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AP Microeconomics: 6.1 Socially Efficient and Inefficient Market Outcomes

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Focus on negative production externalities.

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Negative externalities can be created by both consumption and production of goods. Here's what that means:

Negative Externalities of Consumption

Negative externalities of consumption exist when the consumption of a good results in social costs being greater than private costs (private benefits are higher than social benefits). They are overproduced and over-consumed.

Example: A common example of negative externalities of consumption is the phenomenon of noise pollution. When someone inconsiderately blasts music ("consumes" music) so loudly that it disturbs their neighbors, their neighbors (who are stressed out, may lose sleep, etc.) are affected in such a way as to derive less benefit from their home. Those neighbors, in effect, pay the cost for the noise pollution disrupting their living space.

The optimal consumption level should be Q* at P*, but in the table above, it's at Q at P.

Examples of policies that work to actively discourage negative externalities of consumption include indirect taxes, awareness campaigns and education, and outright bans.

Negative Externalities of Production

Negative externalities of production are those that arise when the production process of a particular good causes harm; this means that the production of the good creates social costs higher than private costs (as well as private benefits higher than social benefits).

Example: One of the most serious and well-known examples of negative externalities of production is the environmental harm created by industrial production. For example, let's say a shoe factory owned by Mr. Smith is dumping its toxic industrial waste into a river. Mr. Smith makes money from selling those shoes, but does not pay for the river pollution that the factory is creating (unless the government institutes a fine or other negative consequences for such polluting practices). The cost of the river pollution is paid by the people who rely on that river for water; they are, for instance, likely to experience the major cost of negative health effects as a result of consuming polluted water.

Policies that discourage or even prevent negative externalities of production include imposing taxes on polluters, as well as fining polluters, particularly by forcing them to make compensatory payments to those who have been experiencing the costs of their pollution.

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Negative Externalities | Intelligent Economist

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Negative externalities can be created by both consumption and production of goods. Here's what that means: Negative externalities of consumption exist when the consumption of a good results in social costs being greater than private costs (private benefits are higher than social benefits). They are overproduced and over-consumed.

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Focus on positive consumption externalities.

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Whether positive or negative, externalities are the effects of a good's consumption or production on third parties; these effects are not accounted for in the price of said good. Externalities are otherwise known as "spill-over effects."

Positive externalities are the benefits experienced by these third parties as a result of consumption or production; in contrast, negative externalities are the harms to those third parties. Because positive externalities are primarily beneficial to society as a whole, they are to be promoted whenever possible.

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Positive Externalities | Intelligent Economist

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Whether positive or negative, externalities are the effects of a good's consumption or production on third parties; these effects are not accounted for in the price of said good. Externalities are otherwise known as "spill-over effects." Positive externalities are the benefits experienced by these third parties as a result of consumption or production; in contrast, negative externalities are the harms to those third parties.

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1. What are externalities and why can they lead to inefficiency in a market economy?

2. Why do externalities often require government intervention?

3. What is the difference between negative and positive externalities?

4. What is the importance of the Coase theorem?

5. How do external benefits and costs cause inefficiency in the markets for goods?

6. Why are some government policies to deal with externalities efficient while others are not?

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Define social efficiency.

Explain (using graphs where appropriate) why resource allocation in perfectly competitive markets is socially efficient.

Explain (using graphs where appropriate) how private incentives can lead to actions by rational agents that are socially undesirable (inefficient) market outcomes.

Explain equilibrium allocations in imperfect markets relative to efficient allocations (using graphs where appropriate) and why these markets are inefficient.

Calculate (using graphs where appropriate) the deadweight loss resulting from the production of a non-efficient quantity.

Define externalities.

Explain (using graphs where appropriate) how in the presence of externalities, private markets do not take into consideration social costs or social benefits.

Explain (using graphs where appropriate) how public policies address positive or negative externalities.

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Perfectly competitive markets allocate resources efficiently, but imperfect competition often results in market inefficiencies.

Private incentives can fail to account for all socially relevant considerations.

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The optimal quantity of a good occurs where the marginal benefit of consuming the last unit equals the marginal cost of producing that last unit, thus maximizing total economic surplus.

The market equilibrium quantity is equal to the socially optimal quantity only when all social benefits and costs are internalized by individuals in the market. Total economic surplus is maximized at that quantity.

Rational agents can pursue private actions to exploit or exercise market characteristics known as market power.

Rational agents make optimal decisions by equating private marginal benefits and private marginal costs that can result in market inefficiencies.

Policymakers use cost-benefit analysis to evaluate different actions to reduce or eliminate market inefficiencies.

Market inefficiencies can be eliminated by designing policies that equate marginal social benefit with marginal social cost.

Equilibrium allocations can deviate from efficient allocations due to situations such as monopoly; oligopoly; monopolistic competition; negative and positive externalities in production or consumption; asymmetric information; and insufficient production of public goods.

Producing any non-efficient quantity results in deadweight loss.

