University of Toronto ECO101: Introductory Economics

Department of Economics Robert Gazzale, PhD

Solved Problems: Externalities

Version With Solutions

1. Assume market demand characterized by M W T P (Q) = 42 − Q and market supply charac-

terized by M C(Q) = 6 + 2Q. Further, assume a negative externality equal to $6 per unit
transacted.1

(a) Solve for the equilibrium quantity transacted (Q∗ ) in a market without interventions as
well as the efficient quantity Qeffic .

Suggested Solution: In the equilibrium of the market without interventions, the

quantity will equate private benefits and costs:

M P B(Q∗ ) = M P C(Q∗ )
42 − Q∗ = 6 + 2Q∗
36 = 3Q∗
Q∗ = 12

The efficient quantity equates marginal societal benefits and costs. For the negative
externality, we can either incorporate the negative externality by subtracting from
private benefits or incorporate it by adding it to private costs. Let’s go the latter route:

M SB(Qeffic ) = M SC(Qeffic )
M P B(Qeffic ) = M P C(Qeffic ) + M EC(Qeffic )
42 − Qeffic = 6 + 2Qeffic + 6
30 = 3Qeffic
Qeffic = 10

(b) In an appropriately labelled graph, clearly identify the deadweight loss resulting from a
market without interventions.
Suggested Solution: See Figure 1
1
When the final rolls around, you should be able to do this problem in your sleep.

20171213: Page 1 Externalities: Problems: Solutions

University of Toronto ECO101: Introductory Economics
Department of Economics Robert Gazzale, PhD

Figure 1: Your standard negative externality.

(c) Calculate the deadweight loss resulting from a market without interventions.
Suggested Solution: The height of the DWL triangle is 6 (the size of the externality
at Q∗ ) and the base of the externality is 2 (the 2 extra transactions from Qeffic = 10 to
Q∗ = 12). Deadweight loss is thus 6.
(d) Solve for the tax that maximizes total surplus.
Suggested Solution: The quick way: if we have a negative externality whose cost is
constant, then the tax must be equal that constant (6 in this case.)
The thought process. We want to make sure we stop at Qeffic = 10. At Qeffic = 10, the dif-
ference between private costs (M P C(Qeffic ) = 26) and private benefits (M P B(Qeffic ) =
32) is M EC(Qeffic ) = 6. Therefore, if we make the parties pay M EC(Qeffic ) = 6, private
costs will exactly equal private benefits and there will be no further transactions.
(e) Explain how a tax increases total surplus despite (by definition) decreasing both con-
sumer and producer surplus.
Suggested Solution: When transactions 10 through 12 happened, they happened
because they were privately beneficial. So, when these transactions no longer happen,
the associated buyers and sellers must be worse off.
However, the “problem” with these transactions is that the combined surplus each cre-
ated for buyer and seller was less than the societal cost of these transactions. Thus the
benefit of these transactions not happening (not incurring the relatively large societal
cost) is greater than the cost of these transactions not happening (losing the relatively
smaller private benefit).

2. Assume market demand characterized by M W T P (Q) = 42 − Q and market supply charac-

terized by M C(Q) = 6 + 2Q. Further, assume a positive externality equal to $9 per unit
transacted.2

(a) Solve for the equilibrium quantity transacted (Q∗ ) in a market without interventions as
well as the efficient quantity Qeffic .

2
When the final rolls around, you should be able to do this problem in your sleep.

20171213: Page 2 Externalities: Problems: Solutions

University of Toronto ECO101: Introductory Economics
Department of Economics Robert Gazzale, PhD

Suggested Solution: In the equilibrium of the market without interventions, the

quantity will equate private benefits and costs. This should look familiar:

M P B(Q∗ ) = M P C(Q∗ )
42 − Q∗ = 6 + 2Q∗
36 = 3Q∗
Q∗ = 12

The efficient quantity equates marginal societal benefits and costs. For the positive
externality, we can either incorporate the positive externality by adding it to private
benefits or incorporate it by subtracting it from private costs. Let’s go the former route:

M SB(Qeffic ) = M SC(Qeffic )
M P B(Qeffic ) + M EB(Qeffic ) = M P C(Qeffic )
42 − Qeffic + 9 = 6 + 2Qeffic
45 = 3Qeffic
Qeffic = 15

(b) In an appropriately labelled graph, clearly identify the deadweight loss resulting from a
market without interventions.
Suggested Solution: See Figure 2

Figure 2: Your standard positive externality.

