Module 4 - Externalities

Question 1

What are the two ways we can measure the net benefits (benefits less expenditures) to consumers who purchase goods in a market:

Answer 1

1 Consumers’ Willingness to Pay less expenditures

2 Consumers’ Surplus

Question 2

How can we measure the total willingness of consumers to pay (WTP) for the goods?

Answer 2

the area under the demand curve.

Calculated as the area under the demand curve bounded between zero and
the amount purchased.

Question 3

What is willingness to pay?

Answer 3

the maximum amount a person would be willing to pay in order to receive a good/service.

Question 4

What are consumer total expenditures?

Answer 4

the price they have to pay times the quantity they purchase.

E.G: P x Q.

Question 5

What are consumers net benefits?

Answer 5

Willingness to Pay less Expenditures

Question 6

What is consumer surplus?

Answer 6

the excess of benefits over expenditures:
CS = WTP - P Q

Question 7

What is the observed (P, Q) point on the demand curve?

Answer 7

the quantity
purchased-consumed (P, Q).

Question 8

What are profits?

Answer 8

Profits are equal to revenue less costs.
Π = rev - costs

Question 9

What is revenue?

Answer 9

the quantity sold times the market price:
Q x P

Question 10

what are costs?

Answer 10

all the expenditures that a firm incurs in production.

We can measure these (variable) costs as the area under the supply curve.

Question 11

What is Producers’ surplus?

Answer 11

the excess of revenue over costs:
PS = REVENUE - Costs

Question 12

What does a supply curve show?

Answer 12

the amount of goods a firm is willing and able to offer at different prices.

Question 13

How do firms determine how many goods to sell?

Answer 13

Firms will only sell one additional good as long as the price they receive is larger than, or equal, to the additional cost of producing that good.

Question 14

What is social surplus?

Answer 14

the net benefit of consuming goods and
services that accrue to all members of society

Benefits accrue to consumers. We measure this as Willingness to Pay (WTP)

Costs are incurred by firms so are counted as a cost to society

= WTP – COSTS

Question 15

Social surplus can also be considered using producer surplus and consumer surplus.

Answer 15

SS = CS + PS

Question 16

How is the consumer surplus calculated?

Answer 16

The somewhat triangular area labeled by F shows the area of consumer surplus, which shows that the equilibrium price in the market was less than what many of the consumers were willing to pay.

Question 17

How is the producer surplus calculated?

Answer 17

The somewhat triangular area labeled by G shows the area of producer surplus, which shows that the equilibrium price received in the market was greater than what many of the producers were willing to accept for their products.

Question 18

What is the “invisible hand” hypothesis?

Answer 18

individuals, motivated by self-interest only, can arrive at an outcome that is in the greatest social interest.

Firms only care about profits and consumers only care about their personal
welfare. They interact though markets and the market equilibrium maximizes social welfare.

Question 19

What is market failure?

Answer 19

Failure to maximize social surplus

Question 20

What does the “invisible hand” hypothesis imply?

Answer 20

A decentralized market will allocate resources, both for production and consumption, in the SAME WAY that a benevolent, omniscient dictator concerned with maximizing social welfare would.

There is no role for government intervention in the economy since the government COULD NOT do better than a decentralized system.

Allocations are efficient but not necessarily fair or equitable.

Question 21

What is the assumption of the benchmark case of Perfect competition (No externalities)?

Answer 21

All benefits accrue only to consumers of the product and all costs accrue only to firms in the industry. No other consumers or firms are affected at all (no externalities).

Question 22

What is the problem and the claim of the benchmark case of Perfect competition (No externalities)?

Answer 22

PROBLEM: Will the unregulated market produce at the social
optimum?

CLAIM: Yes, the unregulated market maximizes social surplus so
is efficient.

Question 23

How do you show that social surplus is at a maximum in the benchmark case of perfect competition?

Answer 23

We want to show that Social Surplus is at
a maximum.

Approach 1: SS = WTP - C :
total willingness to pay minus total costs of production

Approach 2: SS = CS + PS :
Consumer plus producer surplus

Question 24

What is dead weight loss (DWL)?

Answer 24

Any outcome that does not maximize net benefits

Can be an uncaptured net benefit or an excess cost

Question 25

What happens if Q is less the Q*?

Answer 25

Costs fall with lower production, but WTP falls by more We have some social surplus that is uncaptured. This is a lost opportunity and so constitutes a Dead Weight Loss

Question 26

What happens if Q is more than Q*?

