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

Market Failure 1

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


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