METU

Department of Economics
Econ 210: Principles of Economics
All Sections
Spring 2025-2026

Externalities are the effects of a decision on a third party that are not taken into
account by the decision- maker.
Negative externalities occur when the effects are detrimental to others.
Example: Second-hand smoke and carbon monoxide emissions
Positive externalities occur when the effects are beneficial to others.
Example: Education
A publ c good s nonexclus ve and nonr val

• Nonexclus ve: No one can be excluded from ts benef ts.

• Nonr val: Consumpt on by one does not preclude consumpt on by others.
Many goods prov ded by the government have publ c- good aspects to them.
There are no pure publ c goods; nat onal defense s the closest example.

A pr vate good s only suppl ed to the nd v dual who bought t. Once a pure
publ c good s suppl ed to one nd v dual, t s s multaneously suppl ed to all.

To create market demand:

• Pr vate goods: sum demand curves hor zontally
• Publ c goods: sum demand curves vert cally

A common resource s nonexclus ve and r val.

The tragedy of the commons refers to the overexplo tat on of a common
good by nd v dual, rat onal actors.

An adverse select on problem s a problem that occurs when buyers and

sellers have d fferent amounts of nformat on about the good for sale.
A moral hazard problem s a problem that ar ses when people don t have to
bear the negat ve consequences of the r act ons.

The three types of market fa lure covered (external t es, publ c goods, and
nformat onal problems) show that all real-world markets n some way fa l.
Market fa lures should not automat cally call for government ntervent on
because governments fa l, too.
METU
Department of Economics
Econ 210: Principles of Economics
All Sections
Spring 2023-2024

Problem Set 5

Part A: Short Questions

Q1: Define the following terms:

a) Externality: A benefit or cost that affects someone who is not directly

involved in the production or consumption of a good or service.
b) Private cost: The cost borne by the producer of a good or service.
c) Social Cost: The total cost of producing a good or service, including both
the private cost and any external cost.
d) Private benefit: The benefit received by the consumer of a good or
service.
e) Social Benefit: The total benefit from consuming a good or service,
including both the private benefit and any external benefit.
f) Market Failure: A situation in which the market fails to produce the
efficient level of output.
g) Property Rights: The rights individuals or businesses have to the
exclusive use of their property, including the right to buy or sell it.
h) Rivalry: The situation that occurs when one person’s consumption of a
unit of a good means no one else can consume it.
i) Excludability: The situation in which anyone who does not pay for a good
cannot consume it.
Part B: Problems

Q1: When you drive a car, you generate several negative externalities: You
cause some additional air pollution, you increase the chances that other
drivers will have an accident, and you cause some additional congestion on
roads, causing other drivers to spend more time in traffic. Ian Parry of the
International Monetary Fund and Kenneth Small of the University of
California, Irvine, have estimated that these external costs amount to about
$1.00 per gallon of gasoline. Taxes on gasoline vary by state and currently
average about $0.50 per gallon.

a) Draw a graph showing the gasoline market. Indicate the efficient

equilibrium quantity and the market equilibrium quantity.
b) Given the information in this problem, if the government wanted to bring
about the efficient level of gasoline production, how large a tax should the
government impose on gasoline? Will the price consumers pay for gasoline
rise by the full amount of the tax? Briefly explain using your graph from part
(a).
Solution:

a) In this case, the tax is levied on the consumption of gasoline rather than
on its production, so your graph should show the demand curve
representing marginal social benefit being below the demand curve
showing marginal private benefit. (Of course, the government actually
collects the tax from sellers rather than from consumers, but we get the
same result whether the government imposes a tax on the buyers of a good
or on the sellers.) Your graph should also show the market equilibrium
quantity of gasoline, QMarket, being greater than the efficient equilibrium
quantity, QEfficient.
b) If Parry and Small are correct that the external cost from consuming
gasoline is $1.00 per gallon, then the tax per gallon should be raised from
$0.50 to $1.00 per gallon. You should show the effect of the increase in the
tax on your graph.

