Market failure - externalities Flashcards
MSB =
MSC =
MSB = marginal social benefit = demand
MSC = marginal social cost = supply
MSB = MSC = EQUILIBRIUM
MSC = total cost of society when one more unit i sproduced
MPB = benefit to consumers of consuming one more unit of a good
Externality
An externality occurs when the production or consumption of a good or service has an effect on a third party. If the effect is harmful we call it a negative externality. When the effect is beneficial, we call it a positive externality.
Negative externalities create external costs MSC>MSB
Positive externalities external benefits MSB > MSC
Production externalities MPC≠ MSC
Consumption externalities MPB ≠ MSB
Merit goods and demarit goods
MG : Goods that are beneficial to the individual and society as a whole, and are usually under-provided in a free market.
DG: Goods that have negative effects when consumed and cause negative externalities of consumption.
Negative externality of production ex. Steel making requieres energy mostly comming from fossil fuels. China has struggeled to balance the demand for steel.
When the production of a good or service generates a negative effect on a third party or society, which has not been factored into the costs of producing the good.
MSC > MPC as firms do not take extra costs into consideration
Overallocation of resources
Society produces an ammount Q2> QE and sells lower prie P2<PE. Not socially optimum
All units produced from QE to Q2 have a higher cost for society than the benefit they bring to it
Goverment responses to negative externalities of production
carbon tax, legislation, tradable emissions permit
Upward shit of the supply curve from MPC to MPC+tax=MSC
that meets the point of allocative efficiency where MSC+MSB
Carbon tax on polluting firms to correct negative externaliy adv and disv example
Adv
- easier to app,y
- tax revenues
disv
- difficult to measure pollution
- difficult to identify firms
- taxes make firms pay but do not stop the polluton completly
Legislation example: 2017 Uk environmental agency fines to major polluting firms like Heinken
Gvt passes laws that firms must comply which makes firms cost of prodction increase
disv:
- unemplotment (reduced market size)
- Reduced consumption of a needed good
- difficult to implemebt
Tradable emissions permit
Ex: Kyoto Protocol under the UN to reduce greenhousegaas emissions between countries
Gvt sets the level of admitted pollution
Adv:
- encourages lower cost methods of reducing emissions like clean enegry
- helps achive environmental objectives
-price of permits determined by market
- provides internal coopeartion
disv:
- difficult to set an acceptable level
- difficut to measure a firms level of polluton
Positive externality of production
A positive externality of production is when the production of a good or service generates a positive effect on a third party or society, which has not been factored into the costs of producing the good.
Why is a positive externality of production inefficient
MSC<MPC
Marginal social cost is smaller than the Marginal private cost
Smaller amount produced than sociallly optimal - underallocation of resources
Annotation and graph of positive externality of production
The total cost for society is smaller than the private cost MSC<MPC.
Because private cost of producing is greater results in underallocation of resources
Q2<QE>PE.</QE>
There is a potential welfare gain if resources are allocated efficiently.
Gvt responses to positive externality of production
Subsidies
Direct gvt provision
- Subsidy will shift the supply downward to MSC=MPC+subsidy as firms costs of production are reduced.
Direct gvt provision
Gvt responses to positive externality of production
Subsidies or direct gv provision
- Subsidy will shift the supply downward to MSC=MPC+subsidy as firms costs of production are reduced –> Social welfare gained
Difficult to estimate subsidy opp cost gvt
Social welfare gained
Negative externality of consumption an example
When the consumption of a good or service generates a negative effect on a third party or society, which has not been factored into the calculation when deciding to consume that good.
Consumption of cigarrettes means that non smokers are also affected or cars pollute the air for everyone
Why is negative externality of consumption market failure?
MPC is bigger than MSC
Market is producing at MPC = MSC and nt at MSC=MSB
Graph and annotation of Negative externality of consumption
total benefit for society (MSB) is lower than the private benefit (MPB)
MPB>MSB
Q1>QE and high price P1
All of the units consumed from Q* to Q1 have a higher cost for society than the benefit they bring to it (MSC > MSB).
Gvt responses to negative externality of consumption
Quantity must be reduced from Q2 to Q1
-indirect tax –> MSC shifts left ex. Pigouvian taxes
Problems:
- Price inlesatoc goods (addictuve)
- Black markets
- do not stop the effect
- negative advertising –> MPB shifts left to MSB
Problems
-High cost opp cost - efficiency doubts
Positive externality of consumption
A positive externality of consumption is when the consumption of a good or service generates a positive effect on a third party or society, which was factored into the costs.
Why is positive externality of consumption a marekt failure
MSB > MPB
Underallocation of resourcers. Society would be better off if more goods were consumed and therefoe produced
Q1<QE, P1>PE
Goverment responses to Positive externality of production
- subsidizing firms
adv: more at lower P disv: OppCost gvt , inefficiency as revenue is guaranteed by gvt - direct gvt provision
adv: public services, disv: quality, equity, opp cost
-positive advertising
adv: educate, aware disv: hugh costs
-legislation
adv; complusory consumption disv: resentment of laws and rifhghts
