1. CRC Economics1

2. 2 Exercises Econ 304 Chapter 10

3. CRC Economics3 Do you know … how externalities affect a market? why externalities cause social inefficiency? what governments do to deal with externalities?

4. CRC Economics4 Definitions Market D = MPB S = MPC E = equilibrium point, where (MPB = D) = (MPC = S) Pe = market (equilibrium) price Qe = market (equilibrium) output

5. CRC Economics5 Definitions Society  Dsoc = MSB = MPB + MEB = D + MEB  Ssoc = MSC = MPC + MEC = S + MEC  Esoc = social equilibrium point, where MSB = MSC  Psoc = social (equilibrium) price, or socially optimal price  Qsoc = social (equilibrium) output, or socially optimal output

6. CRC Economics6 1. How externalities affect a market? No externalities Negative production externalities Positive production externalities Negative consumption externalities Positive consumption externalities Exercises

7. CRC Economics7 a. A market without externalities P Q D S Suppose that originally the market looks like the graph below and that there are no externalities. What is the market price? Market output? Socially optimal price? Socially optimal output? E Pe Qe = MPC = MPB = Ssoc= MSC = Dsoc= MSB = Esoc = Psoc = Qsoc

8. CRC Economics8 No externalities, i.e. MEB = MEC = 0  Dsoc = MSB = MPB + MEB = D + MEB = D  Ssoc = MSC = MPC + MEC = S + MEC = S  Esoc = E  Psoc = Pe  Qsoc = Qe  With no externalities, a free market is socially efficient.

9. CRC Economics9 b. A market with externalities P Q D S Suppose that originally the market looks like the graph below and that there are negative production externalities. E Pe Qe = MPC = MPB Ssoc= MSC = Dsoc= MSB Esoc Qsoc Psoc MEC What is the market price? Market output? Socially optimal price? Socially optimal output?

10. CRC Economics10 c. A market with externalities P Q D S Suppose that originally the market looks like the graph below and that there are positive production externalities. E Pe Qe = MPC = MPB Ssoc= MSC = Dsoc= MSB Esoc Qsoc Psoc MEB What is the market price? Market output? Socially optimal price? Socially optimal output?

11. CRC Economics11 d. A market with externalities P Q D S Suppose that originally the market looks like the graph below and that there are positive consumption externalities. E Pe Qe = MPC = MPB = Ssoc= MSC Dsoc= MSB Esoc Qsoc Psoc MEB What is the market price? Market output? Socially optimal price? Socially optimal output?

12. CRC Economics12 e. A market with externalities P Q D S Suppose that originally the market looks like the graph below and that there are negative consumption externalities. E Pe Qe = MPC = MPB = Ssoc= MSC Dsoc= MSB Esoc Qsoc Psoc MEC What is the market price? Market output? Socially optimal price? Socially optimal output?

13. CRC Economics13 f. Exercises P Q D S Suppose that originally the market looks like the graph below and that there are externalities. E Pe Qe = MPC = MPB Qsoc Psoc Can you tell the type of externalities that affects this market? Qsoc negative externalities Esoc Esoc on S => consumption

14. CRC Economics14 f. Exercises P Q D S Suppose that originally the market looks like the graph below and that there are externalities. E Pe Qe = MPC = MPB Qsoc Psoc Esoc Qsoc > Qe => positive externalities Esoc on D => production Can you tell the type of externalities that affects this market?

15. CRC Economics15 2. Why do externalities cause social inefficiency? Social efficiency occurs at Esoc, where (Dsoc = MSB) = (Ssoc = MSC) At Esoc, society achieves socially optimal output Qsoc at socially optimal price Psoc. The presence of externalities cause Qsoc to be different from Qe.

16. CRC Economics16 With externalities, i.e. MEB <> 0 and/or MEC <> 0  Dsoc = MSB = MPB + MEB = D + MEB <> D  Ssoc = MSC = MPC + MEC = S + MEC <> S  Esoc <> E  Psoc <> Pe  Qsoc <> Qe  With externalities, a free market is socially inefficient.

17. CRC Economics17 3. What governments do to deal with externalities? Positive externalities => Qsoc > Qe, i.e. too little is being produced in markets. Governments give subsidies to raise Qe. Negative externalities => Qsoc < Qe, i.e. too much is being produced in markets Governments impose taxes to reduce Qe.

18. CRC Economics18 Summary Production externalities Positive MEB > 0 Ssoc < S Negative MEC > 0 Ssoc > S Consumption externalities Positive MEB > 0 Dsoc > D Negative MEC > 0 Dsoc < D Qsoc > QeQsoc < QeQsoc > QeQsoc < Qe Qe is too smallQe is too largeQe is too smallQe is too large SubsidiesTaxesSubsidiesTaxes

19. CRC Economics19