L25 - Externalities Flashcards
What is market failure?
where markets do not lead to social efficiency under certain conditions
- in these flashcards, we look at market failure due to the effect of transactions on third parties
(i. e. there are side effects from production or consumption)
What are external benefits and costs called?
- externalities
- Externalities imply that social benefits/costs diverge from private benefits/costs
The market will lead to a point that is privately efficient, not socially efficient
What are the characteristics of Externalities?
1 - Externalities can be positive or negative
2 - Externalities can be created in the production or in consumption
3 - Banning all products with negative externalities is not socially desirable
What is under Externalities can be positive or negative?
- Negative externality is when there is an external cost on a third party
- Positive externality is when there is an external benefit on a third party
A market produces:
(i) too much if there is a negative externality
(ii) too little if there is a positive externality
What are the different types under Externalities can be created in the production or in consumption?
- negative production externality
- negative consumption externality
- positive production externality
- positive consumption externality
What is under the section Banning all products with negative externalities is not socially desirable?
The right amount finds the best trade-off between its benefits and costs
What does Negative Production Externality (external costs in production) look like on a graph?
- With Price, costs and benefits on the y-axis and Quantity on the x-axis
- thinking of a factory that is causing pollution
- negative gradient line of D = MPB = MSB ( also equals MSB because there is no externalities in the consumption of the good)
- positive gradient line of S = MC = MPC
- if left to the market output would be produced at the interception –> but is the market socially efficient
- by plotting the MSC = MXC + MPC where MXC is the external cost that effect society but not the firm
- which creates a steeper gradient line from where the supply curve originated –> this line differs because of the externality –> therefore MSC doesnt equal MPC
- the steeper MSC line get further away from the supply line showing that this costs gets larger the more that is produced
- the socially efficient output is given when the lines of MSB=MSC which occurs at an output less that what the market is producing –> this happens because the firms arent taking the account of the pollution –> not socially efficient
- the welfare cost to society occurs in the triangular area above the market equilibrium on the MSC line to the point where there is social equilibrium
What does Positive Production Externality (external benefits in production) look like on a graph?
With Price, costs and benefits on the y-axis and Quantity on the x-axis
- think of a firm for producing a medicine –> societal benefit of producing it
- negative gradient line of D = MPB = MSB ( also equals MSB because there is no externalities in the consumption of the good)
- positive gradient line of S = MC = MPC
- if left to the market output would be produced at the interception –> but is the market socially efficient
- by plotting the line of MSC = MXB + MPC which creates a flatter line originating for where the supply curve started
- we can see that social efficiency actually occurs at a output level above what the market is producing
- the welfare loss for society occurs in the triangle area below market equilibrium and the MSC line up to the point of social efficiency –> this is what society is losing out on
How can you correct the effects of externalities in a market?
- social planner would want to intervene in markets that are socially inefficient
- Social efficiency can be achieved by using market-based policies, such as:
per unit taxes and per unit subsidies
Generally, the social planner should:
(a) tax activities that are produced too much by markets
(b) subsidise activities that are produced too little by markets
- In this way, the social planner can internalise the externality
- It attempts to align private incentives with social efficiency
- A Tax that corrects the effects of a negative externality is called a Pigovian tax
(after 20th Century Economist Arthur Pigou, an early advocate for their use)
Why would we want to use market-based policies?
- An alternative is to simply regulate the market.
- But most economists prefer market-based policies: per unit taxes & subsidies
Consider the following example:
- Each firm pumps X units of pollution per unit of output into the atmosphere
The government wants to reduce the amount of pollution. It has two options:
a) regulation: restrict waste to Y units of pollution per unit of output
b) Pigovian tax: each firm pays t per unit of output
Why is a Pigovian tax better than regulation?
- The tax will reduce pollution
- The tax reduces pollution more efficiently
- The tax is better for the environment
- The tax raises money for the government
What does the effects of a Pigovian tax look like on a graph?
- price, costs and benefits on the y-axis and Quantity on the x-axis
- negative gradient line of D = MPB = MSB ( also equals MSB because there is no externalities in the consumption of the good)
- positive gradient line of S = MC = MPC
- if left to the market output would be produced at the interception –> but is the market socially efficient
- looking at a negative externalities where the MSC is diverging above from the MPC line
- and the market is producing more than what would be consider socially efficient at MSB=MSC
- with the wealfare loss to society occure in the triangle area above market equilibrium to the MSC curve to the point of social efficient
- A pigovian tax shift the Supply curve up –> increases prices per unit of the good which increases it MPC and increase the equilibrium so less is produced
- this reduces the welfare loss to society and brings output towards what would be socially efficient
- if you can get the tax right you can actually make output the socially desirable level
