## Positive Consumption Externality

Positive Consumption Externality: The type/name of the externality tells you what you need to do!

Positive = Positive (duh!) (we want more of it)
Consumption = Benefits = Demand (there will be two demand curves, MSB & MPB)
• Positive = we want more
• Consumption = benefits = demand
• Triangle = DWL (dead weight loss) (points to society) & is between the two demand curves
• SOQ = Socially Optimal Quantity or the quantity desired by society (Pos.= more quantity)
• Underproduction =  If we want more we must be underproducing the good. (duh!)
• MSB = MSC, obviously where social benefits and costs equal,  equilibrium quantity- Q*
• Subsidy shifts supply right, lowering price, increasing quantity consumed.
• CLG - always a correctly labelled graph
• Triangle - always points to society - to help you know which demand/cost curve is drawn above or below, know that the triangle always points to (MSB) society for a Positive Consumption Externality... Your going to say,, but Charles I could draw the curve pointing to the left and still have it between the curves,,, but then the triangles point would be pointing to an equilibrium of less production (we need more).
• Subsidy has been granted, shifting supply right, lowering price.
• Check your graph and make sure it is showing what you want,,, to get more consumption prices must go lower. (look above and you will see this is exactly what has happened, prices have decreased and quantity produced has risen.)

## Positive Production Externality

pajholden - Positive Externalities - Video

Positive Production Externality: The type/name of the externality tells you what you need to do!

Positive = Positive (duh!) (we want more of it)
Production = Production = Costs = Supply (there will be two supply curves, MSC & MPC)
• Positive = we want more
• Production = costs = supply
• Triangle = DWL (dead weight loss) (points to society) & is between the two supply curves
• SOQ = Socially Optimal Quantity or the quantity desired by society (Pos.= more quantity)
• Underproduction =  If we want more we must be underproducing the good. (duh!)
• MSB = MSC, obviously where social benefits and costs equal,  equilibrium quantity- Q*
• CLG - always a correctly labelled graph
• Triangle - always points to society - to help you know which supply/cost curve is drawn above or below, know that the triangle always points to (MSC) society for a Positive Production Externality... Your going to say,, but Charles I could draw the curve pointing to the left and still have it between the curves,,, but then the triangles point would be pointing to an equilibrium of less production (we need more).
• Check your graph and make sure it is showing what you want,,, to get more production prices must go lower. (look above and you will see this is exactly what has happened, prices have increased and quantity produced has fallen.)

An example of a positive production externality would be a case of bee keepers producing honey next to an orchard. Bees help in the pollination of the orchard, causing a benefit (unpaid) to the orchard owner.

Demand in this instance, which always reflects the MPB of buyers of honey, and is identical to the MSB as no external effects of honey consumption are assumed. (D,MSB,MPB)

Supply of honey reflects the MPC of honey producers (costs paid, labour and bees). Since the honey producer's production process entails external benefits to apple growers in the form of pollination, it follows that the social costs of honey production are lower than the private costs that the beekeepers consider. The MSC of honey production are therefore lower than the MPC by the amount of the external benefit created. (Triangle points to Society = MSC)

There is an underproduction of this good, so prices need to be lowered. This is normally done through the use of a subsidy granted to the producer. This decreases the costs of production increasing output levels.

2008 AP Microeconomics Exam
Answer (B) Subsidizing flu shots will lead to the socially efficient level of output.
(socially efficient level = socially optimal quantity)

Reffonomics, excellent website

## Negative Consumption Externalities

Negative Consumption Externality: The name of the externality tells you what you need to do!

Negative = Negative (duh!) (we want less of it)
Consumption  = Benefits = Demand (there will be two Demand curves, MSB & MPB)
• Negative = we want less
• Consumption = benefits = demand
• Triangle = DWL (dead weight loss) (points to society) & is between the two demand curves
• SOQ = Socially Optimal Quantity or the quantity desired by society (Neg.=less quantity)
• Overproduction =  If we want less we must be over producing the good (duh!)
• MSB = MSC, obviously where social benefits and costs equal,  equilibrium quantity- Q*
• Indirect tax pushes costs higher, shifting supply left, causing higher prices
• CLG - always a correctly labelled graph
• Triangle - always points to society - to help you know which demand/cost curve is drawn above or below, know that the triangle always points to (MSB) society for a Negative Consumption Externality... Your going to say,, but Charles, I could draw the curve pointing to the right and still have it between the curves,,, but then the triangles point will be pointing to an equilibrium of more production (we want less).
• Indirect tax equal to the external costs of consumption is needed to decrease supply and to increase the price of the good.
• Check your graph and make sure it is showing what you want,,, to get less production prices must go higher. (look above and you will see this is exactly what has happened, prices have increased (with the tax) and quantity produced has fallen.)
Examples: (drugs, alcohol, cigarettes) also known as demerit goods.

