Module 4 - Externalities Flashcards
What are the two ways we can measure the net benefits (benefits less expenditures) to consumers who purchase goods in a market:
1 Consumers’ Willingness to Pay less expenditures
2 Consumers’ Surplus
How can we measure the total willingness of consumers to pay (WTP) for the goods?
the area under the demand curve.
Calculated as the area under the demand curve bounded between zero and
the amount purchased.
What is willingness to pay?
the maximum amount a person would be willing to pay in order to receive a good/service.
What are consumer total expenditures?
the price they have to pay times the quantity they purchase.
E.G: P x Q.
What are consumers net benefits?
Willingness to Pay less Expenditures
What is consumer surplus?
the excess of benefits over expenditures:
CS = WTP - P Q
What is the observed (P, Q) point on the demand curve?
the quantity
purchased-consumed (P, Q).
What are profits?
Profits are equal to revenue less costs.
Π = rev - costs
What is revenue?
the quantity sold times the market price:
Q x P
what are costs?
all the expenditures that a firm incurs in production.
We can measure these (variable) costs as the area under the supply curve.
What is Producers’ surplus?
the excess of revenue over costs:
PS = REVENUE - Costs
What does a supply curve show?
the amount of goods a firm is willing and able to offer at different prices.
How do firms determine how many goods to sell?
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.
What is social surplus?
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
Social surplus can also be considered using producer surplus and consumer surplus.
SS = CS + PS
How is the consumer surplus calculated?
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.
How is the producer surplus calculated?
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.
What is the “invisible hand” hypothesis?
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.
What is market failure?
Failure to maximize social surplus
What does the “invisible hand” hypothesis imply?
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.
What is the assumption of the benchmark case of Perfect competition (No externalities)?
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).
What is the problem and the claim of the benchmark case of Perfect competition (No externalities)?
PROBLEM: Will the unregulated market produce at the social
optimum?
CLAIM: Yes, the unregulated market maximizes social surplus so
is efficient.
How do you show that social surplus is at a maximum in the benchmark case of perfect competition?
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
What is dead weight loss (DWL)?
Any outcome that does not maximize net benefits
Can be an uncaptured net benefit or an excess cost
What happens if Q is less the Q*?
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
What happens if Q is more than Q*?
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
What is a price ceiling?
The maximum amount a product can sell for
What is a price floor?
The minimum amount a product can sell for
How does a price ceiling affect social surplus?
It reduces it
How does a price floor affect social surplus?
It reduces it.
What do we assume when governments interfere in the market place?
CASE 2: Competitive market with a consumption tax
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.
What is the problem and the claim when governments interfere in the marketplace?
CASE 2: Competitive market with a consumption tax
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
What is a consumption tax?
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
does consumer tax alter social surplus?
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.
What is an externality?
An externality exists when the welfare of some agent depends, at least partially, on the activities of other agents.
- Often unanticipated or unknown
What are positive externalities?
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.
What are negative externalities?
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).
What are pecuniary externalities?
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.
What do we assume when we have a negative consumption externality?
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;
What is the problem and the claim when we have a negative consumption externality?
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
What is the marginal external cost curve?
Each additional increase in consumption leads to more external damages.
How do we use the demand curve to tell us how consumers benefit from consumption?
We subtract damages from WTP to get the true social benefit.
The Social Marginal Benefit curve (SMB) = PMB - MEC
Do damages affect consumption?
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
What does social surplus with negative externalities look like?
Since we have too much pollution,
what might governments do about it?
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
What does externalities with consumption tax look like?
What does externalities with production tax look like?
What can we assume when we have open access markets?
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.
What is the claim when we have open access markets?
CLAIM: An unrestricted equilibrium emerges where there is too much fishing.