The graph shows that although the tax shifts down the demand curve for
gasoline, the price consumers pay increases by less than the amount of the
tax. To see this, note that the price consumers pay rises from PMarket to P,
which is smaller than the per gallon tax, which equals the vertical distance
between PEfficient and P.
Q7:

a) How a negative externality in production reduces economic efficiency?

How can the government deal with this externality? Explain by using
graphs.
b) How a positive externality in consumption reduces economic efficiency?

How can the government deal with this externality? Explain by using
graphs.

Solution:

a)

Typically, economists assume that the producer of a good or service must

bear all the costs of production. But we now know that this assumption is
not always true. For instance, in the production of electricity, private costs
are borne by the utility, but some external costs of pollution like cost of acid
rain are borne by people who are not customers of the utility. The social
cost of producing electricity is the sum of the private cost plus the external
cost. The graph above shows the effect on the market for electricity of a
negative externality in production. S1 is the market supply curve and
represents only the private costs that utilities have to bear in generating
electricity. Firms will supply an additional unit of a good or service only if
they receive a price equal to the additional cost of producing that unit, so a
supply curve represents the marginal cost of producing a good or service. If
utilities also had to bear the cost of pollution, the supply curve would be S2,
which represents the true marginal social cost of generating electricity. The
equilibrium with price PEfficient and quantity QEfficient is efficient. The equilibrium
with price PMarket and quantity QMarket is not efficient. To see why, remember
that an equilibrium is economically efficient if economic surplus—which is
the sum of consumer surplus plus producer surplus—is at a maximum.
When economic surplus is at a maximum, the net benefit to society from
the production of the good or service is at a maximum. With an equilibrium
quantity of QEfficient, economic surplus is at a maximum, and the equilibrium
is efficient. But, with an equilibrium quantity of QMarket, economic surplus is
reduced by the deadweight loss—equal to the yellow triangle in the graph—
and the equilibrium is not efficient. The deadweight loss occurs because
the supply curve is above the demand curve for the production of the units
of electricity between QEfficient and QMarket. That is, the additional cost—
including the external cost—of producing these units is greater than the
marginal benefit to consumers, as represented by the demand curve. In
other words, because of the cost of the pollution, economic efficiency would
be improved if less electricity were produced. We can conclude the
following: When there is a negative externality in producing a good or
service, too much of the good or service will be produced at market
equilibrium. Briefly, because utilities do not bear the cost of acid rain, they
produce electricity beyond the economically efficient level. Supply curve S1
represents just the marginal private cost that the utility has to pay. Supply
curve S2 represents the marginal social cost, which includes the costs to
those affected by acid rain. If the supply curve were S2 rather than S1,
market equilibrium would occur at price PEfficient and quantity QEfficient, the
economically efficient level of output. But, when the supply curve is S1, the
market equilibrium occurs at price PMarket and quantity QMarket where there is
a deadweight loss equal to the area of the yellow triangle. Because of the
deadweight loss, this equilibrium is not efficient.

To deal with a negative externality in production, the government should

impose a tax equal to the cost of the externality. The effect of such a tax is
shown in the graph above. By imposing a tax on the production of electricity
equal to the cost of acid rain, the government will cause electric utilities to
internalize the externality. As a consequence, the cost of the acid rain will
become a private cost borne by the utilities, and the supply curve for
electricity will shift from S1 to S2. The result will be a decrease in the
equilibrium output of electricity from QMarket to the efficient level, QEfficient. The
price consumers pay for electricity will rise from PMarket—which does not
include the cost of acid rain—to PEfficient—which does include the cost.
Producers will receive a price P, which is equal to PEfficient minus the amount
of the tax.

b)

