fv2 - externalities

AP Microeconomics Unit 6 – Market Failure and the Role of Government: Externalities

Page 1: Understanding Externalities

  • Definition of Externality

    • A third-person side effect of an economic decision impacting someone other than the original decision-maker.

  • Types of Externalities

    • Negative Externality

      • Results in external costs to others; marginal social cost (MSC) > marginal private cost (MPC).

      • Government intervention: per-unit tax to mitigate effects and achieve socially optimal quantity.

    • Positive Externality

      • Results in external benefits for others; marginal social benefit (MSB) > marginal private benefit (MPB).

      • Government intervention: per-unit subsidy to encourage production of socially beneficial goods.

Page 2: Negative Externalities

  • Characteristics of Negative Externalities

    • External costs separate from internal costs to the firm.

    • Common examples: smoking, pollution from factories.

  • Graphical Representation

    • At free market quantity, MSC > MPC, indicating societal costs exceed firm costs.

    • Firms produce at point where demand equals supply, ignoring external costs.

Page 3: Correcting Negative Externalities

  • Government Intervention

    • Imposing a per-unit tax shifts the supply curve from MPC to MSC, aligning production with social optimality.

  • Positive Externalities

    • External benefits to society; examples include flu vaccines and education.

    • At free market quantity, MSB > MPC, indicating societal benefits exceed firm benefits.

    • Government provides per-unit subsidies to increase demand and production.

Page 4: Pigouvian Taxes and Subsidies

  • Market Failure and Government Role

    • Market failures require external correction, typically by the government.

  • Pigouvian Taxes

    • Tax on negative externalities shifts MPC up to equal MSC, reducing overproduction.

  • Pigouvian Subsidies

    • Subsidy on positive externalities shifts MPC down to encourage production.

Page 5: AP Exam Focus on Externalities

  • Key Concepts for Exam

    • Understanding externalities requires knowledge of supply and demand, market disequilibrium, and deadweight loss.

  • Sample Exam Question

    • Analyzing graphs with MSC, MPC, MSB, and demand curves in the context of monopolies and externalities.

Page 6: Exam Question Breakdown

  • Monopolist's Behavior

    • Profit-maximizing price and quantity determined by MR = MPC.

  • Identifying Negative Externalities

    • MSC > MPC indicates external costs.

  • Socially Optimal Quantity

    • Where MSC = MSB.

Page 7: Key Terms to Review

  • Deadweight Loss

    • Loss of economic efficiency when equilibrium is not achieved.

  • External Costs

    • Negative side effects affecting third parties, leading to overproduction.

  • Externality

    • Costs or benefits incurred by third parties not involved in a transaction.

Page 8: Additional Key Terms

  • Marginal Social Cost (MSC)

    • Total cost to society for producing an additional unit, including external costs.

  • Market Disequilibrium

    • Occurs when quantity demanded does not equal quantity supplied.

  • Monopoly

    • Market structure with a single seller, leading to inefficiencies.

Page 9: Conclusion on Externalities

  • Positive Externality

    • Benefits third parties without direct involvement in the transaction.

  • Surplus

    • Occurs when quantity supplied exceeds quantity demanded, impacting market efficiency.