(c) Calculate the deadweight loss resulting from a market without interventions.
Suggested Solution: The height of the DWL triangle is 9 (the size of the externality
at Q∗ ) and the base of the externality is 3 (the 3 “missing” transactions from Q∗ = 12
to Qeffic = 15). Deadweight loss is thus 27 1
2 = 13 2 .

20171213: Page 3 Externalities: Problems: Solutions

University of Toronto ECO101: Introductory Economics
Department of Economics Robert Gazzale, PhD

(d) Solve for the per-unit subsidy that maximizes total surplus.3
Suggested Solution: The quick way: if we have a positive externality whose benefit
is constant, then the subsidy must be equal that constant (9 in this case.)
The thought process. We want to make sure we do not stop at Q∗ = 12, but rather con-
tinue on to Qeffic = 15. At Qeffic = 15, the difference between private costs (M P C(Qeffic ) =
36) and private benefits (M P B(Qeffic ) = 27) is M EB(Qeffic ) = 9. Therefore, if we give
the parties pay M EB(Qeffic ) = $9, private costs will exactly equal private benefits for
the 15th unit.

3. Assume a perfectly competitive market where consumption imposes an external cost whose
total size increases with quantity transacted. As we go from a market without government
intervention to one where we implement the optimal Pigovian tax, what happens to each of
the following items?

• Producer Surplus
• Consumer Surplus
• Government Surplus
• Total external cost
• Total Surplus

Suggested Solution:

Producer surplus must decrease as we are implementing a tax (selling fewer units and
receiving less for each unit).
Consumer surplus must decrease as we are implementing a tax (buying fewer units and
paying more for each unit).
Government surplus must increase as we go from no tax to a tax.
External cost must decrease as quantity decreases.
Total surplus must increase as we go from a quantity greater than the efficient quantity to
the efficient (i.e., surplus maximizing) quantity.

4. Demand characterized by M W T P (Q) = 10 − Q2 and supply by M C(Q) = 1 + Q

4. The
consumption of this good causes marginal external cost of $3 per unit consumed.

(a) Calculate equilibrium price P ∗ and quantity Q∗ . In addition, calculate:

• Producer Surplus
• Consumer Surplus
• Government Surplus
• Total external cost
• Total Surplus
Suggested Solution: We find the equilibrium price and quantity by equating M P B(Q)
(i.e., M W T P (Q)) and M P C(Q) (i.e., M C(Q)).
3
A subsidy is like a negative tax: the government pays someone a certain amount for each unit produced.

20171213: Page 4 Externalities: Problems: Solutions

University of Toronto ECO101: Introductory Economics
Department of Economics Robert Gazzale, PhD

Q∗ Q∗
10 − =1+
2 4
3 ∗
9= Q
4
Q∗ = 12
12
P∗ = 1 + =4
4
The equilibrium is depicted in figure 3.
Producer surplus is the triangle with base equal to 12 units and height equal to $4-
$1=$3 for a total area of $18.
Consumer surplus is the triangle with base equal to 12 units and height equal to
$10-$4=$6 for a total area of $36.
Government surplus is zero.
External cost is $3 per unit times 12 units equalling $36.
Total surplus is $18+$36+$0-$36=$18.
(b) In Galen’s view of the world, the societal benefit of any item is the benefit that the con-
sumer receives minus the cost its consumption imposes. Solve for the efficient quantity
Qeffic in a manner consistent with Galen’s view of the world.
Suggested Solution: The efficient quantity equates M SB and M SC:

M SB(Qeffic ) = M SC(Qeffic )
M W T P (Qeffic ) − M EC(Qeffic ) = M C(Qeffic ) (1)
Qeffic Qeffic
10 − −3=1+
2 4
3
6 = Qeffic
4
Qeffic = 8

(c) In Mo’s view of the world, the societal cost of any item is the sum of the private and
external costs. Solve for the efficient quantity Qeffic in a manner consistent with Mo’s
view of the world.
Suggested Solution: The efficient quantity equates M SB and M SC:

M SB(Qeffic ) = M SC(Qeffic )
M W T P (Qeffic ) = M C(Qeffic ) + M EC(Qeffic ) (2)

At this point, you will notice that there is absolutely no difference between equation (1)
and equation (2). I really do not see the need to solve this, we are going to get Qeffic = 8.
Implication: In finding the efficient quantity with a negative externality, it does not
matter whether we subtract the external cost from the private benefit (and not adjust
private costs) OR add the external cost to the private cost (and not adjust the private
benefits.) Either approach yields the same benefits.