The socially optimal quantity of a good occurs where the marginal social benefit of consuming the last unit equals the marginal social cost of producing that last unit, thus maximizing total economic surplus.

Externalities are either positive or negative and arise from lack of well-defined property rights and/or high transaction costs.

In the presence of externalities, rational agents respond to private costs and benefits and not to external costs and benefits.

Rational agents have the incentive to free ride when a good is non-excludable.

Policies that address positive or negative externalities include taxes/subsidies, environmental regulation, public provision, the assignment of property rights, and the reassignment of property rights through private transactions.

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APMic Unit 6 Lesson 1 - Externalities Flashcards | Quizlet

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Start studying APMic Unit 6 Lesson 1 - Externalities. Learn vocabulary, terms, and more with flashcards, games, and other study tools.

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Joseph Stiglitz: The financial crisis was a market failure

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Joseph Stiglitz of Columbia University tells The CORE Project (http://core-econ.org) how the financial crisis of 2008 was a perfect storm of market failure.

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A carbon tax aims to make individuals and firms pay the full social cost of carbon pollution. In theory, the tax will reduce pollution and encourage more environmentally friendly alternatives. However, critics argue a tax on carbon will increase costs for business and reduce levels of investment and economic growth.

The purpose of a carbon tax

The purpose of a carbon tax is to internalise this externality. What this means is that the final price of the good should include the external costs and not just the private cost. It is similar to the ' polluter pays principle. ' - which was incorporated into international law at the 1992 Rio Summit. It simply means those who cause environmental costs should be made to pay the full social cost of their actions.
Diagram to show welfare loss of a negative externality
This diagram shows that in a free market (without any tax), we get overconsumption (Q1) of carbon, leading to a welfare loss to society.
Social efficiency with Carbon Tax
The tax shifts the supply curve from S to S2. With the tax, consumers now face the full social cost (SMC). Quantity falls from Q1 to Q2. Q2 is socially efficient because social marginal cost = social marginal benefit.
Revenue neutral
In theory, a carbon tax could be revenue-neutral. This means the tax raised from taxing carbon emissions can be used to reduce other taxes. There should be no overall increase in the tax burden. The aim is to increase social efficiency by making people aware of the full social cost.

Arguments for a Carbon Tax

1. Encourages alternatives. A higher price of carbon emissions will encourage firms and consumers to develop more efficient engines or alternatives to consuming carbon emissions. For example, with carbon taxes, it will be more efficient to develop hydrogen engines or solar power.

It might encourage more people to cycle or walk to work. This would have health benefits such as the lower risk of a heart attack.

This could make it more feasible to generate electricity from green sources (e.g. solar power). If we develop more green sources it will also make us less reliant on oil.

It will help make the transition to a post-oil economy easier.

2. Raises revenue. The revenue raised from a carbon tax could be used to subsidise alternatives such as green electricity or the revenue raised could be used to repair the damage caused by environmental pollution. Alternatively, a higher carbon tax could be used to reduce other taxes, such as VAT.

3. Leads to a socially efficient outcome. It makes people pay the social cost and overcomes the excess consumption we see in a free market.

4. Improves the environment. With higher taxes, firms will reduce pollution and look for alternatives which have a lower environmental impact. For example, it will make solar power even more competitive than traditional fossil fuels.

5. Evidence of success. Countries which have implemented carbon taxes have seen encouraging results - resulting in lower carbon emissions than would otherwise have occured, and in many cases substantial falls in CO2 emissions. For example, Sweden introduced a carbon tax of €33 per tonne in 1991. Over time, the tax was increased to €120 per tonne. (Some sectors like manufacturing, agriculture and forestry, received a discounted rate). Link - carbon price works in Sweden)

Source: Eurostat, 2018a

Since the mid-1990s emission levels in Sweden has fallen by over 20%, making it one of the more successful EU countries in reducing emissions - despite a period of strong economic growth. This shows a carbon tax can play a role in enabling lower carbon emissions, without holding back economic growth and rising living standards.

Successful implementations of carbon tax/ carbon pricing include

UK - coal use fell sharply after introduction of a carbon tax of around $25 per ton in 2013. In the UK greenhouse gas emissions have fallen to lowest level since 1890. (NY Times)

British Colombia (a province of Canada) introduced a scheme in 2008 to charge a levy on carbon. In the first four years of the scheme 2008 and 2012, Karen Tam Wu of the Pembina Institute said "We saw fossil fuel consumption decrease by more than 17% and in the rest of Canada fuel consumption increased by more than 1%," (link)

Canada has implemented an ambitious carbon pricing tax (named pollution pricing). In Canada, it has led to higher energy bills, but 90% of proceeds are given to households in the form of tax rebates. The full success of the scheme is not fully evaluated, but it retains popular support

Problems of a Carbon Tax

Production may shift to countries with no or lower carbon taxes. (so-called 'pollution havens') This can give developing countries an incentive to encourage production processes which cause pollution, i.e. there is 'outsourcing' of pollution.

The cost of administrating the tax may be quite expensive reducing its efficiency.

