1. Alex plants a variety of trees, shrubs, and flowers in his backyard. The landscaping beautifies the neighborhood. Which of the following is true?
a. This will not generate any externalities.
b. This will generate an external benefit.
c. This will generate an external cost.
d. This will generate both external benefits and external costs.
2. If the production of a good generates external costs, then which of the following is correct?
a. The gov't can tax production of the good to increase efficiency.
b. Market forces may lead to an overallocation of resources to produce the good.
c. All of these answers are correct.
d. At the market quantity, output of the good is higher than the efficient quantity.
- 4 years agoFavorite Answer
1. The trick is to read the statement carefully. If you notice, it mentions only one consequence: the landscape in the neighborhood improved. That is obviously a benefit and, while it is something the owner does enjoy, it is also an improvement the whole neighborhood can enjoy.
So, it is (b): it's an external benefit.
2. One way to view an external cost is to think of it as being a matter of missing market -- that is, something is being consumed, except the price is set at zero. That is to say, the costs of each unit produced will be too low. In plain economics, your cost function is shifted rightward and so is the supply function.
Now, let's see what happens with each options.
(a) A tax. As a tax has the exact opposite effect, the answer is an obvious yes. If it compensates exactly the external effect (that is, if it covers the costs), it is a solution. We have a name for that by the way: a Pigouvian tax, named after the economist Arthur Pigou.
(b) and (d) If you include the external costs into your cost function, the supply function would shift leftward. The new equilibrium would yield fewer quantities produced and consumed, as well as a higher price -- and that would be the efficient allocation. If you do nothing for the firm to include these costs in their calculations, it's the increased supply function you would have. The price would be too low and the quantities, both produced and consumed, would be too high at equilibrium. If you do not see this, draw a simply supply and demand graphic and you'll see it.
So, yes: too much of that good would be produced. If you followed the logic right, you know this means the firm will consume too much of other goods and services to produce it when compared to the efficient allocation of resources. Hence, the answer must be (c).