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University of Toronto ECO101: Introductory Economics
Department of Economics Robert Gazzale, PhD

(d) Explain why the 7th unit is desirable (from an efficiency perspective) while the 9th unit
is not.
Suggested Solution: In each case, an external cost of $3 is imposed. For unit 7, the
private net benefit is M W T P (7) − M C(7) = 10 − 72 − (1 + 74 = 3 34 . As this benefit is
larger than the external cost, this unit increases total surplus. For unit 9, the private
net benefit is M W T P (9) − M C(9) = 10 − 92 − (1 + 94 = 2 41 . As this benefit is smaller
than the external cost, this unit decreases total surplus.
(e) Assume the optimal Pigovian tax, payable by the sellers. Calculate equilibrium price Pt∗
and quantity Q∗t . In addition, calculate:
• Producer Surplus
• Consumer Surplus
• Government Surplus
• Total external cost
• Total Surplus
Suggested Solution: We want consumption to stop at Q = Qeffic = 8. As 8 units
are demanded when the price is M W T P (8) = 10 − 28 = 6, we want buyers to face a
price Pb = $6. As 8 units are supplied when the price is M C(8) = 1 + 84 = 3, we want
sellers to receive Ps = $3. Therefore we need a tax τ = $3. (Of course, we could have
just remembered that the optimal Pigovian tax is equal to the marginal external cost at
Qeffic . As marginal external cost is $3 for all units, the optimal tax must be $3.) The
equilibrium with tax is depicted in figure 3.
Producer surplus is the triangle with base equal to 8 units and height equal to $3-
$1=$2 for a total area of $8.
Consumer surplus is the triangle with base equal to 8 units and height equal to $10-
$6=$4 for a total area of $16.
Government surplus is $3 per unit times 8 units equalling $24.
External cost is $3 per unit times 8 units equalling $24.
Total surplus is $8+$16+$24-$24=$24.
Hey! Look at that! All of our predictions came true!
(f) Depict the following in a graph:
• M SB = M W T P
• M SC = M C + M EC
Identify the following areas:
• DW L, CS, P S, and total external cost in the market without government interven-
tion.
• CS, P S, GS and total external cost in the market after the introduction of the
optimal Pigovian tax.
• The loss in CS that is transformed into GS.
• The loss in P S that is transformed into GS.
• The loss in CS due to fewer units being transacted.
• The loss in P S due to fewer units being transacted.
• The reduction in external cost resulting from the introduction of the tax.

20171213: Page 6 Externalities: Problems: Solutions

University of Toronto ECO101: Introductory Economics
Department of Economics Robert Gazzale, PhD

Suggested Solution: See figure 3.

Figure 3: So many areas!.

• In the market without government intervention: DW L = FIJ, CS = CEJ, P S = ACJ,

and total external cost== ACIJ.
• In the market after the introduction of the optimal Pigovian tax: CS = DEF, P S = ABH,
GS = BDFH and total external cost= ACFH
• The loss in CS that is transformed into GS = CDFG.
• The loss in P S that is transformed into GS = BCGH.
• The loss in CS due to fewer units being transacted = GFJ.
• The loss in P S due to fewer units being transacted = HGJ.
• The reduction in external cost resulting from the introduction of the tax = HFIJ.

Note that the last three items give us the reduction in DW L = FIJ. For units 0 to Qeffic ,
the tax has no impact on total surplus. For these units, the tax effectively transfers surplus
from buyers and sellers to the government. The change in total surplus comes from the units
that no longer happen: Qeffic to Q∗ . Yes, both consumers and producers lose surplus on these
items (GFJ and HGJ, respectively). However, the reduction in external cost HFIJ is greater
than the sum of lost producer and consumer surplus. How much bigger? The deadweight loss
triangle DW L = FIJ!

5. Consider the implementation of a Pigovian tax to correct for a negative externality. True,
False, or Uncertain: If total tax revenues are exactly equal to the external costs, then
surplus is maximized.
Suggested Solution: False, for the Pigovian resulting in the efficient quantity, tax revenues
will only equal external costs if marginal external costs are constant . . .

6. Marginal private benefit: M W T P (Q) = 100 − Q. Marginal private cost: M P C = 20.

Marginal external cost: M EC(Q) = 10. Given the tax which results in surplus maximization,
what are total government revenues and total external costs?

