# Externalities. 5 Microeconomics ACTIVITY 5-2

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1 ACTIVITY 5-2 Externalities A market externality refers to a situation where some of the costs or benefits from an activity fall on someone other than the people directly involved in the activity. Externalities may be either positive (the activity provides a benefit to someone else) or negative (the activity places a cost on someone else). Costs that fall on someone else are called external costs, and benefits that fall on someone else are called external benefits. These external effects of an activity are also called social spillover costs and social spillover benefits, or third-party costs and third-party benefits. The demand curve for a good or service shows the marginal private benefit (MPB) to those individuals who are consuming the product. It shows how many units will be demanded by consumers at different prices. The demand curve also shows the highest prices consumers will pay for different quantities of the product. The supply curve of a good or service shows the marginal private cost (MPC) to those individuals who are producing the product. It shows how many units will be supplied by producers at different prices. The supply curve also shows the lowest prices producers will accept for different quantities of the product. If there are no positive externalities associated with the activity, then the marginal private benefit from an additional unit will be equal to the marginal social benefit (MSB). The marginal social benefit shows the benefit to society from an extra unit of the activity. If no one other than the person associated with the activity receives any benefit from the extra unit, then MPB = MSB. If there are no negative externalities associated with the activity, then the marginal private cost from an additional unit will be equal to the marginal social cost (MSC). The marginal social cost shows the cost to society from an extra unit of the activity. If no one other than the person associated with the activity incurs any cost from the extra unit, then MPC = MSC. Consumers of a product buy according to their marginal private benefits as shown by the demand curve, and producers of the item produce according to their marginal private costs as shown by the supply curve. The equilibrium quantity of the product in a perfectly competitive market will be the quantity where MPB = MPC. This is where the market demand curve intersects the market supply curve. If there are no externalities, the competitive market output is the socially optimal (efficient) quantity because it is where MSB = MSC. Society feels the market is producing exactly the right amount of the product. Given the marginal benefit society is receiving from the last unit, it feels the correct amount of its scarce resources is being allocated to the provision of that unit. The competitive market results in market failures, however, if there are positive or negative externalities associated with the consumption or production of the good or service. These spillover benefits or costs, if not corrected, will result in the market producing either too much or too little of the activity from society s perspective. The externalities drive a wedge between the MSB and the MPB, or between the MSC and the MPC. Because the market will produce the output where MPB = MPC, these differences yield a quantity of the product at which MSB is not equal to MSC. We often turn to the government to attempt to correct these market failures. Advanced Placement Economics Microeconomics: Student Resource Manual Council for Economic Education, New York, N.Y. 277

2 ACTIVITY 5-2 (CONTINUED) To understand how externalities can result in market failures, it is important that you know these relationships: Marginal Social Benefit = Marginal Private Benefit + Marginal External Benefit MSB = MPB + MEB Marginal Social Cost = Marginal Private Cost + Marginal External Cost Summary of key points: MSC = MPC + MEC Society wants a market to produce the quantity where MSB = MSC. Private decision makers want to have the quantity where MPB = MPC. As long as MEB and MEC are zero (no externalities), the market quantity will be the socially optimal (efficient) quantity. If MEB or MEC is not zero, we will have a market failure. Student Alert: Some textbooks use slightly different approaches to the topic of externalities. While the end results with regard to the effects of externalities are the same, be sure you understand the approach and terminology that are being used. Part A: How Much Music? Figure External Benefits BENEFITS, COSTS MSC = MPC MSB = MPB + MEB MPB HOURS OF MUSIC 278 Advanced Placement Economics Microeconomics: Student Resource Manual Council for Economic Education, New York, N.Y.

