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Externality

Externality. John R. Swinton, Ph.D. Center for Economic Education Georgia College & State University. Externality. Question: Assume that the market for good X is perfectly competitive and that the production of good X creates a negative externality. Externality.

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Externality

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  1. Externality John R. Swinton, Ph.D. Center for Economic Education Georgia College & State University

  2. Externality • Question: • Assume that the market for good X is perfectly competitive and that the production of good X creates a negative externality.

  3. Externality • (a) Draw a correctly labeled graph of the market for good X and show each of the following: Price good X Demand (or MB) 0 Quantity good X

  4. Externality • (i) The marginal private cost and the marginal social cost for good X, labeled MPC and MSC, respectively. MSC Price good X MPC Demand (or MB) 0 Quantity good X

  5. Externality • (ii) The market quantity, labeled Qm. MSC Price good X MPC Pm Demand (or MB) 0 Quantity good X Qm

  6. Externality • (iii) The allocatively efficient quantity, labeled Qs. MSC Price good X MPC Ps Pm Demand (or MB) 0 Quantity good X Qs Qm

  7. Externality • (iv) The area of deadweight loss, shaded completely. MSC Price good X MPC DWL Ps Pm Demand (or MB) 0 Quantity good X Qs Qm

  8. Externality • (b) Assume a lump sum tax is imposed on the produces of good X. What happens to the deadweight loss? Explain MSC MPC + Tax Price good X MPC DWL Ps Pm Demand (or MB) Unit Tax 0 Quantity good X Qs Qm

  9. Externality • Traditional (A.C. Pigou) Approach: • Identify Externality • Impose a tax (or subsidy) that requires producer to internalize the external cost (or benefit) • New price (MPC + Tax) represents the true cost to society of producing the good

  10. Externality • Three Different Types of Taxes: • Tax on offending product (Good X) = Pigouvian Tax • Tax on input into production process that causes the externality (e.g. Gasoline Tax) • Tax on the pollutant itself (e.g. Carbon Tax)

  11. Externality • Alternative Approaches to Externality: • Liability Law (e.g. Erin Brockovich) • Well-defined Property Rights (Coase theorem) • Limited Property Rights (e.g. Tradable Pollution Permits)

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