## Negative Production Externality

Negative Production Externality: The type/name of the externality tells you what you need to do!

Negative = Negative (duh!) (we want less of it)
Production = Production = Costs = Supply (there will be two supply curves, MSC & MPC)

• Negative = we want less
• Production = costs = supply
• Triangle = DWL (dead weight loss) (points to society) & is between the two supply curves
• SOQ = Socially Optimal Quantity or the quantity desired by society (Neg.=less quantity)
• Overproduction =  If we want less we must be over producing the good (duh!)
• MSB = MSC, obviously where social benefits and costs equal,  equilibrium quantity- Q*
• CLG - always a correctly labelled graph

• Triangle - always points to society - to help you know which supply/cost curve is drawn above or below, know that the triangle always points to (MSC) society for a Negative Production Externality... Your going to say,, but Charles I could draw the curve pointing to the right and still have it between the curves,,, but then the triangles point will be pointing to an equilibrium of more production (we need less).
• Check your graph and make sure it is showing what you want,,, to get less production prices must go higher. (look above and you will see this is exactly what has happened, prices have increased and quantity produced has fallen.)
In the graph above the most used reason for a negative production externality to happen is due to pollution, (water, air, soil, road congestion). Pollution therefore harms society at some level, society being the injured third party. To correct for the cost of the pollution imposed on society an indirect tax equal to the size of the external cost (pollution harm to society) is imposed on the firm to make them pay for their pollution (to get them to internalize the cost they have placed upon society) The tax causes their production processes to become more expensive and they produce less (hopefully). Known as the "Polluter pays principle" designed and formulated by Pigou (1920) also known as a Pigovian tax,,  a carbon tax is a Pigovian tax.

The government must estimate the harm done to society and propose an amount of tax that causes the firm to produce at the new lower level, Q*. That is difficult. Also, as you know now the PED of a good also effects the amount consumers or producers will assume of the tax.

Draw this graph about 50 times and explain to yourself what is happening.

Examples:
• 1995 AP Microeconomics Exam:
Answer (B) encourage firms to use the most efficient method to reduce pollution.
• 1995 AP Microeconomic Exam:
Answer (C) The private market price will be to low.
(notice in the graph at the top of the page the Price is low and then the SOQ (socially optimal quantity) is Q* produced with the higher Price.
• 2000 AP Microeconomics Exam:
• Answer (C) society's marginal cost being higher than the firms marginal cost.                               (check out the graph above)

• 2000 AP Microeconomics Exam:

• 2005 AP Microeconomics Exam:
Answer (A) The price of cigarettes will be two low and the quantity sold will be to high.                                   (overproduction)
• 2005 AP Microeconomics Exam:

Answer (B) The production or consumption of a good generates a negative externality.

• 2008 AP Microeconomics Exam:
Answer (B) Price will be less than the marginal social cost.

Welker on Negative Externalities of Production: Video

## Market Failure - Externalities - Spill Over

Market Failure: When market forces (demand and supply) alone fail to allocate scarce resources efficiently, either that to much or not enough of a good is produced or consumed.

Externality - When an economic activity creates benefits or imposes costs for third parties for which these do not pay for, or do not get compensated for, respectively.

4 Types:
• Externalities - Positive & Negative Production, Positive & Negative Consumption
• Public Goods
• Monopoly Power - (more when get to monopoly, proper)
• Asymmetric Information

## Externalities

mjmfoodie: Market Failure

mjmfoodie: Externalities

An externality leads to a market failure as either more or less than the socially optimal amount is produced or consumed. Market forces alone fail to lead to an efficient resource allocation.

Externalities may arise in the production process, where they are known as production externalities, or in the consumption process, in which they are known as consumption externalities. If the impose costs on third parties they are considered negative externalities. In contrast, if they create benefits they are considered positive externalities.

### Production = Costs = Supply = MPC & MSC  (Remember this)

MPC - Marginal Private Costs: defined as the costs of producing an extra unit of output. Include, wages costs of raw materials and other costs that the firm takes into consideration in its decision making process to produce. It follows that the supply curve reflects the MPC of a competitive firm.

