekeepers for pol¬lination services. But why don’t the beekeepers pay the fruit farmers? After all, the beekeepers need the fruit farmers to make honey, so why does the payment go one way and not the other? (Hint: What if the honey produced by some fruits and veg¬etables, such as almonds, is bitter?) Solution 17. Start from a situation where beekeepers do not pay farmers and farmers do not pay beekeepers. Each group creates an external benefit for the other but which group is willing to pay more for additional services? It could go either way but in practice it appears that the farmers are willing to pay more for additional pollination than beekeepers are willing to pay for additional fruit farms. But if bees produced gold or diamonds instead of honey, beekeepers would probably end up paying the fruit farmers. 18. A government is deciding between command and control solutions versus tax and subsidy solutions to solve an externality problem. In each case, explain why you think one is better, using arguments from the chapter. a. Suppose that whales are threatened with extinction because a large number of people like to eat whale meat. Governments are torn between banning all whaling except for certain religious ceremonies and heavily taxing all whale meat. Assume that only a few countries in the world consume whale meat, and that they have fairly efficient governments. b. Fires create external costs because they spread from one building to another. Should governments encourage subsidies to install sprinkler systems or should they just mandate that everyone have sprinklers? c. Pets who procreate can create external costs due to problems with stray animals. Strays are extremely common on the streets of poor countries. Sterilization can solve the problem, but is a tax/subsidy or command and control a better method to encourage sterilization? Does the best solution depend on the sex of the animal? Solution 18. a. Command and control might work best here. If the tax is set too low, then whales may become extinct and there is no turning back from that result. Banning the eating of whale meat could inefficiently reduce whale meat consumption, creating a deadweight loss, but that loss will probably be small and we can change the law as whales recover. Notice that if extinction was not likely, then a tax would probably be better, so as whale populations recover it would then make sense to switch from a ban to a tax. b. The cost and benefit of sprinklers vary greatly, depending on the building (apartment, house, factory, art gallery, and so on) and location (how close are the neighbors?). A command and control approach would likely create a lot of waste. A subsidy allows for more flexibility—even better would be a subsidy that was larger in more densely populated areas such as cities. c. This is the most ambiguous of the three. People who own male pets probably don’t pay the cost of creating new pets so subsidies to male pet owners for neutering (or a tax on non-neutered male animals) might have to be large to encourage them to sterilize their pets. Notice also that one male pet can create a lot of strays. It may be better to use command and control for people who own male animals. Male pets are like smallpox. With females, the story is different. People pay a lot of the costs of pregnant females themselves already, since they have to put up with a pregnant animal for a few months and because the beloved animal could die in childbirth and because it may be emotionally painful for owners to give up the new baby animals. Further, one female can give birth to only a limited number of offspring at a time. Sterilizing female pets is like getting the flu shot; subsidies might work better. Challenges 19. Before Coase presented his theorem, economists who wanted economic efficiency argued that people should be responsible for the damage they do—they should pay for the social costs of their actions. This advice fits nicely with notions of personal responsibility. Explain how the Coase theorem refutes this older argument. Solution 19. Coase explained that the polluter and the pollutee are both responsible for creating the externality. If we keep this in mind, we can see that sometimes it will be cheaper to eliminate the problem by reducing the pollution directly (the traditional approach) but sometimes it will be cheaper to eliminate the problem by having the pollutee move or adjust in some other way. If transaction costs are low, bargaining will reach the efficient solution, whatever it is. But if transactions costs are high and we need a political solution, it can still be helpful to remember that the problem is jointly created—thus, Coase’s insight is of general importance. 20. A government is torn between selling annual pollution allowances and setting an annual pollution tax. Unlike in the messy real world, this government is quite certain that it can achieve the same price and quantity either way. It wants to choose the method that will pull in more government tax revenue. Is selling allowances better for revenues or is setting a pollution tax better, or will both raise exactly the same amount of revenue? (Hint: Recall that tax revenue is a rectangle. Compare the size of the tax rectangle in Figure 10.5 with the most someone will pay for the right to pollute at the efficient level.) Solution 20. Revenues will be the same. If the auction is competitive, the price of each permit will equal the difference between the marginal cost of producing one more unit of the polluting product at the efficient quantity (read off the supply curve) and the selling price of one more unit of the product at the efficient quantity (read off the social cost curve). If the permit price were any higher, too little of the product would be produced; if the permit price were any lower, too much. This gap is the same as the tax rectangle (formed from the tax wedge) in Figure 10.5. The figure below illustrates. The permit price at the efficient quantity will be just equal to the tax when the tax is set at the efficient level. As a result, tax revenues and permit revenues are identical. 21. Palm Springs, California, was once the playground of the rich and famous—for example, the town has a Frank Sinatra Drive, a Bob Hope Drive, and a Bing Crosby Drive. The city once had a law against building any structure that could cast a shadow on anyone else’s property between 9 am and 3 pm. (Source: Armen Alchian and William Allen. 1964. University Economics, Belmont, CA: Wadsworth). What are some alternatives to this command and control solution? Are they any better than this approach? Solution 21. One could just put an extra tax on shadow-casting buildings. This would deter people from building such buildings. But it would be hard to find out how much each person in Palm Springs hates having shadows on their property. Some people wouldn’t mind much, while others wouldn’t allow it for all the wealth of Croesus. An easier solution would be the Coasian one. Just let people have a right to “no shadow,” and let them sell that right to their neighbors if their neighbors will pay enough. 22. At indoor shopping malls, who makes sure that no business plays music too loud, that no store is closed too often, and that the common areas aren’t polluted with garbage? What incentive does this party have to prevent these externalities? Does your answer help explain why parents are quite happy to let their preteen and teen children stroll the malls? Solution 22. The mall’s management does all of this. They set rules, acting as a private government. They “internalize” the cost of all of these bad behaviors because a well-run mall can charge higher rents. Thus, malls, especially in affluent suburbs, have become relatively safe havens with their own private police and cleaning services. Solution Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766
Download
Close
Close