20171213: Page 7 Externalities: Problems: Solutions

University of Toronto ECO101: Introductory Economics
Department of Economics Robert Gazzale, PhD

Suggested Solution: The short way: we know that in this case, government revenues will
exactly equal external costs. We know this because the optimal Pigovian tax equals that
external cost at the optimal quantity, and the external cost is $10 for all units. Thus we have
a $10 tax per unit and a $10 cost per unit.
The long way: solve for the efficient quantity:

100 − Qeffic = |20 {z

+ 10}
| {z }
MSB M SC
effic
Q = 70

We want consumption to stop at 70 units, meaning we need the consumers to face a total
per-unit cost of $30. With M P C = 20, we set the tax equal to $10. Both external cost and
tax revenue are 70 × $10 = $700

7. Marginal private benefit: M W T P (Q) = 100 − Q. Marginal private cost: M P C = 20.

Marginal external cost: M EC(Q) = Q. Given the tax which results in surplus maximization,
what are total government revenues and total external costs?
Suggested Solution: Solve for the efficient quantity:

100 − Qeffic = 20 + Qeffic

| {z } | {z }
MSB M SC
effic
2Q = 80
Qeffic = 40

We want consumption to stop at 40 units, but M W T P (40) = $60 and M C(40) = $20. If we
implement a tax of $60-$20=$40, consumption will stop at 40 units.4
So, we have 40 units transacted with a tax equal to $40, meaning GS = $1600. External
costs are the area under M EC(Q) = Q from Q = 0 to Q = 40. This area is a triangle with
base and height equal to 40, or 40×$40
2 = $800.
Why this is important. We often think of taxes on externalities as a way to compensate
the “victims” of the externality-causing action. While a government may use tax revenues
towards this end, keep the following in mind. First, the tax resulting in the optimal level
of an activity need not go to the victims. There is no surplus difference between a dollar in
Justin Trudeau’s pocket and a dollar in your pocket. Second, unless the marginal externality
is constant, the external costs and the government revenues will not be the same.

8. True, False, or Uncertain: Increasing a tax in an otherwise perfectly competitive market

decreases Total Surplus.
Suggested Solution: Uncertain. True if no externalities. May be false if initial tax less
than optimal Pigovian tax.

9. Consider an industrial process that produces a negative externality. For each of 10 firms, the
(per-year) private benefit of adopting the industrial process is given in the following table.
4
As advertised, optimal Pigovian tax is equal to the marginal external cost at the efficient quantity: M EC(Qeffic ) =
effic
Q = $40.

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University of Toronto ECO101: Introductory Economics
Department of Economics Robert Gazzale, PhD

Firm A B C D E F G H I J
Private Benefit $10 $9 $8 $7 $6 $5 $4 $3 $2 $1
On January 1, each firm decides whether or not to adopt the process for the year. Each firm
faces a private cost of $4.50 (per year) if it adopts the process. Each firm that adopts the
process causes a negative externality equal to $2.

(a) In 2020, there is no government intervention in the market. What are:

i. firm surplus generated by this industrial process;
ii. the total surplus generated by this industrial process; and
iii. the deadweight loss generated by this outcome?
Suggested Solution: In 2020, firms A through F adopt the industrial process because
for each of these firms, the private benefit is larger than the private cost. In Table 1, I
calculate the private and total surplus generated by each of these adoptions. For firm
surplus, we add up the second to last row to get $18. For total surplus, we incorporate
the external cost, and adding up the last row, we get a total surplus equal to $6. (Alter-
natively, with six firms adopting, the external cost is $12, meaning T S = $18 − $12 = 6.)
Firm A B C D E F G H I J
Private Benefit $10 $9 $8 $7 $6 $5 $4 $3 $2 $1
Societal Cost $6.50 $6.50 $6.50 $6.50 $6.50 $6.50
Private Surplus $5.50 $4.50 $3.50 $2.50 $1.50 $0.50
Total Surplus $3.50 $2.50 $1.50 $0.50 -$0.50 -$1.50

Table 1: Surplus calculations.

Efficiency requires that only those firms whose private benefit is at least as large as the
societal cost $4.50+$2.00=$6.50 adopts the process. This is satisfied only by firms A
through D. The deadweight loss is the negative surplus generated by firms E and F:
$0.50+$1.50=$2.00.
(b) In 2021, the government considers implementing a tax designed to maximize total sur-
plus. If it does so:
i. identify a per-unit tax that results in the efficient quantity;
ii. calculate the 2021 firm surplus generated by this industrial process;
iii. calculate the 2021 external cost generated by this industrial process;
iv. calculate the 2021 total surplus generated by this industrial process.
Suggested Solution: It wants to make sure that firm D adopts the process, but not
firm E. As long as the tax is less than $2.50, firm D adopts the process. (It is indifferent
at a tax equal to $2.50.) As long as the tax is greater than $1.50, firm E does not adopt
the the process. (It is indifferent at a tax equal to $1.50.) Let’s split the difference and
assume a tax equal to $2.
In this case, firm surplus is $8 (i.e., the last row for firms A–D). Total surplus is $8, as
the external cost of $8 is exactly equal to the government surplus of $8.
We get a slightly different answer if we choose a different tax. Under the assumption that
firm D adopts the process if indifferent, a tax of $2.50 works. In this case, each firm’s
surplus drops by $0.50 when compared to the $2 tax (meaning a total firm decreases by
$2 to $6), but government surplus increases by $2 to $10. These two effects cancel each
other out, and as the external cost remains at $8, total surplus is still $8.

