5. Negative externalities

Define market failure

When markets fail to achieve allocative efficiency, causing either an underallocation or overallocation of resources. (sometimes called suboptimal allocation)

Define externalities

Positive/negative side-effects arising from the production/consumption of a good or service that is imposed on a third party who is not involved in the transaction.

What do MPC and MSC stand for and how are they different?

MPC: marginal private cost

MSC: marginal social cost

MPC refers to the cost on producers of a good to produce one more unit, while MSC refers to the cost on society from producing one more unit of the good

What do MPB and MSB stand for and how are they different?

MPB: marginal private benefit

MSB: marginal social benefit

MPB refers to the benefit that consumers receive from consuming one more unit of a good, while MSB refers to the benefit that society receives from consuming one more unit of the good

Distinguish between MPB = MPC and MSB = MSC

MPB = MPC is the market equilibrium

MSB = MSC is the allocative efficiency

Define negative production externalities

A cost on an uninvolved third party arising from the production of a good or service

Graphical representation of negative production externalities

MSC > MPC: greater cost on society

Overallocation and overproduction (MSC > MSB)

Define common access resources

Resources that are not owned by anyone, do not have a price, and are available for anyone’s use without payment nor restrictions that are non-excludable and rivalrous

Non-excludable: cannot prevent people from consuming it even if they have not paid

Rivalrous: consumption by one person causes a reduction in availability for others

Why do common access resources tend to be over-consumed?

Due to the profit-maximising nature of consumers and firms, every individual would try to extract as much benefit as possible. Due to the non-excludable nature of common access resources, everyone can consume as much common access resources as they can. Furthermore, due to the rivalrous nature of common access resources, this profit-maximising behaviour causes the consumption of common access resources at an unsustainable rate, causing depletion.

Define sustainability

Development that meets present needs without compromising the ability of future generations to meet their own needs

Note: sustainability does not apply to non-renewable resources

Graphical representation of government regulations on production

Define market-based policies

Government policies that alter the structure of relative prices and therefore the incentives of producers and consumers

4 examples of market-based policies

1. Pigouvian tax: tax imposed on each unit of output

2. Carbon tax: tax imposed on each unit of carbon emissions

3. Tradable permits: quotas for pollution that can be exchanged among firms

4. Subsidies: government assistance provided to individuals and firms

Graphical representation pigouvian tax

Graphical representation of carbon tax

Note: there is a new MSC in the long run

Graphical representation of tradable permits

The impact on the product is the same as the impact of a carbon tax

Quantity supplied for tradable permits is fixed in order to adhere to the cap set by the government

Evaluating market-based policies

Advantages	Disadvantages
Alters the structure of relative prices Incentivises both producers and consumers to alter their behaviour → moving closer to allocative efficiency Additional source of government revenue (if using tax) which can subsidise renewable energy Lower implementation cost	Technical difficulties: difficult to determine the appropriate amount of tax (assign monetary value for the harm) Carbon taxes are usually set too low Difficult to determine a ‘cap’ for tradable permits How to distribute permits fairly? If demand is inelastic then not likely going to be effective (firms will pass higher price down to consumers) Regressive effects May be affected by politics

• Usually preferred when dealing with negative production externalities/overuse of common access resources

• Pigouvian tax, carbon tax, and tradable permits force firms to internalise the external cost

• Carbon tax is usually preferred to tradable permits because it provides government revenue

• Tax on emissions is usually preferred to tax on output as it encourages more sustainable behaviour

Evaluating government regulations

Advantages	Disadvantages
Easier to implement (avoid technical difficulties) Force firms to comply  A ban may be most effective since the accepted amount is zero (e.g. certain chemicals like CFCs)	Do not offer incentives to reduce emissions Costly: gov. needs to enforce regulations May be affected by politics

Define negative consumption externalities

Cost on a third party due to the consumption of a good or service

Graphical representation of negative consumption externalities

MSB < MPB

Overallocation and overconsumption as MSB < MSC

Define demerit goods

Goods and services which are deemed harmful for consumers

Impact of government regulation & advertisement on goods with negative consumption externalities

Define excise tax

a tax levied on the the production of certain goods and services (usually demerit goods) which aims to discourage their consumption

Graphical representation of an excise tax: optimum level

DWL fully eliminated

Graphical representation of an excise tax: less than optimum

DWL reduced but not fully eliminated