CRC Economics 1

CRC Economics 2

ExercisesEcon 304

Chapter 10

CRC Economics 3

Do you know …

how externalities affect a market?

why externalities cause social inefficiency?

what governments do to deal with externalities?

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Definitions

Market• D = MPB• S = MPC• E = equilibrium point,

where (MPB = D) = (MPC = S)• Pe = market (equilibrium) price• Qe = market (equilibrium) output

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Definitions

Society Dsoc = MSB = MPB + MEB = D + MEB Ssoc = MSC = MPC + MEC = S + MEC Esoc = social equilibrium point,

where MSB = MSC Psoc = social (equilibrium) price, or

socially optimal price Qsoc = social (equilibrium) output, or

socially optimal output

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1. How externalities affect a market?

No externalities Negative production externalities Positive production externalities Negative consumption externalities Positive consumption externalities Exercises

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a. A market without externalities

P

Q

D

S

Suppose that originally the market looks like the graph below and that there are no externalities.

What is the market price? Market output? Socially optimal price? Socially optimal output?

EPe

Qe

= MPC

= MPB

= Ssoc = MSC

= Dsoc = MSB

= Esoc

= Psoc

= Qsoc

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No externalities, i.e. MEB = MEC = 0

Dsoc = MSB = MPB + MEB = D + MEB = D Ssoc = MSC = MPC + MEC = S + MEC = S Esoc = E Psoc = Pe Qsoc = Qe With no externalities, a free market is

socially efficient.

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b. A market with externalities

P

Q

D

S

Suppose that originally the market looks like the graph below and that there are negative production externalities.

EPe

Qe

= MPC

= MPB

Ssoc = MSC

= Dsoc = MSB

Esoc

Qsoc

Psoc MEC

What is the market price? Market output? Socially optimal price? Socially optimal output?

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c. A market with externalities

P

Q

D

S

Suppose that originally the market looks like the graph below and that there are positive production externalities.

EPe

Qe

= MPC

= MPB

Ssoc = MSC

= Dsoc = MSB

Esoc

Qsoc

Psoc

MEB

What is the market price? Market output? Socially optimal price? Socially optimal output?

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d. A market with externalities

P

Q

D

S

Suppose that originally the market looks like the graph below and that there are positive consumption externalities.

EPe

Qe

= MPC

= MPB

= Ssoc = MSC

Dsoc = MSB

Esoc

Qsoc

Psoc

MEB

What is the market price? Market output? Socially optimal price? Socially optimal output?

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e. A market with externalities

P

Q

D

S

Suppose that originally the market looks like the graph below and that there are negative consumption externalities.

EPe

Qe

= MPC

= MPB

= Ssoc = MSC

Dsoc = MSB

Esoc

Qsoc

Psoc MEC

What is the market price? Market output? Socially optimal price? Socially optimal output?

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f. Exercises

P

Q

D

S

Suppose that originally the market looks like the graph below and that there are externalities.

EPe

Qe

= MPC

= MPB

Qsoc

Psoc

Can you tell the type of externalities that affects this market?

Qsoc < Qe => negative externalities

Esoc

Esoc on S => consumption

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f. Exercises

P

Q

D

S

Suppose that originally the market looks like the graph below and that there are externalities.

EPe

Qe

= MPC

= MPB

Qsoc

Psoc

Esoc

Qsoc > Qe => positive externalities

Esoc on D => production

Can you tell the type of externalities that affects this market?

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2. Why do externalities cause social inefficiency?

Social efficiency occurs at Esoc, where (Dsoc = MSB) = (Ssoc = MSC)

At Esoc, society achieves socially optimal output Qsoc at socially optimal price Psoc.

The presence of externalities cause Qsoc to be different from Qe.

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With externalities, i.e. MEB <> 0 and/or MEC <> 0

Dsoc = MSB = MPB + MEB = D + MEB <> D

Ssoc = MSC = MPC + MEC = S + MEC <> S

Esoc <> E Psoc <> Pe Qsoc <> Qe With externalities, a free market is socially

inefficient.

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3. What governments do to deal with externalities?

Positive externalities => Qsoc > Qe, i.e. too little is being produced in markets.

Governments give subsidies to raise Qe. Negative externalities => Qsoc < Qe, i.e.

too much is being produced in markets Governments impose taxes to reduce Qe.

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Summary

Production externalities

Positive

MEB > 0

Ssoc < S

Negative

MEC > 0

Ssoc > S

Consumption externalities

Positive

MEB > 0

Dsoc > D

Negative

MEC > 0

Dsoc < D

Qsoc > Qe Qsoc < Qe Qsoc > Qe Qsoc < QeQe is too small Qe is too large Qe is too small Qe is too large

Subsidies Taxes Subsidies Taxes

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