External Benefits & Triangle of Welfare Gain

Question 1

What does the free market ignore?

Answer 1

Free market ignores positive ➕ externalities (demand curve at MPB)

Question 2

When and how are the external benefits seen?

Answer 2

External benefits seen when consumer demand curve shifts ➡️ & becomes MSB curve (note actual consumer demand curve remains at MPB & ➕ externalities ignored- shift hypothetical to see welfare gain due to ignored ➕ externalities)

Question 3

Describe the external benefit diagram with the triangle of welfare gain

Answer 3

1) Draw downwards facing MPB curve
2) Draw downwards facing MSB curve slightly above it stemming from the same point of origin as the MPB curve
3) The gap between the MSB and MPB curves indicates the external benefit
4) Draw single upwards facing MPC=MSC curve
5) Triangular area on left hand side between MSB and MPB curve shows triangle of welfare gain

Question 4

What does the external benefit diagram with the triangle of welfare gain show?

Answer 4

When external benefits ignored (without MSB curve just MPB curve)- underpricing & underproduction (see ⬅️)

Marginal social benefit (MSB) = QeMTQ2
Marginal social cost (MSC) = QeZTQ2

MSB area of output ⬆️ than MSC- … excess shown by triangle of welfare gain MTZ

Market failed- welfare gain to society because ➕ externalities ignored

Question 5

How do you draw the triangle of welfare gain correctly?

Answer 5

NOTE- when drawing welfare gain triangle- start from free market equilibrium (MPC = MPB) and draw vertical line upwards to the MSB curve

Question 6

What are the impacts of external benefits on consumers & producers (market failure)?

Answer 6

1) Underproduction (firms)- free market level output ⬇️ than social optimum output level (see diagram ⬆️)
2) Underpricing (firms)- free market market price ⬇️ than social optimum price level (see diagram ⬆️)- society should be prepared to pay 💵 ⬆️ to maximise external benefits
3) Potential welfare gain- marginal social benefits ⬆️ than marginal social costs (see diagram ⬆️)
4) Government intervention- internalise external benefits- correct market failure e.g. subsidies (⬆️ production to counter underproduction)