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Various Problems on Externalities

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1. Country A is a country that produces a variety of goods and services. Considering the policies/events listed below, how might country's A production possibilities frontier change (ie shift out or in)?
a. The government deregulates industries.
b. The government increases military spending.
c. The government increases taxes collected from business.
d. Public schools decrease college tuition.
e. OPEC oil embargo.

2. Define the term market failure. What can lead to market failure?

3. The following table shows the marginal private cost (MPC) and the marginal social cost (MSC) of a chemical factory.

Tons of Chemicals MPC MSC
1 100 120
2 110 130
3 120 140
4 130 150
5 140 160

Answer the following questions:
(1) What is the marginal cost of the factory's externality? Is it constant at all quantities?
(2) If the factory is a perfectly competitive firm and is not required by the government to internalize its external cost, how many tons should the factory produce, given that the market price of a ton of chemicals is $130?
(3) If the factory is a perfectly competitive firm and is required by the government to internalize its external cost, how many tons should the factory produce, given that the market price of a ton of chemicals is $130?

4. What is the difference between a negative and a positive externality? Give an example of each.

5. What is a government failure? List four reasons why it might occur.

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Solution Summary

Explains what externality is and when does government intervention become necessary. Also explains how social costs can be included in pricing decisions.

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1. The production possibilities frontier is the boundary between what you can and what you cannot produce. It depends on the amount of available resources. It is a theoretical boundary, and hence the only things that will influence are changes in the availability of resources. Therefore, we need to look at each of the given options with the view of their impact on available resources. Price changes will only have an impact of moving you on the PPF, and not shift it.

(a) The government deregulates industry: Deregulation spurs investment and thus helps push the PPF out.

(b) The government increases military spending: This means the government spending goes up, and the impact of that on the PPF is a matter of debate. Up to a certain extent increasing government spending is expected to increase economic growth, but if the government becomes too big it hurts growth, and hence shrinks the PPF. For more see http://www.heritage.org/research/budget/bg1831.cfm.

(c) The government increases tax collection: Productivity declines as the tax rate increases, as people choose to work less. Thus ...

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