WELLESLEY COLLEGE DEPARTMENT OF ECONOMICS

ECONOMICS 101 JOHNSON

Review Notes on Externalities

Here, we briefly review the welfare analysis of externalities, with tables for each ofthe cases. Note here that we've drawn cases for which the marginal externality benefit or cost is not constant (thus the MSC or MSB curve is not drawn parallel to the S or D curve), but the internalization policy will still be the same: tax markets with negative externalities to reach Q efficient/optimal and subsidize markets with positive externalities to reach Q efficient/optimal. Don't be too concerned with putting price lines in for the consumer's and producer's prices in each case. Concentrate more on the idea that I might consider reducing the SlJM of CS + PS + GR in exchange for either a greatef increase in externality benefit or a greater reduction in externality cost. In both cases, government action can increase TOTAL SS ( CS + PS + GR + Externality Effects) by having the market participants take those external effects into account. Enjoy! An externaHt)' is an effect on someone's well-being for which no compensation is provided in the market. Pollution constitutes a negative (or detrimental) externality. Planting a beautiful garden in onels front yard produces a positive (or beneficial) externality.

The marsinal social cost ofproducing a good consists ofthe cost to the producer ~ the cost of any extemaHties that affect society.

Marginal private cost is shown by the supply curve. The marginal social cost curve is obtained by taking the relevant supply curve and adding the marainal cost ofthe externality vertically at each Qyantity. (Note that this marginal cost may be different at different quantities.)

The marsinal social benefit ofconsuming a good consists ofthe gain to the consumer JIli.nys the cost ofany externalities that affect the rest ofsociety.

Marginal private benefit is shown by the demand curve. The marginal social benefit curve is obtained by taking the relevant demand curve and adding the marainal benefit ofthe externality vertically at each Quantity.

Neiative production Externalitjes

As an example, consider The Daily Catch restaurant, which can prod~ce great calamari, but only by causing the whole street to reek offish and garlic. This means that the marginal social cost curve for calamari will be higher than the supply curve at all points, since the cost to the restaurant ofproducing calamari does not take into account the effect ofthe bad smell on other people. The difference may be greater for small amounts ofcalamari, since once the street reeks adding a little more smell doesn't make things much worse.

MSC P

S -MPC

MARGINAL COST OF ETERNALITY AT 0'

o 0' NEGATIVE PRODUCTION EXTERNALITY Social surplus is maximized at the quantity for which the marginal social benefit (MSB) from consuming the good equals the marginal social cost (MSC) of producing it. If there are no externalities, marginal social benefit equals the marginal private benefit, which is represented by consumers' reservation prices and the demand curve. Further, marginal social cost equals the marginal private cost, which is represented by the supply curve. Th~~, the social su.rpl~s l1l\v. maximizing condition MSB = MSC becomes equiyalent to the condition D = S, which ISJ (.\''f\J automaticalJy satisfied by a competitive market equilibrium. T~M.

Ifthere are externalities, however, the competitive market equilibrium level ofoutput is nQ1 the social surplus maximizing level of output. Thus the competitive market equilibrium represents a deadweight loss. Here is the situation in our calamari example:

P

D -MPB-MSB

"------'-_...... :..._---~Q QEFF Q HKT .

NEGATIVE PRODUCTION EXTERNALITY

With a negative externality the market produces more calamari than the social surplus maximizing amount. Why?

When the last units ofQ were produced, the market thought that their benefits (what people were willing to pay, the demand curve) slightly outweighed the costs of production (the supply curve), so the market said "go ahead and produce." In fact the costs to society (the cost of production plus the externality) were greater than the benefits,so w~ want the markc;t to say "don't produce anymore."

We can use the above diagram to find the total additional cost associated with the externality at QMKT and QEFF. The additional cost is the difference between the MSC curve and the supply curve for all units produced. Thus, at QMKT the cost ofthe externality is B + C + D; at QEFF the cost ofihe externality is B. Notice that the cost ofthe externality does not go away at the efficient quantity, but it is lessened.

Now that we can find the cost ofthe externality, we can use a welfare table to find the deadweight loss that occurs when Qt.~T is produced. The welfare table for externalities is different from the previous welfare tables you have used in two ways: +Go,/-t. ~~. 1. Instead offinding consumer surplus and producer surplus~eparately, we will lump them together. This means that we will not have to worry about what the price is at the market quantity and the efficient quantity; we can simply look for the area between the demand curve and the supply curve. When the demand curve is above theAupply curve (the usual case), this area represents positive consumer and producer surplu\f\lWhen the supply curve is above the demand curve (we will see this when we do positive externalities), this area represents neBative consumer and producer surplus.+ 6~

2. The cost ofthe externalities is included in social surplus. The basic formula we will use is

social surplus = (consumer surplus + producer surplus) + q~ - additional costs of negative externalities + additional benefits of positive externalities.