3 ACTIVITY 5-2 (CONTINUED) 1. Margaret has Wendy as her roommate in a college residence hall. Wendy has brought an expensive stereo system to play in the room. Figure shows Wendy s MPB and MPC curves for music played on the stereo system. Based on Figure 5-2.1, answer the following questions. (A) If Wendy considers only the MPB and MPC from playing music, how many hours of music will be played? Label the number of hours in Figure as Q P to indicate the private market quantity. (B) Assume that Wendy plays music only at times that do not disturb Margaret and plays only music that Margaret also enjoys. The MSB = MPB + MEB curve in Figure shows the MSB from the music, including the MEB to Margaret. If Wendy considers the MSB from playing music rather than only the MPB, what happens to the quantity of music played? Label the number of hours as Q S in Figure to indicate the socially optimal quantity. (C) In Figure 5-2.1, what does the vertical gap between the MSB and MPB curves represent? (D) Assuming there are no external costs from the music, when Wendy does not consider the MEB from playing music, the number of hours played is (greater than / equal to / less than) the socially efficient number of hours. Figure External Costs BENEFITS, COSTS MSC = MPC + MEC MPC MSB = MPB HOURS OF MUSIC 2. Again, Wendy has a new stereo system and Margaret is her roommate. (A) In Figure 5-2.2, assume Wendy only considers her MPB and MPC from music. How many hours of music will be played? Label the number of hours in Figure as Q P to indicate the private market quantity. (B) Now assume that Wendy plays music only at times that Margaret is trying to study and plays only music that Margaret hates. In Figure 5-2.2, the MSC = MPC + MEC curve shows the MSC from the music, including the MEC to Margaret. If Wendy considers the MSC from playing music rather than only the MPC, what happens to the quantity of music played? Label the number of hours as Q S in Figure to indicate the socially optimal quantity. (C) In Figure 5-2.2, what does the vertical gap between the MSC and MPC curves represent? Advanced Placement Economics Microeconomics: Student Resource Manual Council for Economic Education, New York, N.Y. 279

4 ACTIVITY 5-2 (CONTINUED) (D) Assuming there are no external benefits from the music, when Wendy does not consider the MEC from playing music, the number of hours played is (greater than / equal to / less than) the socially efficient number of hours. 3. How can government regulation (in this case, residence hall rules) assure the efficient quantity of music? Consider the circumstances under which prohibiting stereos or imposing daily quiet hours are efficient ways to regulate stereo use in the hall. Does economics suggest a more efficient approach to stereo regulation? Part B: More Externalities Examples 4. For each of these activities, explain whether there is a positive or negative externality. (A) Private high school education (B) Smog from an electric power plant (C) Your neighbor s yappy dog (D) Pre-kindergarten measles vaccinations Part C: Applying Your Knowledge of Externalities The Women s National Basketball Association (WNBA) is considering awarding a new franchise to the city of Metropolis, but only if the team has a new arena in which to play. Proponents of the franchise argue that the team will generate new businesses, provide jobs, increase tax revenue, and promote tourism in Metropolis. Opponents argue that most of the money spent on basketball games will come from Metropolis-area residents who will simply reduce their spending on other activities. The opponents claim there will be few new jobs, little increase in tax revenue, and few new tourists coming 280 Advanced Placement Economics Microeconomics: Student Resource Manual Council for Economic Education, New York, N.Y.

5 ACTIVITY 5-2 (CONTINUED) to Metropolis. They also say the new arena will cause property values to fall in the area and create traffic congestion and noise pollution. Voters have the following three proposals before them: Proposal #1: No city money should be used to construct the arena. Team owners should pay the full cost of building the facility and include that cost in the price of game tickets. Proposal #2: The city should place a tax on each ticket sold to pay the full cost of the arena. Proposal #3: The city should build the arena and lease the right to play there to the basketball club at a subsidized rate. For the analysis that follows, assume the output of the team is the number of tickets sold. 5. What assumption does Proposal #1 make about external costs and external benefits associated with the new franchise? Figure can be used to illustrate the position of opponents to the franchise. Answer the following questions based on this graph. Figure Social Spillover Costs BENEFITS, COSTS \$20 \$17 B A MSC = MPC + MEC MPC MPB = MSB TICKETS (1,000s) 6. What assumption is made about social spillover benefits from the franchise? Explain. 7. What assumption is made about social spillover costs from the franchise? Explain. Advanced Placement Economics Microeconomics: Student Resource Manual Council for Economic Education, New York, N.Y. 281

