Lecture 12 – Externality

Microeconomics Lecture Gap Sheet - way

Part 1 – Types of Externalities

1) Negative Production Externality – Imposed __________ 2) Positive Production Externality – Produces ___________
Honey farms and fruits farms

3) Negative Consumption Externality – Imposed _________ 4)Positive Consumption Externality–Produces _________

Production 4 Types of Externality

Externality 1 Negative Production Externality
Externality
Consumption 2 Positive Production Externality
Definition Externality

An externality is a _____ or ________ that affects someone Negative 3 Negative Consumption Externality
Externality
who is _________________________ in the Externality 4 Positive Consumption Externality
Positive
production or consumption of a good. Externality

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 Part 2 – Negative Production Externality External Cost and Marginal Social Cost
Microeconomics Lecture Gap Sheet - way

Price and Cost

Marginal Private Cost (MC) + Marginal External Cost = _______________ Cost (MSC)
(__________________) (__________________) (___________ by entire society)

2.2 Methods to Solve Negative Production Externality

1) Coase Theorem  Private solution is possible to solve negative production externality Q

Chemical Factory owns the river and 500 homes

Two identical rivers with 500 homes along each river. Coase Theorem - Valuing an External Cost The factories will produce some pollution
One river is polluted by chemical factory The chemical factories own the river and the 500 homes alongside it but it is the efficient quantity. The efficient
quantity of pollution is not zero. MSC
The other river has no pollution. Ceteris paribus.
Two rivers P (Marginal Social Cost)

One Polluted River One Clean River

500 identical homes 500 identical homes
$1,500 pm rent $2,500 pm rent MC
(Pollution is the only detectable difference) (Marginal Private Cost)
For the 500 homes on polluted river
External cost on polluted river = $1,000 pm per home D = MSB
= $500,000 pm (500 homes)

 The chemical factories are now confronted with the cost of The factory will produce lower quantity Q
their production – forgone rent from the people who live by
Two identical rivers with 500 homes along each river.
the polluted river
One river is polluted by chemical factory
The other river has no pollution. Ceteris paribus.
Coase Theorem - Valuing an External Home owners owns the river and 500 homes
Cost The factories will produce some pollution
but it is the efficient quantity. The efficient
Suppose the residents own the river and the 500 homes alongside it quantity of pollution is not zero. MSC
(Marginal Social Cost)
P
Two rivers
One Polluted River Once Clean River
Polluted River Clean River 500 identical homes 500 identical homes
• $1,500 pm rental • $2,500 pm rental $1,500 pm rent $2,500 pm rent MC
(Pollution is the only detectable difference) (Marginal Private Cost)
1) Chemical Factory Owns the Two Rivers
Factory forgo the $1,000 difference in rent from polluted river For the 500 homes on polluted river
External cost on polluted river = $1,000 pm per home D = MSB
2) Home Owners Owns the Two Rivers
= $500,000 pm (500 homes)
Factory pays $1,000 per home for allowing to pollute the river
 Now the factories must pay a fee to the homeowners for the The factory will produce lower quantity Q 2
Outcome : Regardless of who owns the river, the outcome is the same for factory right to dump their waste
Someone must own the property
 The amount of chemical produced and the amount of waste
dumped are the same whoever owns the home and the river.
 Microeconomics Lecture Gap Sheet - way
Condition for Coase Theorem
1 Property rights must exist
Pivogian Tax
2 Small number of parties involved
3 Low transaction cost
4 Reasonable demand

Price and Cost

2 Government Action (Command and Control)

A) Tax (Pigovian Tax)

 Set the tax = _______________
 MC + ______ = MSC
 Behave as if the party _________ the external cost

B) Emission Charges Q
 Government set a __________________ of pollution emission
 The more a firm pollutes, the ________________
 Disadvantage  Has ________________ to the amount of pollution

C) Marketable Permits
 Government set a ____________ to the total pollution emission
 Issue permits that equal to the ___________ pollution emission limit
 Each firm ______________ a certain number of permits or __________ for a certain assigned number of permits
 Firms are allow to ___________ these permits
 Government can __________ the total pollution emission limit over time, and hence __________ pollution

D) Quota
 As pollution might be difficult to measure accurately, government can set ___________________________, called a
quota for each firm

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 Microeconomics Lecture Gap Sheet - way
Part 3 – Positive Consumption Externality

Marginal Benefit (MB) + Marginal External Benefit = Marginal Social Benefit (MSB)
(benefit enjoy by _________) (benefits enjoy by ____________) (enjoy by ___________ society)
External Benefit and Marginal Social Benefit
3.2 Methods to Solve Positive Consumption Externality

Price and Cost

A) Public Provision
 Payment by government to ________ institution to produce a good

B) Private Subsidy
 Payment by government to ________ institution to produce a good

C) Vouchers
 Tokens provided by government to _____________ who can use it to purchase a good

D) Patents and Copyrights

 Incentives to encourage ______________ level of efforts

Public Provision Subsidy Voucher

Subsidy Efficient market equilibrium
Price (paid by student)