It is difficult to evaluate the level of external cost and how much the tax should be.

Possibility of tax evasion. Higher taxes may encourage firms to hide carbon emissions.

If demand is price inelastic, the tax may have to be very high to reduce demand significantly. In the short term, firms may not feel they have many alternatives. Though, over time, demand will become more elastic as more alternatives are generated.

Consumers dislike new taxes and often don't believe that they will be 'revenue neutral'. This is not an economic argument, but it is a political reality and explains why it is often difficult to implement.

A global carbon tax may curtail economic activity in the poor developing world because they can't afford the small increase in energy costs, but the developed world may simply be able to pay. There may be a need for a carbon tax to reflect different abilities to pay.

Evaluation

To be successful, it depends on how the proceeds of carbon tax is distributed. In British Colombia, Canada, the main proceeds of Carbon pricing go directly to firms households - making the carbon tax quite popular amongst important political constituencies.

By contrast, Australia's short-lived carbon tax 2012-14 suffered from lack of political understanding and poor communication about who benefitted from it. Popularity of Carbon Pricing

Carbon Tax vs Cap and Trade
Related

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Carbon Tax - Pros and Cons - Economics Help

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A carbon tax aims to make individuals and firms pay the full social cost of carbon pollution. In theory, the tax will reduce pollution and encourage more environmentally friendly alternatives. However, critics argue a tax on carbon will increase costs for business and reduce levels of investment and economic growth.

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This document contains examples of how externalities are created. It walks you through what to emphasize as externalities are created.

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More on the creation of a negative externality.

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More on the creation of a negative externality.

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Pollution Effects of a Negative Externality

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Pollution Effects of a Negative Externality

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This document walks you through how a firm decides to externalize costs in a market economy.

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A further explanation on how deadweight loss works.

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This document provides an example of tradable permits and explains how they work.

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Working through the use of excise (per unit) taxes to solve a negative externality.

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This document sets up practice questions relating to negative externalities.

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This document includes practice questions relating to a positive externality.

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Pollution, the Government, and MSB=MSC- Microeconomics 6.2

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Micro 6.3 Negative Externalities: Econ Concepts in 60 Seconds-Externality

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Micro 6.4 Positive Externalities- ACDC Econ

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Dave Anderson's Solutions to Externalities Video

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Socially Efficient and Inefficient Market Outcomes

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Socially Efficient and Inefficient Market Outcomes

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AP Micro: POL (BI), POL‑2 (EU), POL‑4 (EU), POL‑5 (EU)

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About this unit

In this unit, we start exploring the arguments for and against government intervention in an otherwise competitive market. We examine the conditions for allocative efficiency, using the marginal social benefit and marginal social cost principle, and the ways in which externalities, public goods, and the market distribution of income create market failures even in competitive free-market economies. In addition, we study the effectiveness of government policies such as subsidies, taxes, quantity controls, and public provision of goods and services, which are designed to correct market failures and achieve allocative efficiency.

AP® is a registered trademark of the College Board, which has not reviewed this resource.

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Market failure and the role of government | Khan Academy

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In this unit, we start exploring the arguments for and against government intervention in an otherwise competitive market. We examine the conditions for allocative efficiency, using the marginal social benefit and marginal social cost principle, and the ways in which externalities, public goods, and the market distribution of income create market failures even in competitive free-market economies.

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If you're seeing this message, it means we're having trouble loading external resources on our website.

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AP Micro: POL (BI), POL‑2 (EU), POL‑4 (EU), POL‑5 (EU)

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Level up on all the skills in this unit and collect up to 600 Mastery points! Start Unit test

About this unit

In this unit, we start exploring the arguments for and against government intervention in an otherwise competitive market. We examine the conditions for allocative efficiency, using the marginal social benefit and marginal social cost principle, and the ways in which externalities, public goods, and the market distribution of income create market failures even in competitive free-market economies. In addition, we study the effectiveness of government policies such as subsidies, taxes, quantity controls, and public provision of goods and services, which are designed to correct market failures and achieve allocative efficiency.

AP® is a registered trademark of the College Board, which has not reviewed this resource.

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Market failure and the role of government | Khan Academy

# data[].attributes.attachment_link.description
In this unit, we start exploring the arguments for and against government intervention in an otherwise competitive market. We examine the conditions for allocative efficiency, using the marginal social benefit and marginal social cost principle, and the ways in which externalities, public goods, and the market distribution of income create market failures even in competitive free-market economies.

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An Introduction to Externalities | Microeconomics Videos

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What are externalities and what are the different kinds of costs? And what does this have to do with the rise of "superbugs"? This video is an introduction to externalities, including the concepts of

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External Benefits | Microeconomics Videos

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What can the flu teach us about economics and externalities? In this video, we go over how vaccines produce positive externalities that help people stay healthy. When someone receives the vaccine,

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The Coase Theorem | Microeconomics Videos

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In this video, we show how bees and pollination demonstrate the Coase Theorem in action: when transaction costs are low and property rights are clearly defined, private arrangements ensure that the