Answer 26

WTP rises with output, but costs rise by even more We have some additional costs that exceed the additional benefits. This results in excess costs so constitutes a Dead Weight Loss

Question 27

What is a price ceiling?

Answer 27

The maximum amount a product can sell for

Question 28

What is a price floor?

Answer 28

The minimum amount a product can sell for

Question 29

How does a price ceiling affect social surplus?

Answer 29

It reduces it

Question 30

How does a price floor affect social surplus?

Answer 30

It reduces it.

Question 31

What do we assume when governments interfere in the market place? CASE 2: Competitive market with a consumption tax

Answer 31

All costs accrue to firms in the industry, all benefits accrue to consumers, but consumption is taxed at a fixed rate per unit of consumption.

Question 32

What is the problem and the claim when governments interfere in the marketplace? CASE 2: Competitive market with a consumption tax

Answer 32

PROBLEM: Does the government intervention produce the social surplus maximizing level of production? CLAIM: No. There is too little production. Output should rise. There is a DWL

Question 33

What is a consumption tax?

Answer 33

is levied at the store like the GST and PST Consumers face the retail price plus the tax on top of it. The price the consumer sees is equal to the market price plus the tax: P consumer= P mkt + tax The retailer collects the tax but remits it to the government. So the price the firm receives is just the market price. P firm = P mkt

Question 34

does consumer tax alter social surplus?

Answer 34

the tax is just a transfer from consumers to the government. The government uses the tax revenues to provide services, support individuals and firms, and build infrastructure. We include the taxes paid as part of social surplus since it contributes to surplus. SS = CS + PS + TAX REVENUE or SS = WTP – COSTS So the tax does not alter social surplus directly except in how it alters market behaviour.

Question 35

What is an externality?

Answer 35

An externality exists when the welfare of some agent depends, at least partially, on the activities of other agents. * Often unanticipated or unknown

Question 36

What are positive externalities?

Answer 36

also known as: external economies * Fixing up your house raises neighborhood property values. * Improving your driving skills benefits others. * A firm investing in training can benefit other firms. * Inventing new products often provides clues for other firms.

Question 37

What are negative externalities?

Answer 37

external dis-economies * Pollution by firms can hurt households and/or other firms. * Pollution by consumers can hurt other people * Driving your car during rush hour slows other people down (congestion externality).

Question 38

What are pecuniary externalities?

Answer 38

effects that feed through the market * Increased production by firms raises labour demand and wages. * Increased consumption by households raises prices for other consumers. NOTE: Pecuniary externalities DO NOT lead to market failure.

Question 39

What do we assume when we have a negative consumption externality?

Answer 39

All costs accrue to firms in the industry but consumption produces a negative externality (call it pollution). Example: CO, NOx, NO2 Pollution from cars; increased risk to pedestrians and cyclists from driving;

Question 40

What is the problem and the claim when we have a negative consumption externality?

Answer 40

PROBLEM: Does an unregulated market produce the efficient level of production? CLAIM: There is too much production from the unregulated market. Hence we have a market failure and an associated deadweight loss

Question 41

What is the marginal external cost curve?

Answer 41

Each additional increase in consumption leads to more external damages.

Question 42

How do we use the demand curve to tell us how consumers benefit from consumption?

Answer 42

We subtract damages from WTP to get the true social benefit. The Social Marginal Benefit curve (SMB) = PMB - MEC

Question 43

Do damages affect consumption?

Answer 43

When we look at the market equilibrium, we see that the damages are irrelevant in determining the equilibrium since consumers are, by assumption, either unknowing of the damages or uncaring

Question 44

What does social surplus with negative externalities look like?

Answer 44

Question 45

Since we have too much pollution, what might governments do about it?

Answer 45

Objective: we need to reduce consumption to where the true marginal benefit curve crosses the supply curve (at QSO ) Possible Instruments: 1. Tax on consumption 2. Tax on production 3. Impose Design standards (catalytic converters) 4. Direct restrictions on driving

Question 46

What does externalities with consumption tax look like?

Answer 46

Question 47

What does externalities with production tax look like?

Answer 47

Question 48

What can we assume when we have open access markets?

Answer 48

ASSUME: * Fishermen have free access to a fishing hole. * The private/social benefit of the fish activity is positive and increasing but at a decreasing rate (downward sloping demand) * Private marginal costs of fishing effort is positive and rising. * The marginal external cost is increasing in fishing effort as it takes everyone longer to catch a fish if there are many fishermen.

Question 49

What is the claim when we have open access markets?

Answer 49

CLAIM: An unrestricted equilibrium emerges where there is too much fishing.