6 ACTIVITY 5-2 (CONTINUED) 8. How many tickets will be sold based on the MPB and MPC? 9. What is the socially optimal number of tickets? 10. What does the vertical gap AB represent? 11. What can the Metropolis city government do to make the market output be equal to the socially efficient output? Explain, using the graph to illustrate your answer. Figure can be used to illustrate the position of supporters of the franchise. Answer the following questions based on this graph. Figure Social Spillover Benefits BENEFITS, COSTS \$20 \$16 \$14 W X MPC = MSC MSB = MPB + MEB MPB TICKETS (1,000s) 12. What assumption is made about social spillover benefits from the franchise? Explain. 282 Advanced Placement Economics Microeconomics: Student Resource Manual Council for Economic Education, New York, N.Y.

7 ACTIVITY 5-2 (CONTINUED) 13. What assumption is made about social spillover costs from the franchise? Explain. 14. How many tickets will be sold based on the MPB and MPC? 15. What is the socially optimal number of tickets? 16. What does the vertical gap WX represent? 17. What can the Metropolis city government do to make the market output be equal to the socially efficient output? Explain, using the graph to illustrate your answer. Part D: Per Unit or Lump Sum? Which Type of Tax or Subsidy to Use? Student Alert: Which form of a tax or subsidy should the government use to correct the effects of an externality? Should it apply a per-unit or a lump-sum adjustment? Figure shows the average total cost (ATC), average variable cost (AVC), marginal cost (MC), demand (D), marginal revenue (MR), and average revenue (AR) functions of a perfectly competitive firm. The firm is producing Q 1 units because that is where MR = MC. Assume there is a negative externality associated with the firm s product and the government would like to have the firm reduce its output. Figure A Profit-Maximizing Perfectly Competitive Firm PRICE P 1 MC 1 ATC 1 AVC 1 D = MR = AR Q 1 QUANTITY Advanced Placement Economics Microeconomics: Student Resource Manual Council for Economic Education, New York, N.Y. 283

8 ACTIVITY 5-2 (CONTINUED) 18. Suppose the government places a per-unit tax of t on the firm s product. Which cost measures will be affected by this per-unit tax: ATC, AVC, average fixed cost (AFC), or MC? Show in Figure how the cost curves will look after the tax is imposed. What happens to the output level the firm wants to produce? Was the per-unit tax successful in having the firm reduce its quantity? Figure The Government Levies a Per-Unit Tax of t PRICE P 1 MC 1 ATC 1 AVC 1 D = MR = AR Q 1 QUANTITY 19. Suppose the government places a one-time, lump-sum tax of T on the firm s product. Which of these cost measures will be affected by this lump-sum tax: ATC, AVC, AFC, or MC? Show in Figure how the graph will look after the tax is imposed. What happens to the output level the firm wants to produce? Was the lump-sum tax successful in having the firm reduce its quantity? Figure The Government Levies a Lump-Sum Tax of T PRICE P 1 MC 1 ATC 1 AVC 1 D = MR = AR Q 1 QUANTITY 284 Advanced Placement Economics Microeconomics: Student Resource Manual Council for Economic Education, New York, N.Y.

9 ACTIVITY 5-2 (CONTINUED) 20. Assume a firm produces a product for which there is a positive externality. As an incentive to the firm to produce more of its product, should the government give the firm a per-unit subsidy or a lump-sum subsidy? Explain. Part E: Summary 21. When positive externalities are involved, private markets produce (more than / exactly / less than) the socially optimal amount of the product. 22. When negative externalities are involved, private markets produce (more than / exactly / less than) the socially optimal amount of the product. 23. Why do economists say the presence of an externality results in a market failure? 24. How can a tax be used to remedy a negative externality? 25. How can a subsidy mitigate an inefficient output level in the presence of a positive externality? Advanced Placement Economics Microeconomics: Student Resource Manual Council for Economic Education, New York, N.Y. 285

