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ECO2011 Basic Microeconomics - Lecture 13

This document discusses externalities and how they can lead to market inefficiencies. It provides the examples of pollution from electricity production as a negative externality, and education as a positive externality. When there are externalities, the market equilibrium will result in too much of the good being produced in the case of negative externalities, and too little being produced in the case of positive externalities, leading to deadweight loss. This represents a situation of market failure as the efficient quantity is not achieved. The larger the externality, the greater the likely magnitude of this market inefficiency.

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50 views

ECO2011 Basic Microeconomics - Lecture 13

This document discusses externalities and how they can lead to market inefficiencies. It provides the examples of pollution from electricity production as a negative externality, and education as a positive externality. When there are externalities, the market equilibrium will result in too much of the good being produced in the case of negative externalities, and too little being produced in the case of positive externalities, leading to deadweight loss. This represents a situation of market failure as the efficient quantity is not achieved. The larger the externality, the greater the likely magnitude of this market inefficiency.

Uploaded by

1194390705
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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ECO2011 Basic Microeconomics

Fall 2020
Emily Zheng
What is the “best” level of pollution?

Is there a way to know what is the optimal level of pollution for a


society?

“No pollution” may be good for the environment, but is probably


not good for people—most modern conveniences in some way
result in pollution.

But unrestrained pollution is probably not optimal either.

Economics offers some ideas for how to decide on how much


pollution to allow.
Pollution as an externality

No-one sets out to create pollution; pollution is an unintended by-


product of various activities.

Pollution would not be a problem if pollution only affected the


person who created it; people would create pollution only until its
marginal cost equaled its marginal benefit.

But pollution is an example of an externality.


EXTERNALITIES AND MARKET INEFFICIENCY

• An externality refers to the uncompensated impact of one


person’s actions on the well-being of a bystander.

• When the impact on the bystander is adverse, the externality


is called a negative externality.

• When the impact on the bystander is beneficial, the


externality is called a positive externality.
Electricity production

Electricity production is an incredibly important industry for a


modern economy.

Consider the market for electricity. It consists of:


• Sellers, who face increasing marginal costs to produce
electricity
• Buyers, who face decreasing marginal benefits of additional
electricity

The actions of these groups generate market supply and


demand curves for electricity.
Cost of electricity production

When firms produce electricity, they have costs of production:


• Buildings
• Equipment
• Fuel
• Labor
• and more besides

Those firms make their decisions about how much to produce


based on these private costs.

But the social cost is higher: the cost to society includes both
the private cost and the external cost of the pollution.
Externalities in the electricity production market

Supply curve S1 represents


just the marginal private
cost that the electricity
producer has to pay.

Supply curve S2 represents


the marginal social cost,
which includes the costs to
those affected by pollution.

The optimal level of


production for society is
QEfficient; at this quantity, the
marginal cost to society is
just equal to the marginal
benefit.
Inefficiency due to negative externalities

However the market


equilibrium results from the
decisions of producers, who
see their cost of production
given by S1.

Price (PMarket) is “too low”


and quantity (QMarket) is “too
high”: the cost to society of
the additional electricity
exceeds its benefit to
society.

Deadweight loss results.


When there is a negative externality in producing a good or service,
too much of the good or service will be produced at market equilibrium.
Externalities

Pollution is an example of a negative externality in production.

Negative externalities might result from consumption.


Example: cigarette smoke, automobile exhaust
barking dogs (loud pets),loud stereos in an apartment building

Externalities might also be positive.


Example: college education, immunizations, restored historic
buildings, research into new technologies

If there are positive externalities, do you expect that too much or


too little of the good will be produced at the market equilibrium?
Externalities in the college education market

College educations have


positive externalities.
The marginal social
benefit from a college
education is greater than
the marginal private
benefit to college students.
Because only the
marginal private benefit is
represented in the market
demand curve D1, the
quantity of college
educations produced,
QMarket, is too low.

When there is a positive externality in consuming a good or service, too little of


the good or service will be produced at market equilibrium.
Externalities and market failure

If there are negative or positive externalities, the market


equilibrium will not result in the efficient quantity being produced.

There will be deadweight loss.

This is an example of market failure: a situation in which the


market fails to produce the efficient level of output.

The larger the externality, the greater is likely to be the size of


the deadweight loss—the extent of the market failure.

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