The Demand Curve (D1) shows the Marginal Social Benefit (MSB) since there is only one curve (for demand) we can assume that there are no externalities considered on the demand side (MSB = MPB). Q* and P* show the price and quantity at the social optimum.
The triangle shows the deadweight loss or welfare loss,
showing the MSC exceeding the MSB. The triangle grows the further out you go
from Q*. This is damage caused by production to a 3rd party in the
sense of an externality. For every point between Q* and Q1 (and
further) the marginal social cost exceeds the marginal social benefit. There is
a market failure as too many goods (Q1) are being produced at too
low a price (P1). The good/service is therefore usually
over-consumed.
Positive
Consumption Externalities
Social
Benefit = Private Benefit + Externality
This is an externality that brings social benefit from the consumption. We can see from the graph that there are 2 demand curves; D1 the MPB (normal market demand curve) and D2 the MSB. There is only one Supply Curve (S1) so MPC = MSC (i.e. there is no externality considered). Q1 and P1 show the normal market price and quantity at E1 and Q* and P* show the price and quantity at the social optimum equilibrium point (E2).
The triangle shows the dead-weight cost. Assuming that the
example above shows the costs and benefits to a frontline health worker
considering whether or not to be vaccinated against flu and we can explain the
graph.
The externality is created because there are benefits to
society from the health worker consuming the vaccination, for example people
are less likely to be come ill. The marginal social benefit from vaccination is
more than the marginal private benefit. In a free market individuals decide for
or against the consumption of vaccinations by assessing the private benefit
they receive from it. Equilibrium occurs where MPB = MPC. Society would like Q*
to be consumed, where the MSB = MSC. For all units of output between Q1 and
Q*, MSB exceeds MSC, showing that there is a benefit to be gained from greater
consumption of vaccination. The shaded triangle shows the welfare loss to
society (the social benefit foregone) if Q1 is consumed instead of
Q*.
Allocative Efficiency occurs when marginal benefit is equal to marginal cost (MB = MC).
A general
explanation:
The graph shows an example of a positive/negative
consumption/production externality. The externality is created because there
are benefits/costs to society from the consumer/producer ... (doing what)...
for example ... The marginal social benefit from ... is more/less than the
marginal private benefit they receive from it. Market equilibrium occurs where
MPB = MPC. Society would like Q* to be consumed/produced, where the MSB = MSC.
For all units of output between Q1 and Q*, MSB is greater/less than
MSC, showing that there is a benefit to be gained from more/less
consumption/production of ... The shaded triangle shows the welfare loss to
society (the social benefit foregone) if Q1 is to be consumed
instead of Q*.
Dealing
with Externalities - Internalising Externalities
Externalities arise when the benefits or costs of a
transaction are not reflected in the market price. There will therefore be a
market failure as the free market will not lead to an optimum allocation of
resources. One way to solve this is to internalise the externality by bring the
cost or benefit into the price system.
Taxation and Subsidies
Indirect taxation or subsidies can be used by the government to correct market failures. A tax would discourage consumption by increasing the price of the product (as the supplier would pass on some of the costs). A subsidy would encourage consumption by reducing the price of the product. This remedy would correct the market failure of externalities. A tax could be used to correct a negative production externality and would discourage the production of demerit goods. Conversely a subsidy would be used to correct a positive consumption externality and encourage the consumption of merit goods.
The Effects of a Subsidy
Advantages
and Disadvantages of Taxes
Tax funds can be used to compensate victims or can be used in
other government schemes, also taxes reduce the amount produced to the social
optimum point where less of the good/service are produced therefore being more
beneficial to society.
Disadvantages of taxes are that firms may relocate to other
countries with less stringent taxes, if the demand for a good or service is
price inelastic then the reduction in good/services wont be great, indirect
taxes make firms less internationally competitive, it might lead to the
development of illegal markets and also it is hard to determine what price to
tax the good or service at.
Advantages
and Disadvantages of Subsidies
The advantage is that they increase the consumption which is
generally considered beneficial (as goods that receive subsidies are usually
merit goods which are under-consumed).
The disadvantage is that there is an opportunity cost to the
government, it may lead to higher taxation or reduced government spending in
other sectors. Also firms may become inefficient in production if they rely
upon subsidies, and the firm may absorb the tax in the form of profits rather
than pass them on to consumers in the form of a price reduction.
Pollution
Permits
One method of reducing pollution is to use a pollution permit
system, under which the government issues or sells permits to firms, allowing
them to pollute up to a certain limit. These permits are then trade able so
that firms that are relatively clean in their production methods can sell their
polluting rights to other firms, whose production methods produce greater
levels of pollution.
Firms that pollute because of their relatively inefficient
production methods will find they are at a disadvantage because they face
higher costs. Rather than continuing to purchase permits, they will have an
incentive to produce less pollution. A second advantage is that the overall
level of pollution can be controlled by this system as the authorities control
the amount of permits that are issued.
However there are issues with the system, sanctions must be
in place for firms that pollute beyond the permitted level, and they must be
cost effective methods for the authorities to check for the level of emissions.
It is also hard to determine how many permits to issue and
the price at which to issue them in order to make sure the MPC equals the MSC.
Advantages
and Disadvantages of Pollution Permits
Advantages include governments being able raise funds which
they can use to compensate victims, firms have an incentive to invest in clean
technology and clean firms receive a source of revenue as they can sell their
excess pollution permits.
Disadvantages include issuing too many or too few permits,
reducing the international competitiveness of firms, leading to some firms
relocating outside an area participating in a permit scheme. Some firms may
pass the costs of pollution permits onto customers therefore increasing the
price for consumers (although this is only likely to happen if the product is
demand inelastic). Also as the price of the permits fluctuate it is difficult
for a firm to determine whether or not to invest in cleaner production methods,
there is a cost to the government to monitor the scheme and unless all
countries participate in a pollution reducing scheme it is unlikely that global
warming will abate.
Property
Rights
The existence of a system of secure property rights is
essential for the economy. The legal system exists to enforce property rights
and to provide the set of rules under which markets operate. When property
rights fail, there is a failure of markets.
One of the reasons that some externalities exist is because
there is a failing in the system of property rights. For example if a firm
pollutes toxic fumes into a residential area then there is an externality, if
the residents could be given property rights over clean air, they could get
compensation from the firm. This would act as an incentive for the firm to
reduce pollution and would also compensate the residents. However with such a
wide range of people being affected it is impossible to practically assign
property right.
Property rights can be effective in curbing the effects of
externalities only if the costs of implementing it are not too high.
Advantages
and Disadvantages of Property Rights
Advantages include more sustainable management as the good
that is being exploited now belongs to someone, and they will want to keep it
for the use of future generations.
Disadvantages include it being difficult for a government to
extend property rights as they don’t know who the property should belong to,
who to give the property to if it spans more than one country and it is
difficult to place a monetary value on the use of a property right.
Government
Regulation
There are various forms of government regulation to correct
market failure. These can include imposing fines or closing down firms that
don’t abide by strict rules regarding environmental and ethical issues.
Advantages
and Disadvantages of Government Regulation
Advantages include reducing the problem of asymmetric
information, raising money for the government from fines and for the rules
being simple to understand.
Disadvantages include it being expensive to monitor and it
being hard to put a monetary value on breaking the regulations.
Page last updated on 20/10/13
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