Friday, September 26, 2014

Market Failure 2 - Negative Production Externality

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.

  • 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

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