Externalities Flashcards
How do supply and demand curves not show externalities?
- only private costs and benefits are included
- affected bystanders cost / benefits is not seen
- total surplus maximised (efficient)
What is the supply curve equal to? (externalities)
Private marginal cost (PMC)
What is the demand curve equal to? (externalities)
Private marginal benefit (PMB, based on utility)
What happens to S/D with externalities?
There is a dead weight loss (harm to the bystander)
Corrective taxes and subsidies aim to eliminate this at the equilibrium
What is an Externality?
An externality is a spillover cost or benefit to a third party, that is not part of the original transaction
What is not considered an externality?
They have already been compensated for the occurrence
- if there is a lower price due to a negative occurrence, it is not an externality
What is SMC?
Social Marginal Cost
What is SMB?
Social Marginal Benefit
What happens with a negative externality of production?
-SMC is higher than PMC/S
-Qp is too high
How do we see an externality of a S/D graph?
Distance between the original curve and new SMB / SMC
What happens with a positive externality of production?
- SMC smaller than PMC/ S
- Qp is too low
How do you calculate SMC for a negative externality of production?
SMC = PMC + Negative Externality
How do you calculate SMC for a positive externality of production?
SMC = PMC - offsetting benefit of production
What happens with a negative externality of consumption?
- SMB smaller than PMB/D
- Qp is too high
What happens with a positive externality of consumption?
- SMB greater than PMB / D
- Qp is too low
How do you calculate SMB for a positive externality of consumption ?
SMB = PMB + Externality (additional benefit)
How do you calculate SMB for a negative externality of consumption?
SMB = PMB - Externality (additional cost)
Define Negative externality of Consumption
There is an offsetting cost to society arising from consumption of the good, that private consumers do not account for
- Society does not value the good as highly as the private individual does
SMB lies below PMB once the external cost is counted for
Define Negative externality of Production
True cost to society (cost of production + externality) is greater than the private cost (cost of production)
SMC lies above PMC
Define Positive Externality of Production
There is some offsetting benefit to society arising from the production of honey, that producers do not account for
- SMC lies below PMB once this benefit has been accounted for
Define Positive externality of Consumption
The true benefits to society are greater than the benefits to the individual
- SMB is above PMB
What is Coase’s Theorem?
This theorem states that if property rights are assigned appropriately (the role of government), private parties can negotiate solutions to the problem of externalities
What is needed for the Coase Theorem to work well?
- Property rights have to be well defined and enforceable
- Transaction costs have to be low (negotiating costs)
What determines who pays compensation (Coase Theorem)
Who has the property right
What is Qp
Qp (private quantity) is where PMC = PMB
What is Qs?
QS (social quantity) is where SMB = SMC
At Qs, all costs, including externalities have been accounted for, and all benefits have been captured, including externalities
How can Supply / PMC be equal to SMC
If supply / PMC are not affected by the externality they become SMC (same from demand / PMB and SMB)
What is a problem with the externality curves?
They are linear - this may not always be the case
What are corrective taxes and subsides for?
removing dead weight loss (from the shift from Qp to Qs)
What do taxes on negative externalities do?
Internalises the externality
- imposes the cost on the producers and consumers who enjoy the private benefit, but generate the negative externality
- Reduces quantity from Qp to Qs (removing DWL)
What is the S+Tax curve identical to?
The SMC curve
Externality is the same size as the tax
How does the decrease in surplus interact with decrease in negative externality (tax)
- The decrease in negative externality is greater than the decreased surplus (1)
Lost negative externality not offset by lost surplus
(Area 1 lost surplus cancels out the area 1 lost negative externality)
(Area 2 is an improvement in efficiency resulting from the tax.)
Why don’t reduce quantity past QS?
Because the area of lost surplus would be greater than the area of lost negative externality
- Qs is the efficient quantity
Where is a subsidy shown?
On the supply side (even if its an externality in consumption)
(money goes to the uni rather than each student)
What is the size of subsidy equal to?
The size of the subsidy (difference between S/SMC and S+Sub) is the same as the size of the externality (difference between D and SMB)
What is the relationship between the gain and cost of subsidy?
The gain outweighs the cost of the subsidy
What may happen if an externality is very large?
banning the good may be more effective than a tax.
Government banning drugs, or making vaccines free and compulsory, is an example of government regulation.