We have seen that a negative externality interferes with achieving

economic efficiency. The same holds true for a positive externality. In
earlier chapters, we assumed that the demand curve represents all the
benefits that come from consuming a good. But, for instance, a college
education generates benefits that are not captured by the student receiving
the education and so are not included in the market demand curve for
college educations. The graph above shows the effect of a positive
externality in consumption on the market for college educations. If students
receiving a college education could capture all its benefits, the demand
curve would be D2, which represents the marginal social benefits. The
actual demand curve is D1, however, which represents only the marginal
private benefits received by students. The efficient equilibrium would occur
at price PEfficient and quantity QEfficient. At this equilibrium, economic surplus is
maximized. The market equilibrium, at price PMarket and quantity QMarket, will
not be efficient because the demand curve is above the supply curve for
production of the units between QMarket and QEfficient. That is, the marginal
benefit—including the external benefit—of producing these units is greater
than the marginal cost. As a result, there is a deadweight loss equal to the
area of the yellow triangle. Because of the positive externality, economic
efficiency would be improved if more college educations were produced.
We can conclude the following: When there is a positive externality in
consuming a good or service, too little of the good or service will be
produced at market equilibrium. Briefly, people who do not consume
college educations can still benefit from them. As a result, the
marginal social benefit from a college education is greater than the
marginal private benefit to college students. Because only the marginal
private benefit is represented in the market demand curve D1, the
quantity of college educations produced, QMarket, is too low. If the market
demand curve were D2 instead of D1, the level of college educations
produced would be QEfficient, which is the efficient level. At the market
equilibrium of QMarket, there is a deadweight loss equal to the area of the
yellow triangle.
The government can deal with a positive externality in consumption by
giving consumers a subsidy, or payment, equal to the value of the
externality. The effect of such a subsidy is shown in the graph above.
By paying college students a subsidy equal to the external benefit from a
college education, the government will cause students to internalize the
externality. That is, the external benefit from a college education will
become a private benefit received by college students, and the demand
curve for college educations will shift from D1 to D2. The equilibrium number
of college educations supplied will increase from Qmarket to the efficient level,
QEfficient. Producers receive the price PEfficient, while consumers pay the price
P, which is equal to PEfficient minus the amount of the subsidy. In fact, the
government does heavily subsidize college educations. All states have
government- operated universities that charge tuitions well below the cost
of providing the education. The state and federal governments also provide
students with grants and low-interest loans that subsidize college
educations. The economic justification for these programs is that college
educations provide an external benefit to society. The government can deal
with a positive externality in consumption by giving consumers a subsidy,
or payment, equal to the value of the externality. The effect of such a
subsidy is shown in the graph above. By paying college students a subsidy
equal to the external benefit from a college education, the government will
cause students to internalize the externality. That is, the external benefit
from a college education will become a private benefit received by college
students, and the demand curve for college educations will shift from D1 to
D2. The equilibrium number of college educations supplied will increase
from Qmarket to the efficient level, QEfficient. Producers receive the price PEfficient,
while consumers pay the price P, which is equal to PEfficient minus the
amount of the subsidy. In fact, the government does heavily subsidize
college educations. All states have government- operated universities that
charge tuitions well below the cost of providing the education. The state
and federal governments also provide students with grants and low-interest
loans that subsidize college educations. The economic justification for
these programs is that college educations provide an external benefit to
society.
Part C: Multiple Choice Questions

Q1: What do economists mean when they say there is "market failure"?
a. Business has introduced a product that consumers do not want.
b. Free markets have led to excessive profits.
c. Markets have surpluses or shortages so that government rationing is
necessary.
d. Free markets yield results that economists do not consider socially
optimal.

Q2: All of the following are considered sources of market failure except:
a. public goods.
b. imperfect information.
c. profit-maximizing behavior.
d. externalities.

Q3: The best example of a positive externality is:

a. roller coaster rides.
b. pollution.
c. alcoholic beverages.
d. education.

