Externalities

Last updated Sep 12, 2023 Edit Source

Demand: Private benefits that consumers receive
Supply: Private costs of production
MPC (Marginal Private Cost): Costs to producers of producing one more unit of a good
MSC (Marginal Social Cost): Costs to society of producing one more unit of a good
MPB (Marginal Private Benefit): Benefits to consumers from consuming one more unit of a good
MSB (Marginal Social Benefit): Benefits to society from consuming one more unit of a good

When MPC=MSC and MPB=MSB socially optimal

MPC = Production cost
MPB = Revenue
MEC = Pollution, etc, INCLUDE TYPE OF POLLUTION
MSC = MPC + MEC
= Total for society

Externalities Externalities occur when the production or consumption of a good/service cause external costs and/or external benefits.

• It is the side effects of economic activity; or
• Unintended consequences of economic activity
• Externalities cause market failure if the price mechanism does not take into account the social costs and benefits of production and consumption

• Occurs when production and/or consumption creates an external cost
• Causes overconsumption/production
  • Market quantity is greater than optimal quantity
  • Market price is less than optimal price
• Results in deadweight loss

• Where the marginal social cost of production is higher than the marginal private cost
• Examples:
  • Air pollution
  • Land pollution
  • Noise pollution

• Where the marginal social benefit of consumption is lower the the marginal private benefit
• Examples:
  • Smoking
  • Alcohol

• External benefits of consumption or production for third parties
• Causes under consumption or production
• Results in deadweight loss

• Where the marginal social benefit of consumption is higher than the marginal private benefit
• Examples:
  • Flu vaccines
  • Education

• Where the marginal social cost of production is lower than the marginal private cost
• Example:
  • Lower transport costs for local firms following construction of new roads

Regulations can forbid the dumping of pollutants to the environment

1. Limit the amount of pollutions
2. Limit the quantity of output to producers
3. Require technologies to reduce emissions

Imposing a tax on per unit of production or pollutant emission.
Internalise the external cost.

• Prevents consumer activities
• Reduce demand towards MSB
• Quantity lowered to $Q_o$ and price lowered to $P_o$

• Prevents consumer activities
• Reduce demand towards MSB
• Quantity lowered to $Q_o$ and price lowered to $P_o$

• Impose indirect tax the size of the external cost
• The impact of the tax is passed onto the consumers as a higher price they now have to burden
• Quantity drops to $Q_o$ and price increases to $P_c$

• Direct government provision:
  • Coming out of government funds
• MPC shifts towards MSC
• Quantity increases to $Q_o$ and price decreases to $P_o$

• Government can provide subsides the size of the external benefit (internalize)
• MSC=MPC + subsidy
• Quantity increases to $Q_o$ and price decreases to $P_o$

• Legislation:
  • Used to increase consumption
  • E.g. Putting compulsory ages to education
• Advertising:
  • Used to increase consumption
  • E.g. Public advertising for education
• Demand increases from MPB to MSB
• Quantity increases to $Q_o$ and price increases to $P_o$

• Direct provision to increase consumption
  • E.g. Education and healthcare
• Supply increases the size of government provision
• Quantity decreases to $Q_o$ and price decreases to $P_c$

• Governments can provide subsidies to producers to lower the cost and hence lower the price for consumers
• Subsidy used to internalize the external benefit
• Quantity increases to $Q_o$ and price decreases to $P_c$

• Limits on production, pollutants, change methods of productions $\rightarrow \space \downarrow$ S
• Tax $\rightarrow$ Shift MPC towards MSC
• Size of tax = MEC

• Legislation/advertising $\rightarrow$ Shift MPB towards MSB $\rightarrow \space \downarrow$ D
• Indirect tax $\rightarrow \space \downarrow$ P

• Direct gov provision $\rightarrow$ MPC towards MSC $\rightarrow \space \uparrow$ S
• Subsidy $\rightarrow$ MPC towards MSC $\rightarrow \space \uparrow$ S

• Legislation/advertising $\rightarrow$ MPB towards MSB $\rightarrow \space \uparrow$ C
• Gov provision
• Subsidy