External Costs & Triangle of Welfare Loss

Question 1

What does the free market ignore?

Answer 1

Free market ignores negative ➖ externalities (supply curve at MPC)

Question 2

When and how are the external costs seen?

Answer 2

External costs seen when firm supply curve shifts ⬅️ & becomes MSC curve (note actual firm supply curve remains at MPC & ➖ externalities ignored- shift hypothetical to see welfare loss due to ignored ➖ externalities)

Question 3

Describe the external cost diagram with the triangle of welfare loss

Answer 3

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

Question 4

What does the external cost diagram with the triangle of welfare loss show?

Answer 4

When external costs ignored (without MSC curve just MPC curve)- underpricing & overproduction (see ⬅️)

Marginal social cost (MSC) = QeWYQ1
Marginal social benefit (MSB) = QeXYQ1

MSC area of output ⬆️ than MSB- … excess shown by triangle of welfare loss XWY

Market failed- welfare loss to society because ➖ externalities ignored

Question 5

How do you draw the triangle of welfare loss correctly?

Answer 5

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

Question 6

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

Answer 6

1) Overproduction (firms)- free market level output ⬆️ than social optimum output level (see diagram ⬆️)
— ⬇️ availability of resources for future generations due to overproduction now
— ⬆️ pollution levels- burning fossil fuels to provide necessary energy for ⬆️ production -> global warming etc
2) Underpricing (firms)- free market market price ⬇️ than social optimum price level (see diagram ⬆️)
3) Welfare loss- marginal social costs ⬆️ than marginal social benefits (see diagram ⬆️)
4) Government intervention- internalise external costs- correct market failure e.g. indirect taxes (⬇️ production to counter overproduction)