Managerial Economics

Externalities and Efficiency

1 LEARNING OBJECTIVE

Externality A benefit or cost that affects someone who is not directly

involved in the production or consumption of a good or service.

The Effect of Externalities

Private cost The cost borne by the producer of a good or service.
Social cost The total cost of producing a good, including both the
private cost and any external cost.

Private benefit The benefit received by the consumer of a good or

service.
Social benefit The total benefit from consuming a good, including both
the private benefit and any external benefit.

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• Negative consumption externality - smoking
• Positive consumption externality – vaccination

• Negative production externality – pollution

• Positive production externality – basic
research
Externalities and Efficiency
HOW A NEGATIVE EXTERNALITY IN PRODUCTION REDUCES ECONOMIC EFFICIENCY

5-1
The Effect of Pollution
on Economic Efficiency

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Externalities and Efficiency
HOW A POSITIVE EXTERNALITY IN CONSUMPTION REDUCES ECONOMIC EFFICIENCY

5-2
The Effect of a Positive
Externality on Efficiency

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• NEGATIVE EXTERNALITY IN PRODUCTION leads to
overallocation of resources eg. Cement

• positIVE EXTERNALITY IN PRODUCTION leads to

underallocation of resources eg. Education

• NEGATIVE EXTERNALITY IN consumpition leads to

overallocation of resources eg. Cigarettes

• POSITIVE EXTERNALITY IN consumpition leads to

UNDERallocation of resources eg. VACCINATION
Price
of college
Education
A S

D
B
C
DS

DP

Quantity of college
Education
Externalities and Efficiency
Externalities Can Result in Market Failure

Market failure Situations where the market

fails to produce the efficient level of output.

What Causes Externalities?

Property rights The rights individuals or

businesses have to the exclusive use of their
property, including the right to buy or sell it.

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Government Solutions to Externalities
3 LEARNING OBJECTIVE

Government Solutions to Externalities

5-5
When There is a Negative
Externality, a Tax Can Bring
About the Efficient Level of
Output

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 5-
3 LEARNING OBJECTIVE 1
• Using a Tax to Deal with a Negative Externality

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Government Solutions to Externalities

Government Solutions to Externalities

5-6
When There is a Positive
Externality, a Subsidy Can
Bring About the Efficient
Level of Output

Pigovian taxes
and subsidies
Government taxes
and subsidies
intended to bring
about an efficient
level of output in the
presence of
externalities.

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Government Solutions to Externalities
Command and Control versus Tradeable
Emissions Allowances

Command and control approach

Government-imposed quantitative limits on the
amount of pollution firms are allowed to
generate, or government-required installation
by firms of specific pollution control devices.

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Government Solutions to Externalities
Command and Control versus Tradeable
Emissions Allowances
5-7
Estimated Cost of the Acid
Rain Program in 2010

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 5-3
•Can Tradeable Permits Reduce Global
Warming?

Rapid growth in China

has led to rapid
increases in CO2
emissions.

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 Evaluation of markets
• Work well but following has to be kept in mind
• 1. citizens without ability to pay can be excluded
from consumption of basic goods
• 2. intervention may be needed to redistribute
resources , example from urban consumers to
farmers using MSP
• 3. in the presence of externalities, misallocation
of resources results. This calls for government
intervention in the form of taxes and subsidies
• Opportunity cost
– Willingness to pay
– Marginal cost
Shift of market equilibrium
 Shift of supply curve

S’
price
S

quantity
Rise in costs – example, rise in oil prices
 Shift of supply curve

S
price
S’

quantity
Fall in costs – example, fall in bandwidth costs, or better yield of onions
 3-4

•The Falling Price of Large

Flat-Screen Televisions

Corning’s breakthrough
spurred the manufacture of
LCD televisions in Taiwan,
South Korea, and Japan,
and an eventual decline in
price.

