Externalities Flashcards
Explain how competitive markets maximise profits
Competitive markets maximises profits using the marginalist principle and maximise profits where marginal revenue is equals to marginal cost of production.
Marginal revenue refers to the additional revenue that a firm makes from selling one more unit of output produced and marginal cost is the additional cost that a firm incurs from increasing output produced by one unit.
When MR > MC, the additional revenue to be obtained from selling an additional unit of output produced is greater than the additional cost of that output produced. There is still higher profit to be gained by increasing output.
When MR < MC, the additional revenue to be obtained from selling an additional unit of output produced is less than the additional cost it would incur. The firm will cut back on its output to increase profits.
Externalities
In their pursuit of self-interest, consumers and producers will only consider their own private costs and benefits.
Hence, these private-decision makers will not take into account any external costs or benefits on third parties.
This results in externalities when some of the costs or benefits associated with the production or consumption of a good spill over onto third parties, without directly affecting the market price, creating a divergence between private and social costs and benefits.
Externalities can be positive (underproduction/underconsumption) or negative (excessive production or consumption)
Explain negative externalities from consumption (e.g. market for alcohol)
The market for alcohol fails due to negative externality in consumption which occurs when external costs are imposed on third-parties from the consumption of a good or service by private individuals.
In pursuit of self-interest, consumers only consider their MPB when making consumption decisions, such as their utility from consuming alcohol which results in them feeling high and relieving of stress. However, they do not consider the external costs to third parties such as the possibility of drunk driving which could result in higher medical expenses for third parties. As such, there is a divergence between MPB and MSB with a difference MEC.
Assuming there are no externalities in production, MPC = MSC, the free market equilibrium occurs at Q0 where MPB=MPC, but the socially optimal output level is Q1 where MSB=MSC (4).
As such there is the overconsumption of Q0Q1 units, and a deadweight loss of area ABC as the additional costs in PRODUCING Q0Q1 units > additional benefits in CONSUMING Q0Q1 units (5). As such there is over-allocation of resources in the market for alcohol resulting in allocative inefficiency and hence market failure.
- MEB <0, MSB < MPB, Over-consumption
Explain negative externalities from production (e.g. petrol chemicals)
Negative externalities from production occur when external costs are imposed on third-parties from the production of a good or service by private firms. The market for petrol chemicals fails due to negative externalities from production. - In their pursuit of self-interest, private firms would only consider their own private costs such as the cost of electricity and manpower and private benefits such as the free market price they receive for the sale of their product. They ignore the external costs imposed on third parties such as fishermen who rely on nearby waters to fish and earn a living. They may have a loss in income due to lower quality and quantity of catch. These external costs result in a divergence between MPC and MSC of producing petrol-chemicals where MSC is higher than MPC.
Assuming there is no externality from the consumption of petrol chemicals and MPB = MSB, free market equilibrium output occurs where MPC = MPB but the socially optimal output level is Q1 where MSB=MSC. There is an overallocation of resources and deadweight loss of area XXX as the additional costs in producing Q0Q1 units > additional benefits in consuming Q0Q1 units. Societal welfare would increase if fewer units of the good are produced. Thus, the current level of output is allocatively inefficient and results in market failure.
Explain positive externality from consumption (e.g. Flu Vaccine)
Positive externality from consumption occurs when an individual consumption confers benefits to third parties who are not directly involved but the individual is not compensated.
In the pursuit of self-interest, individuals only consider their MPB of taking the flu vaccine such as their increased immunity and lower likelihood of missing school or work due to falling ill. However, they do not consider the external benefits conferred onto third parties. These benefits include contributing to herd immunity which is achieved when a sufficient proportion of the population is vaccinated against the disease, creating a protective effect for those who have medical conditions preventing them from getting vaccinated, lower healthcare costs and increased social stability for the society as a whole. As such, there is a divergence between MPB and MSB with a difference MEC. Assuming there are no externalities in production, MPC = MSC, the free market equilibrium occurs at Q0 where MPB = MPC but the socially optimal output occurs at MSB = MSC, there is an overconsumption of QOQ1 units and deadweight loss of area ABC as the additional benefits from consuming Q0Q1 units outweighs the costs of producing Q0Q1 units, resulting in market failure.
Explain positive externality from production (e.g. Vaccines, Organic farming, Beehives of honey producers and pollination, agricultural output)
When a firm’s production increases the well-being of others but the firm is not compensated by those others, resulting in an underproduction of the good.
MPC: Cost of R&D, advertisement
Requires gov intervention in the form of subsidies to incentivise private firms and parmaceutical companies to produce. Increased competition also leads to better quality vaccines. The benefits tend to outweigh the costs including distortion from taxes required to raise revenue to finance the subsidy.
Alternative solutions include positive reinforcement (nudge theory in behavioural economics), fines are highly distortionary
Marginal private cost (MPC)
Direct cost incurred by producers of producing an additional unit of a good
Marginal external cost (MEC)
Any additional costs associated with the production of the good that are imposed on others but that producers do not pay
Marginal social cost (MSC)
MPC + MEC
Social cost to society which includes the private marginal cost to producers plus marginal external cost in the production or consumption of the good or service.
Marginal private benefit (MPB)
The direct benefit to consumers of consuming an additional unit of good or service or producers from producing a good or service
Marginal Social Benefit (MSB)
Social benefits are the total gains in welfare by the whole society and consists of the private and external benefits from the production or consumption of the good or service.
Explain the externality graph
Increasing MPC: Firms are using more resources so they become less efficient.
MEC = consequence imposed on society, not the producers
MSC compromises all costs societies face (MEC + MPC)
In a perfectly competitive market, firms are price takers and set price at a fixed level
where P= MR= MC as companies are rational and want to maximise profit.
At A, firms maximise profits. However, there is overproduction, leading to excessive pollution, resulting in negative externality. Firms disregard negative impacts on society, on fishermen, so we end up in A. However, the pareto efficient and socially optimal quantity would be B where price = MSC.
Private solutions to externalities
1) Internalise externalities
2) Coase theorem
3) Legal system
Explain how internalising externalities work
Involves forming economic units of sufficient size so that most of the consequences of any action occur within the unit (E.g. Households can collectively decide to undertake maintenance of the facilities that affect them all by forming an apartment association.)
However, there is a problem of free-riders ⇒ Must be some way of enforcing the collective agreement such as through a legal system which ensures that the terms of the agreement (how to deal with externalities imposed on each other, to provide ‘public goods’ are adhered to).
Explain the coase theorem
Refer to lecture notes and graph! Need to explain
The coase theorem states that when one party is engaged in an activity that imposes costs on a third party in the form of externalities, a negotiated settlement between the two parties may result in a Pareto-efficient allocation of resources in which the externality is internalised.
The Pareto efficient outcome is attained as long as private bargaining exhausts all potential mutual gains, and this is regardless of which party owns the property rights because externalities arise when individuals do not bear the full consequences of their actions.
The assumption behind the coase theorem is that there are well-defined property rights and costless bargaining, negotiations between the party creating the externality and the party affected.
1) Property rights: Externalities can be dealt with by the proper assignment of property rights to an individual, the right to control some assets and to receive fees for the property’s use.
2) Unitisation of production: Determination of who compensates whom makes a difference to the distributive implications of the externality