20171213: Page 9 Externalities: Problems: Solutions

University of Toronto ECO101: Introductory Economics
Department of Economics Robert Gazzale, PhD

(c) Assume instead a policy where the government pays $2 to any firm which does not adopt
the process. In this case, does firm H adopt the process?
Suggested Solution: As it’s private benefit of adopting the process is $3-$4.50=-
$1.50, it will gladly accept the government’s money and not adopt the process!
(d) If in 2021, if the government pays $2 to any firm that does not adopt the process, what
are:
i. government surplus; and
ii. total surplus?
Suggested Solution: The $2 subsidy increases the opportunity cost of adopting the
process by $2 (to $4.50+$2.00=$6.50), as adopting the process now means giving up the
$2 subsidy. As only firms A–D benefit by more than $6.50, they are the only firms who
adopt the process. This means that six firms (firm E–J) accept the subsidy, meaning
government surplus is −$2 × 6 = −$12.
As we have the efficient outcome, total surplus is still $8.
(e) Before implementing the subsidy, the government realizes that it is subsidizing behaviour
that would have happened any. (That is, they are subsiding firms not to adopt, and
some firms would not have adopted even if the subsidy were not offered.) Assume instead
that the government announces on January 1, 2021 that it will pay $2 to any firm that
a) adopted the process in 2020; and b) does not adopt the process in 2021. What is the
resulting government surplus?
Suggested Solution: Only firms E and F (rationally) meet this requirement meaning
government surplus is −$2 × 2 = −$4.
(f) Why might your answer be different if the government announces on January 1, 2020
that it will pay $2 to any firm that a) adopts the process in 2020; and b) does not adopt
the process in 2021?
Suggested Solution: If firm F adopts the process in 2020, it loses $1.50 for the year,
but gains a $2 subsidy in 2021. Firm F will adopt the process in 2020. Likewise, if firm
E adopts the process in 2020, it loses $0.50 for the year, but gains a $2 subsidy in 2021.
Firm F will adopt the process in 2020.
At this point, you might think I am just being silly. However, this highlights a real-world
problem that policy makers face. Consider, for example, a cap-and-trade policy where
the number of 2021 pollution permits that a firm receives for free depends on the level
of 2020 emissions. As firms would much rather receive pollution permits for free, even if
it is just going to sell them, this provides and incentive for firms to emit more pollution
in 2020 than it would otherwise.5

10. In this question, assume that quantities must be in whole hours. Oscar6 practises the piano
each weekend. Each hour he spends practising is an hour he cannot work at his job which
pays him $15 per hour.7 His benefit for each of 10 hours of practise is:
5
Relatedly, a friend of mine was an officer in a tank battalion. The amount of fuel the army gave him for the year
depended on the amount of fuel used in the previous year. Every December, he had his soldiers turn on the tanks
and leave them running for no other reason except to make sure that they used up their entire fuel allotment so they
did not have their allocation cut the next year.
6
Oscar Peterson is generally considered one of the greatest jazz pianists and the greatest Canadian jazz musician
of all time. He passed away a few years ago in Mississauga.
7
Translation: Working for pay is his next best alternative.

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University of Toronto ECO101: Introductory Economics
Department of Economics Robert Gazzale, PhD

Hour 1 2 3 4 5 6 7 9 9 10
Marginal Benefit $20 $18 $16 $14 $12 $10 $8 $6 $4 $2
Oscar’s window overlooks a café’s patio. The owner of the café has noticed that her profits
increase by $6 for every hour Oscar practises.

