Unit 5 – Market Failure and the Role of Government

Externalities

Essential Questions1. Why are markets inefficient in the presence

of positive and negative externalities?2. How do we identify the area of efficiency

loss (deadweight loss) when externalities are present?

3. How can government correct the inefficiencies created by externalities?

P

Q0

S

D

Pe

Qe

The Perfectly Competitive Market A Model of Efficiency

ConsumerSurplus

ProducerSurplus

What makes the perfectly competitive market efficient?

1. Total surplus is maximized.

2. Price = marginal cost.

3. Marginal benefit = marginal cost.

Not just to the individual, but to society.

P

Q0

MSC

MSB

Pe

Qe

The Perfectly Competitive Market A Model of Efficiency

ConsumerSurplus

ProducerSurplus

In a perfectly competitive market, marginal social benefit = marginal social cost.

P

Q0

Marginal Social Cost

Marginal Social Benefit

Pe

Qe

Important Point: In the absence of externalities, the benefit to society is the same as the benefit to the parties involved in the transaction, and the cost to society is the same as the cost to the parties involved.

ConsumerSurplus

ProducerSurplus

is equal to

Externalities are additional benefits or costs to society. Some third party, other than the

producer or the consumer is getting a benefit or incurring a cost from the transaction.

I. Positive externalities: a third party is enjoying a benefit from the transaction.

II. Negative externalities: a third party is incurring a cost from the transaction.

Positive Externalities – Examples.

- Vaccinations- Education- Health care

- A fence that your neighbor builds- Your neighbor insulates his house

Negative Externalities examples:

- cigarettes- alcohol - Pollution from a chemical plant - neighbor plays new kickin’ stereo real

loud

Graphing Externalities and Finding Deadweight Loss

P

Q0

Marginal Private Benefit(MPB)

Positive externalities complicate the market by adding an external benefit to society that is not included in the

private benefit to the consumer.

Marginal Social Benefit(MSB = MPB + MEB)

Marginal External Benefit (MEB)

P

Q0

MSC

Marginal Private Benefit(MPB)

Pmkt

Qmkt

The market underproduces a good with positive externalities.

Marginal Social Benefit(MSB = MPB + MEB)

Qefficient

P

Q0

MSC

Marginal Private Benefit(MPB)

Pmkt

Qmkt

Where is the area of deadweight loss?

Marginal Social Benefit(MSB)

Qefficient

P

Q0

Marginal Private Cost(MPC)

Negative externalities complicate the market by adding an external cost to society that is not included in the

private cost to the consumer or the producer.Marginal Social Cost

(MSC = MPC + MEC)

Marginal External Cost (MEC)

P

Q0

MPC

Pmkt

Qmkt

The market overproduces a good with negative externalities.

MSB

Qefficient

MSC = MPC + MEC

P

Q0

MPC

Pmkt

Qmkt

Where is the area of deadweight loss?

MSB

Qefficient

MSC

P

Q0

S1

Q2

D

A

S2

Q1

B

C

E

What type of externality?

What is:

S1

S2

Q1

Q2

AB

Deadweight loss

P

Q0

S

Q2

D1

A

Q1

B

C

D2

E

What type of externality?

What is:The area of deadweight loss?The marginal external benefit?The market quantity?The socially efficient quantity?The marginal social benefit?The marginal private benefit?

How can government correct the inefficiencies caused by

externalities?

P

Q0

MSC

MPB

Pmkt

Qmkt

For Positive ExternalitiesThe Government can provide subsidies.

MSB

Qefficient

1. To the consumer.

2. To the producer.

- Must be a per unit subsidy rather than a lump-sum subsidy in order to affect the marginal cost curve.

P

Q0

MSC

MPB

Pmkt

Qmkt

For Positive ExternalitiesSubsidy to the consumer shifts the demand curve up by

the amount of the subsidy.

MSB

Qefficient

2. With the subsidy, MPB = MSB, so the externality and the deadweight loss are eliminated.

Psubsidy

MSB = MPB

1. How much should the subsidy be?

P

Q0

MSC

MPB

Pmkt

Qmkt

For Positive ExternalitiesSubsidy to the producer shifts the supply curve down by

the amount of the subsidy.

MSB

Qefficient

2. With the subsidy, deadweight loss is eliminated because the new output level will be at the socially efficient quantity.

Psubsidy

1. How much should the subsidy be?

MSC2

P

Q0

MPC

Pmkt

Qmkt

For negative externalities, the government can levy a tax in the amount of the marginal external cost.

MSB

Qefficient

MSC2. With the tax, MPC = MSC, so the externality and the deadweight loss are eliminated.Ptax

= MPC