Q4: Alex is playing his music at full volume in his dorm room. The other
people living on his floor find this to be nuisance, but Alex does not care.
Alex's music playing is an example of a:
a. negative externality.
b. positive externality.
c. normative externality.
d. Pareto externality
Q5: Alex is playing his music at full volume in his dorm room. The other
people living on his floor are enjoying his music, but Alex does not know or
care. Alex's music playing is an example of a:
a. negative externality.
b. positive externality.
c. normative externality.
d. Pareto externality.

Q6: Public television periodically runs pledge drives to raise money. Only a
small percentage of the people who benefit from public television are willing
to pay. What do economists call the people who do not pay?
a. Free riders
b. The excludable
c. Adverse selectors
d. Thieves

Refer to the graph above for the questions 7-10

Q7: The above figure shows the market for steel ingots. If the market is
competitive, then to achieve the socially optimal level of pollution, the
government can:
a. institute a specific tax equal to area b.
b. institute a specific tax of $50.
c. institute a specific tax of $25.
d. outlaw the production of steel.

Q8: The above figure shows the market for steel ingots. If the market is
competitive, then the deadweight loss to society is:
a. a
b. b
c. c
d. zero

Q9: The above figure shows the market for steel ingots. The optimal
quantity of pollution
a. is 100 units.
b. is 50 units.
c. is 0 units.
d. cannot be determined from the information provided.

Q10: The above figure shows the market for steel ingots. If the market is
competitive, then
a. the socially optimal quantity of steel is zero.
b. the socially optimal quantity of steel of 50 units is produced.
c. more than the socially optimal quantity of 50 units of steel is produced.
d. the socially optimal quantity of steel of 100 units is produced.
Q11: The exclusive privilege to use an asset is called a(n)
a. property privilege.
b. right to work privilege.
c. property right.
d. exclusive use agreement

Q12: Positive externalities are created when

a. farmers spray pesticide in their fields and it washes into the local river
after the first rainstorm.
b. you purchase the "Mona Lisa" and lock it in a vault.
c. your neighbor plants beautiful trees and flowers in her yard.
d. other consumers reduce their demand for coffee and price thereby
declines.

Q13: In the presence of no externalities,

a. social marginal cost and private marginal cost cannot be compared.
b. social marginal cost is less than private marginal cost.
c. social marginal cost exceeds private marginal cost.
d. social marginal cost equals private marginal cost.

Q14: If a production process creates pollution, a competitive market

produces excessive pollution because
a. private marginal cost of pollution exceeds its social marginal cost.
b. social marginal cost of pollution exceeds its private marginal cost.
c. zero pollution is optimal.
d. the marginal benefit of pollution to the firm is zero

Q15: If a production process generates pollution, then a competitive market

will
a. produce zero output.
b. produce more of the good than is socially optimal.
c. produce the socially optimal quantity of that good.
d. produce less of the good than is socially optimal.
Q16: In the presence of a negative externality, a specific tax can achieve
the social optimum because
a. it internalizes the external cost.
b. the price of the good rises by the full amount of the tax.
c. output is reduced to zero as a result.
d. it directly charges the producer for polluting.

Q17: The existence of externalities is due mainly to the fact that

a. pollution is not a serious problem.
b. the optimal level of pollution is zero.
c. monopolies tend to produce too little of a good anyway.
d. property rights are poorly defined.

Q18: If children go to school and become productive members of society,

a. a positive externality is created by the schools.
b. an externality is created that may be positive or negative.
c. a negative externality is created by the schools.
d. no externality is created by the schools.

Q19: If a production process creates pollution, a competitive market

produces excessive pollution because
a. the firms place too high a price on society's cost of inflation.
b. the firms do not include the social cost of the pollution in their profit-
maximizing decisions.
c. zero pollution is optimal.
d. people are not injured by the pollution.

Q20: In general, an externality is created when

a. When firms have to pay for pollution the environment.
b. When the government subsidizes education.
c. when firms produce a product of low quality and consumers don't like it.
d. people are affected (other than by price) by a transaction which they
were not part of.