(a) Oscar can practise for as many hours as he desires. Assuming bargaining is not possible,
how many hours does Oscar practise each weekend? What is the total surplus generated
by this number of hours of practise?
Suggested Solution: He practises as long as his private benefit is at least as large as
his cost, where his cost is the $15 per hour he gives up by not working for pay. He thus
practises 3 hours each weekend. His surplus from 3 hours of practise is $5+$3+$1=$9.
The café owner’s surplus is 3 × $6 = $18, for a total of $27.
(b) What is the efficient number of hours of practise per weekend? What is the resulting
total surplus?
Suggested Solution: To get the societal benefit of each hour of practise, we add the
$6 external benefit to Oscar’s private benefit. The efficient number of hours is six, as
the societal benefit of the sixth hour is $16 (which is greater than the societal cost of
$15) and the societal benefit of the seventh hour is $14 (which is less than the societal
cost of $15).
To calculate total surplus, we can sum the societal surpluses from hours four, five and
six, and add this sum for the surplus generated from the first three hours (which we
calculated in the previous question).
Hour Four Surplus= $14 + $6 − $15 = $5
Hour Five Surplus= $12 + $6 − $15 = $3
Hour Six Surplus= $10 + $6 − $15 = $1
These additional three hours of practising generate a total surplus of $9, meaning that
the total surplus from six hours of practise is $27+$9=$36.
(c) Oscar can practise as many hours as he desires.8 Assume costless bargaining (and well-
defined and transferable property rights). What is the most amount of money the café
owner pays Oscar?
Suggested Solution: The café owner does not need to pay for the first three hours, as
Oscar will rationally practise three hours every weekend without further compensation.
The café owner’s benefit for the next 3 hours is $18. As long as she does not have to
pay more than $18, she rationally pays Oscar to practise an additional three hours.
(d) Assume costless bargaining (and well-defined and transferable property rights). What
is the least amount of money the café owner pays Oscar?
Suggested Solution: Once again, we do not have to entice Oscar to practise three
hours, but we need to entice him to practise an additional three hours. Before any
payment, his loss from hours four, five and six is −$1 − $3 − $5 = −$9. As long as Oscar
receives $9 or more for these three hours of practise, he rationally practises six hours
per weekend.
8
We are assuming that Oscar owns the property right on practising. This makes sense, as slavery was abolished
in Canada over 180 years ago.

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University of Toronto ECO101: Introductory Economics
Department of Economics Robert Gazzale, PhD

11. Fertilizer costs $5 per unit, and the farmer’s private benefit is M W T P (q) = 20 − q. You live
next to the farmer, and the fertilizer poisons your water supply. Each unit of fertilizer causes
you to pay $3 in filtration costs. (Assume that you have no other access to water; you cannot
drink unfiltered water; and poisoned and then filtered water is indistinguishable from water
that was never poisoned.) Finally, assume costless negotiation.

(a) Assume the farmer has the right to use as much fertilizer as she likes.
i. The Coase Theorem predicts how many units of fertilizer will be used?
ii. What is the most amount of money you offer the farmer to compensate her for
decreasing her fertilizer use?
iii. What is the least amount of money she accepts in compensation for reducing her
fertilizer use?
Suggested Solution: The efficient quantity is 12 as it equates marginal societal
benefit (20 − q) with marginal societal cost ($3+$5=$8). This is the quantity that the
Coase theorem predicts.
Left to her own devices, she uses 15 units of fertilizer as it equates marginal private
benefit (20 − q) with marginal private cost ($5). Importantly, for any and all units
between 12 and 15, her net private benefit is less than the cost it imposes on you ($3).

Figure 4: Producer surpluses.

As the total cost to you for these three units is $3 × 3 = $9, you are willing to pay her
up to $9 to reduce her fertilizer use from 15 to 12. Her surplus from units 12 to 15 is
depicted by triangle C in Figure 4: 3×$32 = $4.50. Thus, if you pay her at least $4.50,
she rationally accepts the money in exchange for reducing her fertilizer use.
Important: Every unit imposes a cost of $3 on you, and for any unit less than 12, her
net private benefit is greater than $3. You therefore do not want purchase any further
reduction as you would have to pay her more than $3 per unit.
(b) Assume you have the right to unpoisoned water.
i. The Coase Theorem predicts how many units of fertilizer will be used?
ii. What is the least amount of money you accept from the farmer to compensate you
for allowing her to use fertilizer?

