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    An Example of an Externality

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    1. Which of the following describes an externality and which does not? Explain the difference.
    a. A policy of restricted coffee exports in Brazil causes the U.S. price of coffee to riseâ?"an increase which in turn also causes the price of tea to rise.
    b. An advertising blimp distracts a motorist who then hits a telephone pole.

    2. Consider a market in which a firm has monopoly power. Suppose in addition that the firm produces under the presence of either a positive or a negative externality. Does the externality necessarily lead to a greater misallocation of resources?

    3. George and Stan live next door to each other. George likes to plant flowers in his garden, but every time he does, Stan's dog comes over and digs them up. Stan's dog is causing the damage, so if economic efficiency is to be achieved, it is necessary that Stan pay to put up a fence around his yard to confine the dog. Do you agree or disagree? Explain.

    4 Why does free access to a common property resource generate an inefficient outcome?

    5. A village is located next to 1000 acres of prime grazing land. The village presently owns the land and allows all residents to graze cows freely. Some members of the village council have suggested that the land is being overgrazed. Is this likely to be true? These same members have also suggested that the village should either require grazers to purchase an annual permit or sell off the land to the grazers. Would either of these be a good idea?

    6. Public television is funded in part by private donations, even though anyone with a television set can watch for free. Can you explain this phenomenon in light of the free rider problem?

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    Solution Preview

    Let's begin by reminding ourselves of the definition of an externality. An externality is a cost or benefit not reflected in prices that is incurred by a party who did not agree to it.

    1. a) Since the increase in the price of tea is reflected in the price of tea, it is internal to the system and therefore not an externality.

    b) This is an example of an externality. The motorist did not agree to the advertising on the blimp and the cost of unsafe roads was not reflected in the cost of advertising.

    2. The Monopoly firm will produce as all firms do where marginal revenue meets marginal cost. If the monopoly produces under a negative externality, then they are not bearing the full cost of production. ...

    Solution Summary

    This posting explores examples of an externality.