MSC - Marginal Social Costs: defined as the costs of producing an extra unit of output that are borne by society. They reflect the value of all resources that are sacrificed in the specific production process. This means that they include not just the labour and other resources that are sacrificed, the costs of which are taken into consideration by the firm, but also include any (External Costs) that are not considered by the the firms, like pollution.

### Consumption  = Benefits = Demand = MPB & MSB (Remember this)

MPB - Marginal Private Benefits: defined as the benefits the individual enjoys from the consumption of an extra unit of the good. The willingness of consumers to pay for an extra unit is determined by the extra benefit he enjoys from consuming that extra unit. The demand curve reflects the MPB enjoyed from consuming extra units of a good.

MSB - Marginal Social Benefits: benefits that society enjoys from each extra unit consumed. MSB includes the private benefits enjoyed by the individual but in addition any benefits others may enjoy as a result (External Benefits).

Reffonomics - Great website - Reffonomics
http://www.reffonomics.com/TRB/INPROGRESS/Microeconomicsindex1Externalities.html

## Elasticity 3 - YED

YED - responsiveness of demand when consumers income changes.

Formula -
pajholden on YED

• if it's positive, it's a normal good
• if it's negative, it's an inferior good
The absolute value shows the level of income elasticity of demand.
• if the YED is 0 < YED < 1  = income inelastic
• if YED > 1 = income elastic
2008 AP Microeconomics Exam
Answer (D) X is an inferior good and is a complement to Y.

Elasticity Cheat Sheet

## Elasticity - XED

XED - (Cross Price Elasticity of Demand) - measures the responsiveness of the demand of one good to a change in the price of another.

Formula -

The sign (+ or - ) determines how we interpret XED for a product:

XED > 0, the two goods are substitutes, if one becomes more expensive then consumers switch to                       the other.

XED < 0, the two goods are compliments, or jointly demanded: if one becomes more expensive and                    people buy less, they will also buy less of the other one.

XED = 0, the two goods are unrelated

XED is positive, or XED >  0

Notice, this is not a demand curve,,, this is a representation using a graph to show the relationship between two competitive goods. As coffee (P to P1) becomes more expensive consumers switch to drinking tea. (Q to Q1), apply the same to the Coke and Pepsi graph.

XED < 0, or XED is negative
Notice, this is not a demand curve,,,, The price of sugar rises and the quantity of tea demanded will fall.

### 2009B - AP Microeconomics Exam FRQ, #2

Answer - if XED is > 1 or positive, then the goods are substitutes, and therefore if the price of  bananas increases (due to crop failure), then the demand for peanuts will increase. Also the equilibrium price and quantity of peanuts will both increase.

Elasticity Cheat Sheet

## Elasticity 1

Ok,, elasticities,, What's the purpose of elasticity?

It's (as a business owner) nice to know that raising the price of your product won't/ or will destroy your income and thus your business. (How much will your revenue change with a price change).

4 sections under this topic:
• PED or price elasticity of demand
• XED or cross price elasticity of demand
• YED or income elasticity of demand
• PES or Price Elasticity of Supply

## PED - Price Elasticity of Demand

Good Video to watch to get introduced to the concept of PED.
PED - measures the responsiveness of quantity demanded to a change in price along a given demand            curve.

Formula -

Yes, this above is the formula but almost never are we given the % change in Qd or Price.

Usually we are given a table of old and new prices and quantities and asked to derive the % change in Qd and price.

more useful formula -
This is known as the midpoint formula.

Example 1:

Example 2:
2008 AP Microeconomics Exam
Answer (B) elastic - use the formula above. Do the math.

## PED varies along a demand Curve.

On a linear negatively sloped demand curve price elasticity varies continuously as one travels up or down the curve.

This makes total sense, responsiveness t a price change (PED) will be higher, the higher the initial price of the good, the more expensive it is.

• PED > 1, demand is price elastic =  % change in Qd is larger than the change in price.

Notice in the graph above, a 25% reduction in price leads to a much larger % change in Qd.
Also notice the demand curve is almost horizontal.

• 0 < PED < 1, demand is price inelastic = % change in Qd is smaller  than the change in price.

Notice the demand curve is almost vertical.
• PED = 1 or Unit Elasticity, % change in Qd is equal to the % change in price.

• PED – ∞, Demand is infinitely or perfectly elastic, a small change in price leads to an infinite change in Qd.
Usually, perfectly elastic demand describes a perfectly competitive firm,,, It can sell any amount at the going price.