To find the deadweight loss associated with an externality, we calculate total social surplus at the efficient level ofoutput, then calculate total social surplus at market level ofoutput, and then use these quantities to find the chanBe in total social surplus that occurs when the market level ~i output is produced instead ofthe efficient level ofoutput. ~. .J.- t1 VI 6~ ~ ~ ett k~~ ([ ~~1 b1~ +G\~ ~ S~~.:::J 'S ~Ql lA.~ •

At QEFF At QMKT Difference l'~ ~ Consumer Surplus + A+B A+B+C C Producer Surplus + ~ft ~~ - Total Cost of B B+C+D C+D Negative Externality ~~. Social Surplus A A-D -D

As the table shows, the deadweight loss that occurs when QMKT is produced is D. ~ {'10-\-t: GR- - 6.~"Jl+. Rw. PoSlt!yero.. P ductlQnxterna'E I" Itles -­

Suppose that in our calamari example people ~ the smell ofgarlic and fish. Then the Daily Catch would be generating a positive externality and the marginal social cost ofproducing calamari would be ~ than the marginal private cost. In other words, the social cost equals the private cost of production m.imI.s the benefits to people walking down the street. In this case the market will produce less calamari than the amount which would maximize social surplus.

p

- MSB

QMKT

POSITIVE PRODUCTION EXTERNALITY We can find the area that represents the total additional benefit associated with the positive production externality. The total additional benefit is the area between the supply curve and the MSC curve for all units produced. At QEFF the additional social benefit associated with the externality is B + C + D; at Q~{},.'T the additional social benefit is B.

Once again we can use a welfare table to find the deadweight loss that occurs when QMKT is produced.

At QEFF At QMKT Difference Consumer Surplus + A-D A D Producer Surplus +6« + Total Benefit of B+C+D B -C-D Positive Externality Social Surplus A+B+C A+B -C

The deadweight ]oss associated with Qfo.fKT is C.

J;xternaUtjes ofConsumption

So far we have discussed positive and negative externalities generated by the production of goods. There are also externalities generated by the consumption of goods. Alcohol and garlic bread have negative externalities associated with their consumption, while education and soap have positive externaliti"es associated with their consumption.

For ne~atiye consumption externalities, we have the following situation:

p MARGINAL COST OF

EXTE~ITY

S =MPC=MSC

w:::;...... :-_-....:. ~~o

OE:ff OMK!

NEGATIVE CONSUMPTION EXTERNALITY

For negative consumption externalities, the additional cost associated with the externality is the area between the demand curve and the MSB curve for all units produced. At QEfF At Q~{KT Difference 1~J ~onsumer Surplus + A+B A+B+C C Producer Surplus Total Cost of A A+C+D C+D -to Negative Externality Kef\~ Social Surplus B B-D -D The deadweight loss that occurs when Q~{KT is produced is area D. Qeff

For positive consumption externalities, we have the following situation:

EFF Q MKT Q Q POSITIVE CONSUMPTION EXTERNALITY

For positive consumption externalities, the additional benefit associated with the externality is the area between the MSB curve and the demand curve for all units produced.

At QEFF At Q~{KT Difference Consumer Surplus + B-D B D Producer Surplus + Total Benefit of A+C+D A -C-D Positive Externality

Social Surplus A+B+C A+B -C

In this case ofa positive consumption externality, the deadweight loss associated with producing QMKT is equal to C. Some final thoughts:

*In cases ofnegative externalities, the government has a positive economic role to tax to reduce the quantity transacted. As we saw in lecture, they may either tax the good (electricity or gasoline) or they may use a Pigovian tax or permit scheme to tax the negative externality itself (pollution).

*In cases ofpositive externalities, the government has a positive economic role to subsidize to increase the quantity transacted.

*Try to convince yourselves that total social surplus is the area bounded by MSB and MSC up to Q efficient/optimal.

*Even with negative externalities, some non-zero production and consumption ofthe good is generally optimal. After all, not many would argue that the negative pollution externality is so very large that setting gasoline quantities to ZERO would be socially optimal. The idea is to make sure that the quantity takes all parties into account - the gasoline makers, the gasoline users, and the cyclists who like to breathe and ride at the same time!