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The Effect of Demand and Supply Shifts on Equilibrium

• The Effect of Shifts in Demand on Equilibrium

3 - 13
The Effect of an Increase in
Demand on Equilibrium

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The Effect of Demand and Supply Shifts on Equilibrium

•The Effect of Shifts in Demand and Supply over Time

3 - 14
Shifts in Demand and Supply over Time

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 3-1
3 LEARNING OBJECTIVE

• Demand and Supply Both Count: A Tale of Two

Letters

Although the demand for Lincoln’s letters is greater than Booth’s, the
supply of Booth’s letters is much smaller, which explains why the
equilibrium price for Booth’s letters is higher.
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The Effect of Demand and Supply Shifts on Equilibrium

•The Effect of Shifts in Demand and Supply over Time

3 - 13
The Demand for Chicken
Has Increased More
Than the Supply

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 3-2
4 LEARNING OBJECTIVE

• High Demand and Low Prices in the Lobster

Market?

Supply and demand for lobster both increase during the summer, but the increase
in supply is greater than the increase in demand, therefore, equilibrium price falls.
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•Remember: A Change in a Good’s Price Does Not Cause
the Demand or Supply Curve to Shift.

The second shift, from D2 to D3, does not occur. After an increase
in demand, from D1 to D2, the higher resulting price does not lead
to a leftward shift of the demand curve to D3. 27 of 34
Understanding Consumer
Demand
 Marginal benefit
• The benefit an individual gets from consuming
an additional unit of a good or service
• Principle of decreasing marginal benefit
– The amount an individual is willing to pay
decreases as the quantity consumed increases
 Consumer Theory
• Consumers optimize their well being subject
to a budget constraint
• Enjoyment from consumption referred to as
utility
• Diminishing marginal utility
Marginal benefit curve

Marginal benefit Rs.

Rs. 30

Rs. 15

10 20 Quantity of
Cake per week
 Budget Set
• Set of goods and services you can buy with the
money you have available to you
Good 1:
Number of
1 2 3
Units
Purchased

Total Value $18 $30 $36

Good 2:
Number of
Units 1 2 3
Purchased

Total value $4 $8 $12

Price of good 1= $12 , price of good 2 = $3

Good 1:
Number of
1 2 3
Units
Purchased

Total Value $18 $30 $36

Good 2:
Number of
Units 1 2 3
Purchased

Total value $4 $8 $12

Price of good 1= $12 , price of good 2 = $3

Income = $18
Good 1: Number of Units
1 2 3
Purchased

Total Value 18 30 36

Marginal value 18 12 6

Marginal value per dollar 1.5 1 0.5

Good 2: Number of Units

Purchased 1 2 3

Total value 4 8 12

Marginal value 4 4 4

Marginal value per dollar 1.33 1.33 1.33

Price of good 1= $12 , price of good 2 = $3, Income = $18

Good 1: Number of Units
1 2 3
Purchased

Total Value 18 30 36

Marginal value 18 12 6

Marginal value per dollar 1.5 1 0.5

Good 2: Number of Units

Purchased 1 2 3

Total value 4 8 12

Marginal value 4 4 4

Marginal value per dollar .8 .8 .8

Price of good 1= $12 , price of good 2 = $5, Income = $18

Income =$18 Price good 1 Price good 2=
= $12 $3
Quantity good 1 = 1 Quantity good 2 = 2

Price good 1 Price good 2=

= $12 $5
Quantity good 1 = Quantity good 2 = 0
1.5
• Principle of equalization of the marginal value
per dollar spent across all the goods in the
consumption basket
 Draw a Budget Set
• Price of coke = $1 per unit, price of snickers
=$2 per unit, income $5

snickers

1 unit of coke, 2 units of snickers

2.5

5 coke
List some other combinations
How do you decide what to choose?

