CDS (I) 2024 General Knowledge · Question 69 of 120

Correct — A, The market mechanism over-produces a good that generates positive externality. This is the statement that is not correct, and it is wrong by exactly one word: the market under-produces such a good, it does not over-produce it. A positive externality means part of the benefit spills over to people who do not pay for it, so a buyer weighing only her own private benefit stops buying sooner than society would want. Standard microeconomics puts it plainly for the case of flu shots — the socially optimal level is greater than the market quantity. Over-production is what happens with a negative externality, where part of the cost is dumped on others and the producer therefore keeps going past the socially efficient point. The statement has simply swapped the two cases, which is why it is the odd one out among four otherwise sound propositions.

• (b)A cap and trade of pollution permits can be used by the government to achieve the social optimum. — This is correct, so it cannot be the answer. Under a permit system the regulator caps the total quantity of emissions and lets firms trade the permits, and because the firms that find abatement cheapest cut the most, the target is met at lower cost to society than under command-and-control rules.
• (c)The optimal amount of subsidy in the case of an activity that produces a positive externality is the difference between the social benefit and the private benefit at the optimum. — This is correct. The gap between social benefit and private benefit is the spillover the market ignores, so paying the actor exactly that gap makes her private calculation match society's and pushes output to the efficient level. It is the mirror image of a Pigouvian tax on a negative externality.
• (d)Tragedy of Commons is an example of negative externality. — This is correct. In a common pasture or an open fishery every extra user takes a benefit for herself while spreading the cost of depletion over everyone else, and an uncompensated cost imposed on third parties is the definition of a negative externality.

An externality is a cost or a benefit that falls on somebody who is not party to the transaction. When the spillover is a benefit — vaccination, education, research, a well-kept garden — private benefit falls short of social benefit and the market settles at too little output. When the spillover is a cost — smoke, effluent, congestion — private cost falls short of social cost and the market settles at too much. In both cases the remedy is to make the decision-maker face the full figure, by a subsidy in the first case and a tax, a permit price or a regulation in the second.

Every not-correct item rewards a quick classification pass, and here three of the four options can be waved through in seconds if you can place each one in the framework. Cap and trade is a market-oriented remedy for a negative externality; the subsidy rule is the standard remedy for a positive one; the tragedy of the commons is a textbook negative externality. That leaves option (a), and its error is the one students make most often, because 'positive' sounds as though more must be happening rather than less. Fix the direction by remembering a single example: if flu shots protect other people as well as the person vaccinated, a private buyer counts only her own protection and too few shots get bought.

• A positive externality leaves private benefit below social benefit, so the market under-produces.
• A negative externality leaves private cost below social cost, so the market over-produces.
• The efficient subsidy for a positive externality equals the gap between social and private benefit at the optimum.
• Under marketable permits the firms that can abate most cheaply abate the most, so a given cut costs society less.
• The tragedy of the commons is the over-use of a shared resource because each user's cost is spread across all users.

• Assuming 'positive externality' means the market does more of something, when it means the market does too little.
• Reading the subsidy rule as the whole social benefit rather than the gap between social and private benefit.
• Skipping the options that are correct — in a not-correct item, confirming three quickly is the fastest route to the fourth.

Asked as a not-correct item in which three options are standard textbook propositions and the fourth reverses the direction of a single effect.

No directly related past PYQ was found.

• practice — not a real PYQ

  In the presence of a negative externality in production, the free-market output is

  • (a)less than the socially optimal output
  • (b)greater than the socially optimal output
  • (c)equal to the socially optimal output
  • (d)zero

  Answer(b) greater than the socially optimal output — part of the cost falls on others, so the producer keeps going past the efficient point.

• practice — not a real PYQ

  Under a cap-and-trade system for pollution, which firms end up cutting emissions the most?

  • (a)The largest firms, regardless of cost
  • (b)The firms for which cutting emissions is cheapest
  • (c)The firms nearest to residential areas
  • (d)All firms cut by the same percentage

  Answer(b) The firms for which cutting emissions is cheapest — they abate and sell their spare permits, which is why the overall target is met at least cost.