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 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
How does a price ceiling affect social surplus?
It reduces it
How does a price floor affect social surplus?
It reduces it.
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
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 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 is the claim when we have open access markets?
CLAIM: An unrestricted equilibrium emerges where there is too much fishing.
