Econ Externalities Flashcards

What is an externality?

An externality occurs when a person's or firm's actions affect others who are not directly involved in the market transaction. Externalities cause market failure because the market outcome is not socially efficient.

What is a positive externality?

A positive externality occurs when a transaction provides benefits to third parties. Examples include vaccines, education, and research. The market underproduces the good, so Qmarket < Qsocial.

What is a negative externality?

A negative externality occurs when a transaction imposes costs on third parties. Examples include pollution and traffic congestion. The market overproduces the good, so Qmarket > Qsocial.

What does the demand curve represent in externality problems?

Demand represents Marginal Private Benefit (MPB), which is the benefit received only by the consumer.

What does the supply curve represent in externality problems?

Supply represents Marginal Private Cost (MPC), which is the cost incurred only by the producer.

What is the formula for Marginal Social Benefit (MSB)?

MSB = MPB + MEB. Marginal Social Benefit equals Marginal Private Benefit plus Marginal External Benefit.

What is the formula for Marginal Social Cost (MSC)?

MSC = MPC + MEC. Marginal Social Cost equals Marginal Private Cost plus Marginal External Cost.

How do you create a Marginal Social Benefit table?

Step 1: Take MPB from the demand price. Step 2: Take MEB from the external benefit table. Step 3: Add them together. MSB = MPB + MEB.

Example of calculating MSB

If MPB = 80 and MEB = 48, then MSB = 80 + 48 = 128.

How do you find MPB in the table?

MPB is the price on the demand curve for that quantity.

How do you find the market equilibrium?

Find where MPB = MPC or where demand equals supply.

Example of market equilibrium from the vaccine table

At price 60, quantity demanded = 6 and quantity supplied = 6. Therefore equilibrium is Q = 6 and P = 60.

How do you find the socially optimal quantity?

Find where MSB = MSC. In the vaccine problem, this occurs where MSB intersects the supply curve.

Example of socially optimal quantity

At Q = 8, MSB = 80 and Supply = 80. Therefore the socially optimal quantity is 8.

How do you graph the demand curve?

Plot price and quantity demanded points and connect them with a downward sloping line. Demand represents MPB.

How do you graph the supply curve?

Plot price and quantity supplied points and connect them with an upward sloping line. Supply represents MPC.

How do you graph the MSB curve?

Calculate MSB values, plot them as new points, and draw a downward sloping line above the demand curve.

Example MSB points from the vaccine problem

(Q=2, P=128), (Q=8, P=80), (Q=18, P=0).

How can you identify a positive externality on a graph?

The MSB curve lies above the demand curve and the market produces too little, meaning Qmarket < Qsocial.

How can you identify a negative externality on a graph?

The MSC curve lies above the supply curve and the market produces too much, meaning Qmarket > Qsocial.

When does deadweight loss occur?

Deadweight loss occurs when the market quantity does not equal the socially optimal quantity.

Where is DWL for a positive externality?

The DWL triangle lies between MSB and supply from Qmarket to Qsocial.

Where is DWL for a negative externality?

The DWL triangle lies between MSC and demand from Qsocial to Qmarket.

What is the formula for deadweight loss?

DWL = (1/2) × base × height.

Example DWL calculation from the vaccine problem

Base = 8 − 6 = 2. Height = 80 − 60 = 20. DWL = (1/2)(2)(20) = 20.

What is market failure?

Market failure occurs when Qmarket ≠ Qsocial and the market does not produce the socially efficient outcome.

How can the government fix positive externalities?

Policies include subsidies, free provision, tax credits, or public programs such as government-funded vaccines.

How can the government fix negative externalities?

Policies include Pigouvian taxes, regulations, pollution permits, or tolls.

Quick rule to identify positive vs negative externalities

If Qmarket < Qsocial → positive externality. If Qmarket > Qsocial → negative externality.

What do the axes represent in externality graphs?

Vertical axis represents price, cost, or benefit. Horizontal axis represents quantity.

What does the demand curve represent on externality graphs?

Demand represents Marginal Private Benefit (MPB).

What does the supply curve represent on externality graphs?

Supply represents Marginal Private Cost (MPC).

How do you recognize a positive externality on a graph?

The Marginal Social Benefit curve lies above the demand curve because MSB = MPB + MEB.

What happens to quantity with a positive externality?

The market produces too little, meaning Qmarket < Qsocial.

Where is the socially optimal quantity with a positive externality?

At the intersection of MSB and supply.

Where is the market equilibrium?

At the intersection of demand and supply.

How do you recognize a negative externality on a graph?

The Marginal Social Cost curve lies above the supply curve because MSC = MPC + MEC.

What happens to quantity with a negative externality?

The market produces too much, meaning Qmarket > Qsocial.

Where is deadweight loss for a positive externality?

Between MSB and supply from Qmarket to Qsocial.

Where is deadweight loss for a negative externality?

Between MSC and demand from Qsocial to Qmarket.

How do you calculate DWL from a graph?

Use triangle area: DWL = (1/2) × base × height. Base is the quantity difference and height is the vertical difference between curves.

Fast way to identify positive vs negative externalities

Ask whether society wants more or less of the good. More means positive externality. Less means negative externality.

Fast way to locate DWL on an externality graph

Find the market quantity and the social quantity. The DWL triangle lies between those quantities.

Fast way to find the socially optimal quantity

Ignore demand and find where the social curve intersects the opposite private curve.

3-second externality graph rule

Identify the social curve (MSB or MSC), find where it intersects the opposite private curve, and compare that quantity to the market equilibrium. If they differ, deadweight loss exists.