Diagrams Flashcards
Unitary elastic demand curve
Draw a diagram to show how the functions of the price mechanism eliminate excess demand in a market.
At P1, there is excess demand, so consumers will bid up the price. This signals to and incentivises producers to supply more, leading to an extension in supply, quantity supplied increases from Qs to Qe. The rising price also rations how much consumers demand, leading to a contraction in demand, quantity demanded decreases from Qd to Qe. This brings us back to equilibrium at Qe and Pe.
Minimum price
Negative production externality diagram
MSC is above MPC because we have to add on the external costs.
Note: this diagram is only for negative production externalities – do not use it when discussing negative consumption externalities (the Principal Examiner has specifically warned against this!).
Tax to internalise a negative production externality
To correct a negative production externality, a tax must be set = the size of the external cost between MSC and MPC at Qs.
Subsidy to internalise a positive consumption externality
To correct a positive consumption externality, a subsidy must be set = the size of the external benefit between MSB and MPB at Qs.
Maximum price
The highest price a good can be legally sold for.
E.g. New York’s rent controls which set a maximum price on the rent a landlord can charge a tenant for a flat.
Note: a maximum price must be set below the market price otherwise it will have no effect.
From our negative externality diagram we know that to internalise a negative externality (like carbon pollution) the size of the tax must be equal to:
The size of the tax should be equal to the size of the external cost, between MPC and MSC, at our socially efficient quantity. X is the socially efficient quantity, and RG is therefore the external cost at the socially efficient quantity. So the size of the tax should be RG.