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11 ACTIVITY 5-3 Private or Public? The Coase Theorem When an activity results in a negative externality (external cost), the market outcome will not be efficient. In these cases, the government may choose to intervene in the market and impose some form of regulation, for example, a legal restriction or a tax. If the external cost the activity creates is borne by those who conduct the activity, the market outcome will be efficient. For example, if a firm dumps its waste into a river, it pollutes the river and creates a negative externality (external cost) for those downstream. The government may intervene to restrict dumping in the river, or it may impose an effluent tax (a tax on each unit of pollution released into the river). If the firm is forced to pay for the pollution it releases into the river, it will dump less. A sufficiently high tax will lead to the optimal reduction in river pollution from the firm. Thus, the firm has internalized the externality. However, in some situations, it may not be necessary to regulate a market to achieve an efficient outcome. It may be possible for the parties affected by an externality to negotiate an efficient outcome on their own. For example, if people who use the river downstream can negotiate with the polluting firm, they may be willing to pay the firm to stop polluting. This idea is embodied in the Coase Theorem, which states that if those who are affected by an externality can negotiate, they may arrive at an efficient solution to the externality problem. Two firms are involved in a dispute. Grunge, Inc., a manufacturing firm, pollutes a nearby river. The pollution travels downstream past White Water Expeditions, a company that provides river rafting trips. Dumping its waste into the river cuts Grunge s waste-disposal costs, while decreasing the number of people who want to raft on the river. The total profits of the two firms (both with and without waste dumping) are shown in Table Table Total Profits per Month With dumping Without dumping Grunge, Inc. \$2,300 \$2,000 White Water Expeditions \$1,500 \$2, What are the total returns to both companies with and without dumping? Which situation (dumping or no dumping) is socially optimal in other words, provides the highest combined returns? 2. If there is no government intervention in the market, and the two companies do not communicate, will Grunge dump waste into the river? Why or why not? Advanced Placement Economics Microeconomics: Student Resource Manual Council for Economic Education, New York, N.Y. 287

12 ACTIVITY 5-3 (CONTINUED) 3. What is the cost to Grunge not to dump waste into the river? 4. What is the cost of the pollution to White Water each month? How much would White Water be willing to pay Grunge to stop dumping waste into the river? 5. If Grunge and White Water could negotiate, at no cost, could they come to an agreement that would eliminate the externality problem and result in the efficient outcome? If not, why not? If so, what would be the payment from White Water to Grunge? 6. Does it matter who has the property right: Grunge to dump or White Water to have clean water? Explain. 288 Advanced Placement Economics Microeconomics: Student Resource Manual Council for Economic Education, New York, N.Y.

13 ACTIVITY 5-4 Economic Efficiency and the Optimum Amount of Pollution Cleanup Student Alert: Does it make sound economic sense to clean up all pollution? The human and environmental damage caused by industrial pollution often arouses public attention. Although it might be nice to restore our environment to its pristine state, pollution cleanup is costly and dollars used for cleanup might be spent elsewhere. It seems, then, that some sort of balance must be struck between undesirable pollution and its costly cleanup. Let s apply marginal analysis to determine an optimal amount of pollution and environmental cleanup. The marginal social benefit (MSB) of cleaning up pollution tends to decline as additional units of pollution are cleaned up. The marginal social cost (MSC) of cleaning up pollution tends to increase as additional units of pollution are cleaned up. If society has accurate information about the total social (public and private) benefits and costs of various amounts of cleanup, society should be able to get close to the most efficient, or optimum, level of cleanup (and/or pollution) where the marginal social benefits equal the marginal social costs (MSB = MSC). Imagine a community in which two firms emit foul sludge into two local lakes (one for each firm). Natural processes gradually break down the sludge, rendering it harmless. But as long as emissions continue, a certain equilibrium level of harmful sludge remains in the lake. If emissions are lowered, this equilibrium level will be reduced. The opposite occurs if emissions are increased. Currently each firm emits five units of sludge each week. Given the information in Tables and 5-4.2, you should be able to determine the optimal level of emissions for this community. Fill in the blanks in the tables, and use this information to answer Questions 1 through 4. Assume that benefits obtained and costs incurred for cleanup at one lake have no impact on costs and benefits at the other lake. Table Firm 1 Reduction of foul sludge emissions Total social benefit of cleanup Marginal social benefit of cleanup Total social cost of cleanup Marginal social cost of cleanup 0 \$0 \$0 1 \$350 \$350 \$160 \$160 2 \$650 \$370 3 \$900 \$630 4 \$1,100 \$940 5 \$1,250 \$1,300 Advanced Placement Economics Microeconomics: Student Resource Manual Council for Economic Education, New York, N.Y. 289