20171213: Page 12 Externalities: Problems: Solutions

University of Toronto ECO101: Introductory Economics
Department of Economics Robert Gazzale, PhD

iii. What is the most amount of money the farmer offers you in compensation for al-
lowing her to use fertilizer?
Suggested Solution: The Coase theorem predicts the efficient outcome: 12 units of
fertilizer. The important insight is that for these 12 units, her surplus is greater than
the cost she imposes on you, therefore there is some price she is willing to pay for these
12 units that you are willing to accept.
These 12 units impose a cost on you equal to $3 × 12 = $36. Thus, if she pays you at
least $36, you willingly sell your right to unpoisoned water (more precisely, you allow
her to use 12 units of fertilizer).
Areas A and B in Figure 4 are her surplus for these first 12 units of fertilizer. Area B
equals $3 × 12 = $36. Area A equals 12×$122 = $72. Her total surplus for these 12 units
is thus $108. As long as she does not pay you more than $108, she rationally pays for
the right to use 12 units of fertilizer.
Important: For each unit of fertilizer past 12, her surplus is less than the cost it imposes
on you ($3). It is therefore not rational for her to purchase more units as the minimum
amount you must receive for each unit ($3) is greater than the surplus she gets from the
unit.

12. In this question, assume that quantities must be in whole tons. Each of two firms, A and B,
emits pollution into a lake. The following table gives the benefit of each ton of pollution:
Ton 1 2 3 4 5 6 7 8 9 10
Marginal Benefit A $10 $9 $8 $7 $6 $5 $4 $3 $2 $1
Marginal Benefit B $20 $18 $16 $14 $12 $10 $8 $6 $4 $2
That is, for the fourth ton that firm A emits, the benefit to firm A of that fourth ton is $7.
For the fourth ton that firm B emits, the benefit to firm B of that fourth ton is $14. Assume
that the firm does not incur any costs in emitting pollution.

(a) How many tons of pollution are emitted absent any tax or regulation?
Suggested Solution: Each firm pollutes as long as the marginal private benefit is at
least as large as the marginal private cost. Therefore, each firm emits 10 tons.
(b) If Firm A was required to reduce its pollution by one-half, what are its total costs of
abatement? If Firm B was required to reduce its pollution by one-half, what are its
total costs of abatement?
Suggested Solution: Required to reduce pollution to 5 tons, Firm A loses the benefits
of tons 6–10: $5+$4+$3+$2+$1=$15. Required to reduce pollution to 5 tons, Firm B
loses the benefits of tons 6–10: $10+$8+$6+$4+$2=$30.
(c) Assume that efficiently reducing pollution by one-half maximizes total surplus. Explain
why it is inefficient to require each firm to reduce pollution by one-half.
Suggested Solution: If each reduces pollution by one-half, each emits five tons. If
we move one of these tons from A to B (i.e., A emits four tons, and B emits six tons),
what happens? A no longer emits ton 5, and thus the bears a cost of $6 (i.e., the lost
benefit). B now get to emit ton 6, and benefits by $10 by doing so. Our little move
keeps the total abatement at 10, but results in a net gain of $10-$6=$4. Therefore each
firm emitting five tons was not efficient.

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University of Toronto ECO101: Introductory Economics
Department of Economics Robert Gazzale, PhD

(d) If we efficiently reduce pollution by one-half, how many tons of pollution does each firm
emit?
Suggested Solution: We want to get rid of (abate) the tons whose benefits are the
smallest. For example, if we wanted to reduce pollution by 1 ton, requiring firm A to
only emit nine tons is most efficient as it only benefited $1 from emitting ton 10 whereas
firm B benefits $2 from its last ton.
What is the most efficient way to reduce pollution by 3 tons? We have already reduced
by 1 ton by cutting A back to 9 tons. Note that we give up $2 if we cut A back to 8
OR if we cut B back to 9. Let’s choose to cut A back to 8 tons and keep B at 10 tons.
We still have one ton to go. If we cut A back to 7, we lose $3 (the benefit A gets from
ton 8), but if we instead cut B back to 9 we lose $2 (the benefit B gets from ton 10).
It is thus less costly for the next reduction to come from firm B. If we needed to most
efficiently reduce pollution by 3 tons, A reduces from 10 to 8, whereas B reduces from
10 to 9.
Ton 10 9 8 7 6 5 4 3 2 1
Marginal Benefit A $10 $9 $8 $7 $6 $5 $4 $3 $2 $1
Marginal Benefit B $20 $18 $16 $14 $12 $10 $8 $6 $4 $2

Table 2: The 10 least beneficial tons of pollution are in bold.

