Problem Set 2 - Due on Jan 22nd

1 Externalities

Problem 1
< Problem Set 1 > - Answers
Answer questions (a) and (b) for each of the following four examples:

1. Smoking by individuals;

2. Toxic waste production by firms;

3. R&D by a high-tech firm; and

4. Individual vaccination against communicable illness.

(a) Is there an externality? If so, describe it, including references to whether it is positive or
negative, and whether it is a consumption or production externality.

• Smoking by individuals generates negative consumption externalities by generating sec-

ondhand smoke.
• Toxic waste production by firms generates negative production externalities because the
harm (or toxicity) is a by-product of the firms production.
• Research and development by a high-tech firm generates positive production externalities
when the results of that research expand the knowledge and productivity of all firms.
• Individual vaccinations generate positive consumption externalities by reducing the num-
ber of people in the population who have a communicable illness. When the number of
infected people is reduced, the probability of catching the illness is reduced for everyone.

(b) If there is an externality, does it seem likely that private markets will arise that allow this
externality to be internalized? Why or why not?

• The problem of secondhand smoke is unlikely to be solved by private markets. Smoke

is widely dispersed, making it difficult to account for and negotiate with every a↵ected
person. In addition, the value of smoking a single cigarette is likely to be small relative
to the transaction costs of negotiating the solution.
• The problem of toxic waste might be amenable to a private market solution. The gen-
erator can be easily identified, and a finite number of people in a localized town or
community are likely to be a↵ected. If local residents have property rights to restrict
toxic waste production, it should be relatively easy for a firm which places a high value
on the ability to produce toxic waste to compensate them in exchange for the right to
pollute.

• A firm that purchases a patent or license is in some sense using a market mechanism
to partially compensate the researching firm for its contribution to the knowledge base.
However, it is hard to completely restrict or contain the flow of information. It is
unlikely that a private market for intellectual property could completely internalize this
externality.
• Private compensation for the reduced risk of exposure associated with vaccinations seems
unlikely. It would be virtually impossible to identify the beneficiaries of increased vac-
cination rates.

Problem 2

Brookhaven has two regions. In Stony Brook, the marginal benefit associated with pollution
cleanup is M B = 300 10Q, while in Port Je↵erson, the marginal benefit associated with pol-
lution cleanup is M B = 200 4Q. Suppose that the marginal cost of cleanup is constant at $12