You rank all the combinations and choose your best one.

snickers

2.5
3 units coke, 1 unit snickers

coke
5
 Now suppose prices change
• Price of coke = $1 per unit, price of snickers =$1 per unit

snickers
2 unit of coke, 3 units of snickers
5

5 coke
List some other combinations
 You rank all the combinations and choose your best one.

snickers
5

2 units of coke, 3 units of snickers

coke
5
Individual Demand for snickers

Demand curve for snickers

Price of
snickers

1 2 3 Quantity of
snickers
Market Demand for snickers: Horizontal Summation of individual demand
curves
 Recap
• Principles of Economics
– Individual
– Aggregate
• Goals of Economic Activity
– Equity
– Efficiency
• Detailed Exploration of Principles of Decision Making
– Marginal versus average quantities
– Opportunity cost
– Equalizing ‘bang per buck’ to maximize utility
– Individual demand curves and the market demand curve
• Efficiency
– Adam Smith
– Prisoners Dilemma (Red card black card game)
The Demand Side of the Market
1 LEARNING OBJECTIVE

• The Demand of an Individual Buyer

3-1
Plotting a Price-Quantity
Combination on a Graph

At a price of $125 per

printer, Kate, the
purchasing manager for the
Prudential Insurance
Company, will be willing to
buy 5 printers in the next
month.

Quantity demanded The

quantity of a good or service
that a consumer is willing to
purchase at a given price.
The Demand Side of the Market
Demand Schedules and Demand Curves
3-2
Kate’s Demand Schedule and •Demand curve A curve that shows the
Demand Curve relationship between the price of a product
and the quantity of the product demanded.
•Demand schedule A table
showing the relationship
between the price of a product
and the quantity of the product
demanded.
The Demand Side of the Market
•Individual Demand and Market Demand
3-3
Deriving the Market Demand Curve
from Individual Demand Curves

Market demand The

demand for a product by all
the consumers in a given
geographical area.
The Demand Side of the Market
• The Law of Demand

The Law of Demand Holding everything else constant, when the

price of a product falls, the quantity demanded of the product will
increases, and when the price of a product rises, the quantity
demanded of the product will decrease.

• What Explains the Law of Demand?

Substitution effect The change in the quantity demanded of a

good that results from a change in price making the good more or
less expensive relative to other goods that are substitutes.

Income effect The change in the quantity demanded of a good

that results from the effect of a change in the good’s price on
consumer purchasing power.
 question
• Two goods – chocolate and ice cream
• Price of chocolate falls
• Substitution effect
– Quantity of chocolate – rises
– Quantity of ice cream – fall
• Income effect
– Quantity of chocolate – rises (if normal good)
– Quantity of ice cream – rise (if normal good)
• Price of choc – rs. 10
• Ice cream – rs. 20
• Income is rs. 10000
• Total Level of happiness (utility) – 5 million utils
• Price of choc falls to Rs. 8
• Ice cream – rs. 20
• I don’t need as much income to get 5 mill utils of happiness
• Let’s say I need only Rs. 8500 income to get 5 mill utils of happiness
• Substitution effect
– Quantity of chocolate – rises
– Quantity of ice cream – falls
• Let’s say I restore your income to Rs. 10000
• Income effect
– Quantity of chocolate – rises (if normal good)
– Quantity of ice cream – rises (if normal good)
• Now your utility increases above 5 mill utils
The Demand Side of the Market

• Holding Everything Else Constant:

The Ceteris Paribus Condition

Ceteris paribus (“all else equal”) The

requirement that when analyzing the
relationship between two variables—such
as price and quantity demanded—other
variables must be held constant.
The Demand Side of the Market
Movement along demand curve – shows different amounts of qty demanded
As the price of the good/service changes
vs shift of demand curve
Variables That Shift Market Demand
 Price of related goods 3-4
Substitutes Goods and services that can be Shifting the Demand Curve
used for the same purpose.
Complements Goods that are used together.
 Income
Normal good A good for which the demand
increases as income rises and decreases as
income falls.
Inferior good A good for which the demand
increases as income falls, and decreases as
income rises.
 Tastes
 Population and demographics
Demographics The characteristics of a
population with respect to age, race, and
gender.
 Expected future prices
Can demand curve be upward sloping?
• Those goods whose demand falls with a
reduction in price are inferior goods for which
the negative income effects overwhelms the
positive substitution effect
• They are a special case of inferior goods and
are called Giffen goods
normal inferior

Income effect Income effect

weaker than stronger than
substitution effect substitution effect

Downward sloping Downward sloping Upward sloping

demand demand demand

Peter england Cheap rum Country liquor