In Table , I follow this logic. The ten tons that are least costly to abate (i.e., those tons
which have the least benefit) are in bold. Alternatively, we could have identified the
10 most valuable tons: the entries not in bold. To most efficiently reduce pollution by
one-half, we allow A to emit three tons (i.e., it reduces emissions by seven tons) and we
allow B to emit seven tons (i.e., it reduces emissions by three tons.)
(e) Identify a per-ton tax rate that results in the efficient reduction of emissions by one-half.
Suggested Solution: $7.50 works. As long as the tax is at least $7 but not more than
$8, firm A rationally emits only three tons and firm B rationally emits seven tons.
(f) Assume 10 pollution permits are allocated to firm A and none are allocated to firm B.
Assume that these permits are tradable (and bargaining is costless). How many tons of
pollution does each firm emit?
Suggested Solution: Firm A emits three tons. Firm B emits seven tons.
At the initial allocation, firm A values its last permit at $1, whereas firm B values its
first permit at $20. Both are made better off if firm A sells a permit to B for some
price between $1 and $20. Having transferred one permit from A to B, A values its last
permit at $2, whereas B values its next permit at $18. Both are made better off if firm
A sells a permit to B for some price between $2 and $18.
Continue this logic until A has four permits and B has six permits. A values its last
permit at $7, whereas B values its next permit at $8. Both are made better off if firm
A sells a permit to B for some price between $7 and $8.
When A has three permits and B has seven permits, there are no further gains from
trade. A values its last permit at $8, whereas B values its next permit at $6. There is
no price where A willingly sells and B willingly buys.
What will be the price if all permits are transacted at the same price (as will be the
case in a competitive market for permits)? Demand for permits must equal the supply
of permits. If the price is between $7 and $8, firm A desires to sell seven permits, and
firm B desires to buy seven permits? Thus, if there is a competitive market for permits,
the price will be between $7 and $8. Once again, $7.50 works.

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University of Toronto ECO101: Introductory Economics
Department of Economics Robert Gazzale, PhD

13. For firm 1, marginal benefit of pollution equals M B1 (q1 ) = 10 − q1 . For firm 2, the marginal
benefit of pollution equals M B2 (q2 ) = 12 − q32 .

(a) Some really smart people have determined the the socially optimal quantity of pollution
is Q = q1 + q2 = 26. Assuming pollution is efficiently allocated between the firms, how
much does each firm emit?
Suggested Solution: Optimality requires M B1 (q1 ) = M B2 (q2 ). We also know that
q1 + q2 = 26, which means q1 = 26 − q2 . Two equations, two unknowns. We are off to
the races.

M B1 (q1 ) = M B2 (q2 ) optimality

q2
10 − q1 = 12 −
3
q2
10 − 26 + q2 = 12 − substitute for q1
3
3
q2 = 28 = 21
4
Therefore, firm two emits 21 units, whereas firm 1 emits 26-21=5 units.
(b) What tax results in 26 units of pollution?
Suggested Solution: We want firm 1 to stop at 5 units and firm 2 to stop at 21 units.
For both firms, the marginal benefit of the last unit equals $5: M B1 (5) = 10 − 5 = 5
and M B2 (21) = 12 − 21 3 = 5. Therefore, a tax equal to $5 results in 26 units in total.
(It also results in the most efficient way to allocate 26 units of pollution.)
(c) Assume that the marginal external cost of pollution is constant. If 26 units of pollution
truly maximizes total surplus, what is the marginal external cost of pollution?
Suggested Solution: $5. Optimality (i.e., efficiency or surplus maximization) requires
M SB = M SC. We found that when 26 units is optimally allocated, each firm’s marginal
benefit is $5. If this is optimal, it means that the marginal external cost of the 26th unit
must be $5. Under the assumption that marginal external cost is constant, the marginal
external cost of each unit must be $5.

14. Assume everyone follows the “do something as long as the benefit is at least as large as the
cost” rule. Ornette, a professional saxophonist, often practises at home between 7:00 PM and
8:00 PM. Billie and Miles, his only 2 neighbours, always like hearing Ornette practise at this
time. TFU: The frequency (e.g., number of evenings per week) with which Ornette practises
between 7:00 and 8:00 PM will be inefficient.
Suggested Solution: Uncertain. True if he does not internalize externality (i.e., if he does
not care or is not made to care that his neighbours enjoy his playing), false if externality is
fully internalized. For example, he may voluntarily “do the right thing” if he cares about his
neighbours well being, either because he just cares or because his neighbours will reciprocate
in some way. Relatedly, the Coase Theorem would predict that his neighbours will find it in
their best interest to “entice” him to practise at a socially optimal frequency.
Let Q be number of times per month that he practises. If he does not take externality into
account, M SB(Q∗ ) = M P B(Q∗ ) + M EB(Q∗ ) > M P B(Q∗ ) = M C(Q∗ ): he could increase
total surplus by practising more frequently. If he does fully internalize externality (e.g., Coase
Theorem, altruism, social norms), M P B = M SB, and his choice is therefore efficient.

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