2.8 market failure & externalities of production Flashcards
define externalities and give example
External costs or benefits to third parties when
a good or service is produced or consumed. An
externality arises when an economic activity
imposes costs or creates benefits on third
parties for which they are not compensated or
do not pay for respectively
e.g vaccines, masks (positive spillover)
cigarettes, alcohol (negative)
taking into account externalities, social efficient output is likely ___ to market equilibrium output
not equal
3rd parties
are entities not involved in the actions of consumers and producers whose interests are not taken into consideration, hence no compensation made
when market equilibrium output is socially inefficient,
(4 points)
- market not producing to what society desires
-scarce resources are not optimally allocated,(allocative inefficient output) - social surplus is not maximised(welfare loss will be present)
- marginal cost =/= marginal benefit
market failure
The failure of markets to achieve allocative efficiency. Markets fail to produce the output at which marginal social benefits are equal to marginal social costs; social or community surplus (consumer surplus + producer surplus) is not maximized.
msb = msc
2 types of externalities
production and consumption
prod:
honey-more bees
crude oil: more pollution
consumption:
cigarettes-second hand smoke
marginal external costs (MEC)
refers to the spillover costs on third parties for producing one more unit of a good
MEC=MSB-MPC
marginal social benefit (MSB)
e extra or additional benefit/utility to society
of consuming an additional unit of output,
including both the private benefit and the
external benefit.
3
MSB=MPB+MEC
marginal social cost (MSC)
The extra or additional cost to society of
producing an additional unit of output,
including both the private cost and the external
costs.
MSC=MPC-MEB
market success
In a self-interested, free and competitive market with no externalities, the price mechanism helps to allocate scarce resources to achieve a socially efficient output (allocative efficient output).
2. Socially efficient output implies achieving of allocative efficiency where
i. the right amount of the goods are produced and consumed from the society’s
point of view,
ii. scarce resources are optimally allocated (allocative efficiency),
iii. social surplus is maximized,
iv. MC = MB.
Marginal private costs (MPC)
Marginal private costs (MPC) refer to costs to producers of producing one more unit of a good.
MPC=MSC+MEB
Marginal social costs (MSC)
Marginal social costs (MSC) refer to costs to society of producing one more unit of a good.
MPC+MEC
Marginal private benefits (MPB)
Marginal private benefits (MPB) refer to benefits to consumers from consuming one more unit of a good.
MPB=MSB-MEC
Marginal social benefits (MSB)
Marginal social benefits (MSB) refer to benefits to society from consuming one more unit of a good.
MSB=MPB+MEC
Marginal external benefits (MEB)
Marginal external benefits (MEB) refer to spillover benefits on 3rd parties for producing or consuming one more unit of a good.
MEB=MPC-MSC
explain overproduction of a good due to external costs in production
Step 1 : Identify competitive mkt without external costs output, Q1 where MPB=MPC)
(Step 2 : Assumption of no external costs on either the SS or DD curve
(Step 3 : Identify type of externality, implications on the supply or demand curve and on the 3rd parties)
(Step 3 : Explanation of external costs on 3rd parties)
(Step 4 : Identify allocative efficient output, Q2 where MSB=MSC)
(Step 5 : Identify allocative inefficient output, Q1 where MSB>MSC or MSB<MSC)
(Step 6 : Identify and explain welfare loss area between Q1Q2)
Competitive mkt without external costs, Q1 is MPB =MPC
• Assuming MEB for consumption equals zero.
• Existence of MEC in producing electricity using coals
• External costs implies negative externalities on 3rd parties namely, stability of the global climate and the degradation of the eco-system (degradation of common pool resources) on neighbouring countries and the country’s future generations
• Due to MEC in production, MSC > MPC for all units produced
• At Q2, MSC = MSB implying allocative efficiency; Q2 is the social optimal output
• At Q1, MSC > MSB implying allocative inefficiency
• Between Q2Q1, welfare loss area E1E2A is seen as the sums of all MSC>MSB
welfare loss
A loss of a part of social surplus (consumer plus
producer surplus) that occurs when there is market failure so that marginal social benefits
are not equal to marginal private benefits.
types of indirect Pigouvian taxes
fuel excise taxed (petrol, gasoline or gas taxes)- specific tax
carbon taxes(tax on carbon content of fuel used) - specific tax
sales tax (tax on just everything we buy - ad val orem tax
carbon tax
incentivises firms to switch to less-pollutive sources of energy
Used to address the problem of global warming and climate change, caused by emissions of greenhouse gases—in particular, carbon dioxide
Carbon tax—tax per unit (specific tax) of carbon content of the fuels
The carbon tax increases the cost of buying fossil fuels and hence firms’ costs of production
Different types of fossil fuels emit different amounts of carbon emissions when burned; the more carbon emitted,
the higher the tax
⊹ If firms switch to less or non-pollutive sources of energy ⊹ →Decrease in MEC ⊹ →Decrease in MSC ⊹ →Increase in socially-optimal quantity / level ⊹ Decrease in carbon tax per unit
strengths and advantages of the use of indirect taxes (fuel and carbon taxes) (4points)
- Assuming that external costs in production can be accurately measured, the imposition of indirect taxes equals to the MEC can internalize the external costs.
- Due to higher COP, it incentives firms to develop and use cleaner methods of production if it is cheaper to do so to reduce the amount of tax firms have to pay.
- Compared to Emissions Trading System (ETS) carbon tax is relatively easier to design, implement and to monitor.
- Carbon taxes can be applied to all users of fossil fuels & do not offer opportunities for manipulation by the govts to offer preferential treatments to supporters.
limitations/disadvantages of indirect taxes(3)
- Since it difficult to quantify external costs in production, it is difficult to determine the actual amount of tax to be imposed to internalize the external costs in production. If the taxes are under-estimated, remnant welfare loss will still exist.
- Carbon tax cannot target a particular desired level of carbon reduction unlike ETS. If it is cheaper for firms to continue to use their production methods and to pay the taxes, then it will lead to uncertain carbon- reducing outcome.
- Carbon tax can be regressive since indirect taxes are paid partly by producers and partly by consumers. Hence, lower-income consumers would be affected proportionately more.
tradeable permits
tradeable permits are rights to produce a certain amount of pollutants over a certain time period issued to firms by governments or international authorities, which can be bought and sold in markets
policies that involve the use of tradeable permits are also known as cap and trade schemes or Emissions Trading Systems(ETS)
ETS
emissions trading systems:
policies that involve the use of tradeable permits are also known as cap and trade schemes or emissions trading systems
price determinate of tradeable permits
Prices of tradeable permits are determined by the market demand for, and market supply of, the tradeable permits
Firms that can generate their output by emitting a lower amount of pollutants than allowed by their permits can sell their extra permits
Firms that need to emit more pollutants than the amount allowed by their permits need to buy more permits