2005 AP Microeconomics Exam
Answer (E) It will not be able to sell any output - I added this, even though you probably haven't had any perfect competition instructions. The fact is that given a graph like the one above showing a perfectly elastic curve could also be given... The perfect elastic curve above shows that at that price (market price) all can be sold,,, Qd is infinite at that price,,, all that they want to sell they can. But any raising of price,, and they will sell nothing/0/nada/zip.

Why? If it increases its price,, consumers will buy elsewhere at the lower price given by competitors.

2000 AP Microeconomics Exam

• PED = 0, Demand is perfectly inelastic, change in price leads to no change in Qd.

Perfectly inelastic demand curve (PED = 0) is often used to describe the case of highly addictive goods such as drugs, or pharmaceutical products of which there are no substitutes, (insulin)

You must for the AP exam know how to draw the graphs above and explain them. The AP exam asks very (interesting) questions about elasticity.

## Determinants of PED

• Substitutes: the number and closeness of available substitutes affect PED. The more substitutes there are for a good, and the closer these are, the more easily people will switch to these alternatives when the price of the good rises: the greater therefore will be the PED.
• Income: the proportion of income spent on the good. The higher the proportion of income spent on a good, the more consumers will be forced to lower consumption when its price rises(the bigger the income effect) and the more price elastic the demand will be. If a small proportion of income is spent on a good (it is insignificant) then a price change will not effect our spending behavior, demand will be price inelastic.
• Time: if someone is pressed for time (gas light comes on in car) the availability of substitutes are limited. It follows that the longer the time period after a price change, the more price elastic the demand is likely to be.
• Necessity: whether consumers consider the good or service a necessity. If it is considered a necessity a price change will tend to affect it less than a price change affects another product (luxury).

## Elasticity & Total Revenue

Total Revenue: is the money received by a firm from the sale of a particular quantity of output and is equal to price times quantity sold.
P*Q = TR, or price times quantity sold is total revenue,

Law of Demand states that as price rises, the quantity demanded decreases,, the change in total revenue depends on the price elasticity of demand, PED.

0 < PED < 1, When demand is inelastic, an increase in price from P1 to P2 will cause a lower % decrease in Qd (quantity demanded) from Q1 to Q2. The gain in total revenue from the price increase is larger than the loss in revenue from quantity decrease.

PED > 1, When demand is elastic, an increase in price from P1 to P2 will cause a higher % decrease in Qd from Q1 to Q2. The gain in total revenue from a price increase is lower than the loss in revenue from a quantity decrease.

PED = 1, When demand is unitary elastic,  price and quantity change in the same proportion.

1995 AP Microeconomics Exam
Answer (A) Inelastic - Price rises proportionately more than quantity, the change in price has a bigger effect  on TR (total revenue) than the change in quantity does

2000 AP Microeconomics Exam
Answer (C) A decrease in price will likely lead to an increase in total revenue. - This is an application of the total revenue test.  A good is elastic if total revenue increases when price decreases (arrows move in opposite directions). Remember, the demand curve becomes inelastic when marginal revenue is negative.  And, it’s unit elastic when MR = 0.

2005 AP Microeconomics Exam
Answer (A) inelastic - When demand is inelastic, an increase in price from P1 to P2 will cause a lower % decrease in Qd (quantity demanded) from Q1 to Q2. The gain in total revenue from the price increase is larger than the loss in revenue from quantity decrease.

### Impact of price change on total revenue under different PED values.

Welker on PED and total revenue.

Elasticity Cheat Sheet

Welker playlist on elasticity

## Government Intervention 7 - FRQ, per-unit tax

Conversations welcome -

## 2014 AP Microeconomics Exam - FRQ, question 3

(a) Draw a CLG (correctly labelled graph) of the gasoline market in which demand is relatively inelastic and the supply is relatively elastic.

You must know that inelastic demand is drawn more vertical (inelastic = I) and elastic is more like the the lines of the E, horizontal... So elastic (supply) is more horizontal and inelastic (demand) is drawn steeper.

