Unit 5 – Market Failure and the Role of Government Externalities

1. Unit 5 – Market Failure and the Role of Government Externalities

2. Essential Questions Why are markets inefficient in the presence of positive and negative externalities? How do we find the area of efficiency loss (deadweight loss) when externalities are present? How can government correct the inefficiencies created by externalities?

3. The Perfectly Competitive Market A Model of Efficiency What makes the perfectly competitive market efficient? Total surplus is maximized. No one could be made better off without making someone else worse off. Marginal benefit = marginal cost. Not just to the individual, but to society. P S Consumer Surplus Pe Producer Surplus D 0 Qe • Q

4. The Perfectly Competitive Market A Model of Efficiency In a perfectly competitive market: Total surplus is maximized. Marginal social benefit = marginal social cost. P MSC Consumer Surplus Pe Producer Surplus MSB 0 Qe • Q

5. 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. P Consumer Surplus Marginal Social Cost Pe is equal to Producer Surplus Marginal Social Benefit 0 Qe • Q

6. 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.

7. Positive Externalities – one more distinction. Positive consumption externalities:a third party benefits when the product is consumed. Brainstorm examples: - vaccinations - education - neighbor buys a mosquito control system - and one big one that’s been in the news all the time lately?

8. Positive Externalities – one more distinction. B. Positive production externalities: a third party benefits when the product is produced. Brainstorm examples: - a new road built by an oil company - a fence that your neighbor builds - your neighbor installs a sidewalk

9. Negative Externalities – one more distinction. Negative consumption externalities:a third party incurs a cost when the product is consumed. Brainstorm examples: - cigarettes - alcohol - neighbor plays new kickin’ stereo real loud

10. Negative Externalities – one more distinction. B. Negative production externalities: a third party incurs a cost when the product is produced. Brainstorm examples: - highway construction - pollution from a chemical plant - noise from a neighbor renovating his house

11. Discussion – what type of externalities are these? Positive or negative? Consumption or production? Antibiotics? Gasoline?

12. Graphing Externalities and Finding Deadweight Loss

13. Positive externalities complicate the market by adding an external benefit to society that is not included in the private benefit to the consumer. P Marginal External Benefit (MEB) Marginal Social Benefit (MSB = MPB + MEB) Marginal Private Benefit (MPB) 0 • Q

14. The market underproducesa good with positive externalities. P MSC Pmkt Marginal Social Benefit (MSB = MPB + MEB) Marginal Private Benefit (MPB) 0 Qmkt Qefficient • Q

15. Where is the area of deadweight loss? P MSC Pmkt Marginal Social Benefit (MSB) Marginal Private Benefit (MPB) 0 Qmkt Qefficient • Q

16. 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. P Marginal Social Cost (MSC = MPC + MEC) Marginal Private Cost (MPC) Marginal External Cost (MEC) 0 • Q

17. The market overproduces a good with negative externalities. P MSC = MPC + MEC MPC Pmkt MSB 0 Qefficient Qmkt • Q

18. Where is the area of deadweight loss? P MSC MPC Pmkt MSB 0 Qefficient Qmkt • Q

19. P What type of externality? What is: Q1 Q2 S1 S2 AB Deadweight loss S2 S1 C A E B D 0 Q2 Q1 • Q

20. P 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? S A C B E D2 D1 0 Q1 Q2 • Q

21. How can government correct the inefficiencies caused by externalities?

22. For Positive Externalities The Government can provide subsidies. P 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. MSC Pmkt MSB MPB 0 Qmkt Qefficient • Q

23. For Positive Externalities Subsidy to the consumer shifts the demand curve up by the amount of the subsidy. P 1. How much should the subsidy be? MSC 2. With the subsidy, MPB = MSB, so the externality and the deadweight loss are eliminated. Psubsidy Pmkt MSB MSB = MPB MPB 0 Qmkt Qefficient • Q

24. For Positive Externalities Subsidy to the producershifts the supply curve down by the amount of the subsidy. P 1. How much should the subsidy be? MSC 2. With the subsidy, deadweight loss is eliminated because the new output level will be at the socially efficient quantity. MSC2 Pmkt MSB Psubsidy MPB 0 Qmkt Qefficient • Q

25. For negative externalities, the government can levy a tax in the amount of the marginal external benefit. P MSC = MPC 2. With the tax, MPC = MSC, so the externality and the deadweight loss are eliminated. MPC Ptax Pmkt MSB 0 Qefficient Qmkt • Q