14 ACTIVITY 5-4 (CONTINUED) 1. Using the data from Table 5-4.1, fill in the blanks or underline the correct words in parentheses. (A) The marginal social benefit (MSB) of reducing emissions by the first unit of foul sludge is \$, and the marginal social cost (MSC) of reducing pollution emissions by the first unit is \$. The MSB is (greater than / equal to / less than) the MSC, so it (would / would not) be economically efficient from society s perspective to require Firm 1 to reduce pollution emission by the first unit. (B) The MSB of eliminating the last (fifth) unit of foul sludge is \$, and the MSC of reducing pollution emissions by the last (fifth) unit is \$. The MSB is (greater than / equal to / less than) the MSC, so it (would / would not) be economically efficient from society s perspective to require Firm 1 to reduce pollution emission by the fifth unit. Table Firm 2 Reduction of foul sludge emissions Total social benefit of cleanup Marginal social benefit of cleanup Total social cost of cleanup Marginal social cost of cleanup 0 \$0 \$0 1 \$350 \$350 \$130 \$130 2 \$650 \$280 3 \$900 \$450 4 \$1,100 \$640 5 \$1,250 \$ Using the data from Table 5-4.2, fill in the blanks or underline the correct words in parentheses. (A) The MSB of eliminating the fourth unit of foul sludge is \$, and the MSC of reducing pollution emissions by this fourth unit is \$. The MSB is (greater than / equal to / less than) the MSC, so it (would / would not) be economically efficient from society s perspective to require Firm 2 to reduce pollution emissions by four units. (B) The MSB of eliminating the fifth (last) unit of foul sludge is \$, and the MSC of reducing pollution emissions by this fifth (last) unit is \$. The MSB is (greater than / equal to / less than) the MSC, so it (would / would not) be economically efficient from society s perspective to require Firm 2 to reduce pollution emissions by five units. 290 Advanced Placement Economics Microeconomics: Student Resource Manual Council for Economic Education, New York, N.Y.

15 ACTIVITY 5-4 (CONTINUED) 3. If this community decides to adopt a pollution control ordinance aimed at maximizing economic efficiency, how should it evaluate each of the following three proposals, all of which are based on the data presented above? Write a brief economic evaluation in the space provided after each of the proposals. Be sure to use the concepts of marginal social benefit and marginal social cost in your analysis. Proposal A. Foul sludge emissions should be reduced (by five units) to zero for each firm because we should eliminate all pollution from our lakes regardless of the cost. This proposal (would / would not) maximize economic efficiency. Proposal B. Firm 2 should be forced to reduce emissions from five units to zero because the total social benefit of cleanup (\$1,250) exceeds the total social cost of cleaning up (\$850). But Firm 1 should not be forced to clean up at all, because the total social benefit of cleanup (\$1,250) is less than the total social cost of reducing emissions to zero (\$1,300). This proposal (would / would not) maximize economic efficiency. Proposal C. In the interest of equal treatment for all, each firm should be forced to clean up (reduce emissions) by three units. This proposal (would / would not) maximize economic efficiency. Advanced Placement Economics Microeconomics: Student Resource Manual Council for Economic Education, New York, N.Y. 291

16 ACTIVITY 5-4 (CONTINUED) 4. Using the data presented above, what do you think is the socially optimal level of emissions reduction for each firm? Explain why you chose these numbers. Firm 1: units Firm 2: units 5. What would you say to someone who makes the following statement? Society should do all it can to eliminate all pollution. 292 Advanced Placement Economics Microeconomics: Student Resource Manual Council for Economic Education, New York, N.Y.

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