Price (paid by student)

Price (paid by student)

S = MSC S1 = MSC S = MSC
Price (paid by student)

S1 = MSC
$25k $25k $25k
$25k Subsidy

$10k MSB $10k MSB $10k MSB

$10k D =MSB
MB
D = MB
D = MB Inefficient market equilibrium D = MB
Q (no of students) Inefficient market equilibrium
Efficient
Q (nomarket equilibrium
of students)
Q (no of students)
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Q (no of students)
 Microeconomics Lecture Gap Sheet - way
Negative Production Externality (Discussed) Positive Consumption Externality (Discussed)

Examples Examples
1) MRT Construction – Production 1) Solar energy - Consumption
Noise – Negative Green energy - Positive

2) Restaurant – Production 2) HDB spaces for fruits/vegetables - Consumption

Smoke & Noise – Negative Provides food - Positive

3) Building construction – Production

Dengue fever - Negative

Negative Consumption Externality Positive Production Externality

Examples Examples
1) Smoking – Consumption 1) Solar energy factories - Production
Affects non-smokers – Negative Green energy – Positive

2) Noise parties – Consumption 2) HDB spaces for growing fruits/vegetables - Production

Affects neighbours – Negative Greenery - Positive

3) Barbecue – Consumption
Smoke & smell affects neighbours - Negative

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 Revision Question 12 Microeconomics Lecture Gap Sheet - way

The construction of the MRT circle has caused many inconveniences to the residents staying in the vicinity. They have to endure the noise, the dust as well
as the relocation of several roads. Analyse the situation using a suitable externality diagram. Comment on the private optimal output and the social optimal
output and explain how the government can help to solve this externality problem.
.

Past Exam Question

Due to widespread overfishing of the seas, much of the wildlife is taken from seas at rates higher than the fished species replacing themselves. Governments are
increasingly becoming interested in ways of preserving the fish stocks. One of the possible ways of preserving the fish stocks is to assign property rights so that each
fishing vessel is allocated a specific patch of ocean to fish in.
(i) Overfishing creates a negative externality to other parts of the economy. Draw a diagram to illustrate the negative externality. Does the market over produce or under
produce the good? Explain.
(ii) How can the use of property rights help the market to reach an efficient outcome? Support your answers with suitable diagrams.
(iii) Apply the concept of Coarse solution and suggest why it may be challenging for governments to achieve the Coarse solution when assigning property rights to prevent
overfishing.

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 Powerpoint Tutorial Questions
Microeconomics Lecture Gap Sheet - way
1 Describe negative production & consumption externality? Suggest examples for each.

2 Describe positive production & consumption externality? Suggest examples for each.

3 Describe the condition for Coase Theorem that is needed for private transactions to be efficient is that.
Describe conditions where it is difficult for Coase Theorem to work

4 The graph below shows the costs and benefits arising from the production of a pesticide that pollutes a lake used by a fish farmer.
a) If no one owns the lake and there is no regulation of pollution, what is the quantity of pesticide produced per week? Explain your answer.
b) What is the socially optimal quantity? Explain your answer.
c) Suggest one way to help the pesticide producer to produce at the socially optimal quantity. Explain your answer.
d) Suppose the production of pesticide causes pollution. Do you think it is best not to produce pesticides so that there will be no pollution? Explain.

5 Solar energy is an alternate method to generate electricity besides the use of fossil fuel. However, installing solar panels on buildings is expensive.
a) If generating electricity using solar panels is competitive and is allowed to operate without any government intervention, use an appropriate diagram to
illustrate and explain the externality.
b) Suggest TWO (2) approaches that governments can take to encourage building owners to install solar panels. Illustrate your answer.

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 Lecture 12 Summary Microeconomics Lecture Gap Sheet - way

Refer to your completed Negative Production Externality Diagram and Positive Consumption Externality Diagram

Methods to Solve Externality Problems - For More Efficient Allocation of Resources Pivogian Tax
MSC
Efficient market (Marginal Social Cost)
1 Negative Production Externalities equilibrium

Price and Cost

i) Property rights (coarse theorem) exist Set Pollution tax = External Cost
ii) Government Actions MC
Taxes (pigovian tax) (Marginal Private Cost)

a) emission charges Inefficient market

b) marketable permits equilibrium

D = MSB

2 Positive Consumption Externality Q

i) Public provision ii) Private subsidy iii) Vouchers

Public Provision Subsidy
Voucher
Efficient market equilibrium
Price (paid by student)
Price (paid by student)

Efficient market equilibrium

Price (paid by student)

S = MSC S1 = MSC
S = MSC
$25k $25k Subsidy
Gov’t payment 
paid by taxpayer $25k
Value of voucher

$10k MSB $10k MSB

D = MB $10k MSB
Inefficient market equilibrium D = MB
Inefficient market equilibrium
Efficient market equilibrium
Q (no of students) Inefficient market equilibrium D = MB
Q (no of students)

Q (no of students)