Chap 3: (Negative) Externalities

Definition to use when starting all market failure qns

Market failure occurs when free markets, operating without any government intervention, fail to allocate scarce resources efficiently and hence society's welfare is not maximised

Why do externalities lead to market failure?

The presence of externalities distorts the signalling function of market prices leading to resource misallocation

Definition to use before talking about negative production externalities

Negative production externalities occur when the production of a good negatively affects the well-being of third parties

Explain the divergence between private and social costs for the diagram for negative production externalities.

The third parties are not compensated by producers for the external costs that they incur. Hence, such external costs are unpriced by the market and not reflected in the MPC which only reflects the private costs of production. This causes a divergence between private and social costs, with MSC lying above MPC as MSC = MPC + MEC.

Definitions to state after drawing externality diagram

MPC, MPB, Qm, Qs

MPC definition to state after drawing externality diagram (eg steel)

Marginal Private Cost (MPC) measures the cost to producers of producing additional units of steel

MPB definition to state after drawing externality diagram (eg steel)

Marginal Private Benefit (MPB) measures the benefit to consumers from consuming additional units of steel

What does Qm represent?

The free-market equilibrium output where MPC = MPB

What does Qs represent?

The optimal quantity to maximise social welfare

What happens when negative production externalities take place without any intervention? (make reference to diagram, eg steel market)

If left to the free market, equilibrium price is Pm and output Qm. Hence, there is an overproduction of Qm-Qs units of steel and an overallocation of resources to the steel market.

What is the impact of negative production externalities on society's welfare? (make reference to diagram)

The overproduction of Qm-Qs results in a loss of welfare for society. This is because MSC exceeds MSB for every unit between Qs and Qm that is overproduced, ie society incurs more costs than benefits to produce each of these units. Society would have been better off not producing those units between Qs and Qm. The total loss of welfare due to the overproduction of Qm-Qs is known as deadweight welfare loss, and is represented by area ABC.

What is the key reason for market failure for negative production externalities?

They cause distortion in market price leading to the market underpricing the good and thus providing the wrong price signals leading to overproduction

What are the two types of solutions for negative production externalities?

Market based solutions and command and control measures

How do market based solutions work in solving negative production externalities?

It relies on the use of the price mechanism. Consumption and production decisions are left to consumers and producers to decide, as long as they take into account the full social costs and benefits of their actions, the outcome will be socially efficient.

What marked based solution can be used to solve negative production externalities, and how can this be done?

Taxes, which raise the market price so that it will reflect the social costs and hence internalise the negative externality

What will happen when the negative externality has been internalised?

Deadweight loss will be eliminated as Qm is reduced to the socially optimal level, Qs

What are the limitations of taxes in internalising negative production externalities?

Lack of information (in trying to estimate the external costs), impractical to use different tax rates (so the tax wouldn't accurately reflect the external costs for each firm)

Which 2 command and control measures can be used to solve negative production externalities?

Regulations and tradable permits

How do command and control measures work in solving negative production externalities?

The government takes over the functions of the market in the allocation of resources, and dictates what to produce, how much to produce, and how to produce using regulations and quotas.

How would regulations function in solving negative production externalities? (eg for factory pollution)

The government would require by law that producers comply with policies (eg equipping their factories with emission reduction devices to reduce pollution), OR a total ban on the product for extreme cases (eg drugs)

What are the limitations of regulations (not ban) in solving negative production externalities?

The effectiveness of regulations highly depend on its compliance, it has high administrative costs, and is a blunt instrument and is unsustainable as it often cannot handle the complexities of the problem it seeks to solve

When is a total ban beneficial/harmful to society respectively? (with reference to diagram)

It is beneficial if it results in net welfare gain and harmful if it results in net welfare loss. When there is a total ban, there would be a welfare loss of Area X due to underproduction. However, it would result in a welfare gain of Area Y due to the removal of the deadweight welfare loss caused by overproduction from Qm-Qs. Hence, whether a ban is beneficial would depend on whether the welfare loss arising from the ban is less than the welfare loss incurred if a ban is not imposed.

For products eg drugs, would a ban increase society's net welfare? Why?

Yes. In this case, the MEC is so large that the MSC exceeds MSB at all levels of output, and there is no welfare gain to society from the production or consumption of even a single unit (ie Area X=0). Hence, a ban will definitely increase society's net welfare.

What are the limitations of regulations (total ban) in solving negative production externalities?

Costly to administer and enforce, and the administrative costs of doing so may outweigh the benefits of the correction. Also, it may work against the welfare of the society if the ban results in greater welfare loss.

Explain how quotas + tradable permits work (system)

Quotas are quantitative restrictions i.e. caps on the quantity that can be legally produced or consumed. Tradable permits is a quota system where the government issues permits to firms allowing them to pollute. They may trade these permits by buying or selling to other firms.

Explain how tradable permits work (how its rolled out irl)

The government will place a cap on the total permissible level of pollution, and estimate the socially efficient level of emissions before issuing the corresponding no. of permits to issue to individual firms. The permits give the firms the legal right to pollute up to the permitted level.

What are the advantages of tradable permits in solving negative production externalities?

Once the cap is determined at the socially efficient level, the government can leave it to the market to distribute the permits efficiently without much government intervention + it provides an incentive for polluting firms to cut back on pollution as they can benefit from selling their unused permits

What are the limitations of tradable permits in solving negative production externalities?

It is difficult to accurately determine the socially optimal quantity of permits to issue, and if permits are over-issued or not sufficiently expensive it will not be effective + requires effective monitoring and enforcement, may fail due to lack of compliance and high administrative costs

Definition to use before talking about negative consumption externalities

Negative consumption externalities occur when the consumption of a good negatively affects the well-being of third parties

What are the 2 solutions for negative consumption externalities?

Taxes and regulations

Explain how taxes can be used to solve negative consumption externalities. (eg for cigarettes)

The government can impose an indirect tax corresponding to the external marginal cost on each unit of cigarette. This shifts the MPC upwards so that the new MPC, which equals MPC + tax, coincides with the MPB at Qs. Hence, the new market equilibrium quantity where MPB = MPC + tax, now coincides with the socially efficient quantity Qs, where MSB = MSC

What will happen if taxes are used to solve negative consumption externalities?

If the tax accurately reflects the marginal external cost, cigarette consumers are now in effect paying for the external cost they impose on others as the price they are paying is now higher. The externality has then been internalised.

What are the limitations of using taxes to solve negative consumption externalities?

Lack of information (in trying to estimate the external costs)

Explain how regulations can be used to solve negative consumption externalities. (eg for cigarettes)

Regulations can help to lower the external cost (MEC) of cigarettes and hence reduce the gap between the market and socially optimal quantity of cigarettes, decreasing the deadweight welfare loss due to the overconsumption of cigarettes

What are the limitations of using regulations to solve negative consumption externalities?

Costly to administer and enforce, and the administrative costs of doing so may outweigh the benefits of the correction. For this to be effective, it has to be accompanied by vigilant policing and a heavy penalty for those who flout the rule.