(b) Suppose the Gov't imposes a \$2 per unit tax on the producers of gasoline. On your graph from part (a), show each of the following after the tax imposed.
• The price paid by buyers, labeled Pb
• The after tax price received by sellers, labelled Ps
• The quantity, labeled Q

• So the price paid by buyers is simply the equilibrium price of the demand and new (s+tax) supply curve. Draw a dotted line over to the price axis and mark it Pb
• The after tax (net) price received by sellers is the amount of the tax. In essence the horizontal distance between the two parallel supply curves. But, to get the after tax price start at the new equilibrium (s+tax) and follow the dotted line down to the original supply curve, look left,, make a dotted line across to the price axis and mark it Ps.
• The quantity demanded at the new higher (higher prices mean less Qd) is less than at the original lower price. Draw a straight line down from the new (s+tax) equilibrium and label the new quantity as Qt.
(C) Using the labeling on your graph, explain how to calculate the total tax revenue collected by the government.

Since Pb is the market price paid by the consumer and the net amount kept by the seller we could write this as
• Pb-Ps times the quantity sold, which is Qt, so (Pb-Ps*Qt)
or
• since we know the tax \$2 and we know the quantity sold, then (\$2 * Qt)
or
• (Pb * Qt) - (Ps * Qt) I'm not writing that out:)
(d) Will the tax burden fall entirely on the buyer, entirely on the seller, more on the buyer and less on the seller, more on the seller and less on the buyer, or equally on the buyer and seller. Explain.

Look at the graph,, its easy to see that the consumer (buyer) will pay more of the tax. When the demand curve is inelastic the buyers bear most of the tax incidence.
Hope this helps.

2005 AP Microeconomics Exam - FRQ, question 2

### 2. The graph above shows the market for a good that is subject to a per-unit tax.    (a) Using the labeling on the graph, identify the following:

• equilibrium price and quantity before the tax.
easy, Yes? The equilibrium before the tax is where the supply curve crosses the demand curve. (NOT the supply curve that says, Supply + Tax)

The equilibrium price before the tax is (follow the dashed line across to the price axis) \$12
The equilibrium quantity before the tax is (follow the dashed line down to the quantity axis) 100

• The area representing the Consumer surplus before the tax.
The consumer surplus before the tax is the areas, A,B,C and F.

• The area representing the Producer surplus before the tax.
The producer surplus before the tax is the areas, D,G,and E. or 100. Why 100 you ask?

Area of a triangle is 1/2 B*H    or (one-half, base times height.)  So the base is 100, the height of the producers surplus (up the price axis) is 2 (12-10=2)   so,   2 X 100 = 200 *1/2 = 100.

### (b) Assume the tax is now imposed. Does the price paid by the buyers rise by the full amount of the tax? Explain!

Remember that the two supply curves are parallel so the tax is the vertical distance between them. In essence the tax shifted the supply curve leftward. Tax is a determinate of supply so a shift occurs.

Where the supply+tax curve crosses the demand curve is the new equilibrium, at that point follow the dotted line down until it touches the original supply curve ,, then look left. (follow the dotted line to the price axis) and you will see a price of \$11.

Go back to the supply+tax curve where it crosses the demand curve, and look left. (follow the dotted line to the price axis) and you will see a price of \$13.

• \$13 minus \$11 = \$2 , two dollars is the tax.
Consider that the former supply/demand equilibrium was at \$12 and now the supply+tax/demand equilibrium is at \$13. The equilibrium price has only moved from \$12 to \$13 so the price paid by the buyers has risen by \$1. (\$12 to \$13 is 1 dollar) So the buyers have not paid the full amount of the tax.

Elasticity explanation - Supply is not perfectly elastic,, or demand is not perfectly inelastic or demand/supply have the same elasticities.

### (C) Using the labeling on the graph, identify each of the following (after the imposition of the tax).

• The net price paid to the sellers.
Remember that net means (tax taken out) so the amount the seller receives minus the tax.

If the equilibrium price is \$13 and the tax is (we now know) \$2 then 13-2 is \$11. So the seller receives \$11 per unit.
• The amount of tax revenue.
Dollar amount of tax (\$2) times, multiplied by, the quantity sold or (go to supply+tax equilibrium and follow the dotted line straight down to the quantity axis) 80.   \$2 X 80 = \$160
In essence the government tax is two dollars and the sellers sells 80 units,, the government gets \$160 dollars in tax revenue.
• The area representing the consumer surplus (after the imposition of the tax).
The area representing the consumer surplus is the area A.
• The area representing the producer surplus (after the imposition of the tax).
The area representing the the producer surplus is the area B.

Now, On the graph above what if the questions had been worded differently,, such as
• The area representing the change in consumer surplus.
The original consumer surplus was area A,B,C and F now, after the imposition of the tax, the area of consumer surplus is just A,,, so the change would be (B,C,F).

Discussions welcome -