EXTERNALITIES AND GOVERNMENT CORRECTIVE ACTIONS The world now is concerned about the environment and the problems confronting Many activities result in negative spillover effects that negatively affect the environment and people living in it. In this chapter, we are going to discuss how these spillover effects can cause markets to fail to achieve an efficient outcome, how government intervention can help achieve efficiency. On the other hand, the are other activities that have positive spillover effects such as vaccination if provi through markets will also produce inefficient output thereby require government corrective measures. Ghapter content] 1) Defines externalities both in consumption and production, in addition to distinguishing between negative and positive externalities 2) Discusses how negative externalities can cause market failure and how corrective taxes can internalize externalities and help achieve efficiency. 3) Discusses how positive externalities can cause market failure and how corrective subsidies can internalize externalities and help achieve efficien e Blue highlight is a main topic ¢ Yellow highlight is a main point e Green highlight is a definition or a rule e There is a translator page maaan aanuasatnMarket Demand Curve = MBP curve = MSB curve Demand reflects the benefit to the whole society because there are no other benefits from consuming the goods other than those that accrue to the direct consumers. ¢ However, in some cases, benefits to the society can be more or less than those that accrue to the direct consumers (ex. HIV Vaccine) e Isa spillover of benefits to third parties. It’s the change in satisfaction which can be positive or negative for someone other than the direct consumer of an item Positive externality in consumption exists when an externality has a positive effect on social well-being other than those of direct consumers, whereby MSB > MPB. ¢ Negative externality in consumption exists when an externality adversely affects non-consumers of the good thereby reducing social well-being, whereby MSB < MPB « Market demand curve = MSB = MPB only when there is no externality in consumption OMAR MOHAMED Bb) Externalities in Production e Market Supply Curve = MPC Curve = MSC Curve Itreflects the Cost to the whole society because there are no other costs from producing the good other than the cost of resources used e However, in some cases, costs to society can be more or less than direct costs of producing the good (ex. pollution) e Is spillover of costs to third parties. It's the change in costs of production of one good due to the production of another good ¢ Positive externalities When externality reduces the costs of production for other production units whereby MSC < MPC < Supply (right of supply curve) e Negative externalities When externality raises the costs of production for other production units whereby MSC > MPC >Supply (left of supply curve) e Market Supply curve = MSC = MPC Only When No Externality in Production e¢ D-=MPB = MSB = S =MPC = MSC when no externality exists e Market failure occurs if externalities exist then markets operating on their own fail to achieve socially optimal (Efficient) allocation of resources e When a negative externality exists, the price of a good or service does not reflect the full marginal social cost of resources allocated to its production. e Market Failure due to Negative Externalities When Negative Externality exists, there is an external cost that is borne by third parties 5 Marginal External Cost (EC )NanIaddlllonaleOSU1o Ihirdipanliesthabansed [fomiproducing another Unitofalaoodorsenvice] [tis important to know that producers base their decisions on marginal private cost (MPC) not MSC. Hence, [GRIBGnEnIEg ¢ Marginal External Cost (MEC) |s considered a part of the marginal social cost (MSC) of producing an additional unit of a good However, it is not reflected in the price of a good MAR MOHAMED: —&A negative externality could be ociated with paper production due to the damage done by pollutants who emit their waste into streams and rivers. Each unit of output results in additional cost to parties other than the buyers or the sellers of the good Assume that perfect competition prevails in the market of paper industry. Figure 3.2 shows the interaction between the market forces and the resulting outcome, Figure 3.2. Negative Externalities in the Paper industry aa 8 Millions of Tons of Paper Per Year « Market Equilibrium: Equilibrium: Q = 5 million Tons per year, P = $100 / ton ¢ The market is not efficient because: D = MPB = MSB S= MPC # MSC Because MSC = MPC + MEC ‘OMAR MOHAMED | ee(OMAR MOHAMED: ¢ Assume that MEC of each ton of Paper = $10 + The market equilibrium output of 5 million tons of paper per year is inefficient because its + MSC = $110 per ton at point G + MSB = $100 per ton at point A + The efficient Output would be at Point B where MSB = MSC = $105 at Q = 4.5 + Thus, there is a Loss in Net gains (Deadweight Loss) due to overproduction. Triangle BGA e When a negative externality exists, too much output is produced and sold in a competitive market relative to the efficient amount Internalizing externality leads to a change in the price to reflect full marginal social cost or benefit of a good. Bin the case of a negative externality, the marginal external cost is added to marginal private cost. 7 ipGnamEg « Fora positive externality, the marginal external benefit is added to marginal private benefit [SAi=iiRGie* To achieve this objective, the government must impose a tax with a value equal to the marginal external cost per unit of output This tax aims at internalizing a negative externality in a way that make sellers of the product pay a fee equal to the marginal external costs per unit of output sold In the market for paper industry, assume that the government imposed a corrective tax on producers of paper to internalize the negative externality resulting from their output, Because MEC = $10, then the corrective tax would be T = $10 This tax is imposed on each unit produced which It considered by producers as an increase in the marginal private cost of production. (Supply Shift Leftward where S’ reflects the full MSC of producing paper.) OMAR MOHAMED pFigure 3.3. A Corrective Tax ames SHY = RAE 2 = nse Millions of Tons of Paper Per Year Market equilibrium: p = $105, Q = 4.5 million tons at Q =4.5, MSB = MSC then market is efficient Tax Revenue = $10 x 4.5 million tons = $ 45 million (area FBJH) The effect of taxes at wellbeing is : The gain in efficiency due to the corrective tax is corresponded to by the triangular area BGA in Figure 3.4. This area measures the growth in net social benefits when annual paper production is reduced to the point at which its marginal social benefit equals marginal social cost. ‘MOHAMED |¢ Positive externality means that there are spillover benefits to third parties. S « Market Failure due to Positive Externalities When a positive externality exists, the price does not reflect the full marginal social benefit of a good or service. Its important to note that, consumers base decisions on marginal private benefit (MPB) not MSB. ¢ Marginal External Benefit (MEB) !s considered a part of the marginal social Benefit (MSB) of a good ¢ is not reflected in the price of a good. e When Positive Externality exists, MSB > MPB Vaccination against a disease causes both direct benefits to consumer as well as spillover benefits to third parties as follows: ¢ The possibility of catching the disease is likely to fall b) Benefits t6lthird parties (who are not vaccinated & don't pay for the vaccine) such as * The number of people who would become hosts for the disease is likely to fall ¢ The probability of contagion is likely to decline ¢ The possibility of outbreaks of the disease for the entire population (including those who are not vaccinated) is likely to decline. OMAR MOHAMED |Assume that perfect competition prevails in the market of vaccination. Figure 3.3 shows the interaction between the market forces and the resulting outcome. Figure 3.3: The Market for Vaccination » Market Equilibrium: Q = 10 million vaccines per year, P = $26 / vaccine » The market is inefficient because : S = MPC = MSC D = MPB # MSB Because MSB = MPB + MEB MAU ABAEDAssume that MEB of each Vaccine= $20 ¢ The market equilibrium output of 10 million vaccines per year is inefficient because its « MSC = $25 per Vaccine at point U « MSB = $45 per Vaccine at point Z * The efficient Output would be at Point V where MSB = MSC = $30 at Q = 12 * Thus, there is a Loss in Net gains (Deadweight Loss) due to Underproduction. Triangle UZV e A positive externality results in, less than (10 million Vaccines) the efficient amount of output (12 million Vaccines) ¢ The marginal external benefit (MEB) per inoculation (Vaccine) is likely to fall as more of the population is inoculated because fewer people will be susceptible to the disease. + If this were the case, marginal external benefit (MEB)would eventually fall to zero when enough people were inoculated MSB exceeds MPBi only if the annual output is less than 16 million inoculations per year. MAR MOHAMED BSFigure 3.4 A Positive Externality for which MEB declines millions of inoculations Per Year ¢ The MSB curve gives the sum of MPB and the MEB at each level of output ¢ The distance between the MSB and the MPBi curves decreases because MEE declines with output. © The implications of this type of externality for market failure are quite important e The supply were s’ = MSC © Equilibrium: Q = 20 Million vaccines per year, P = $20/ vaccine © Market is efficient because : S = MPC = MSC = $20 D = MPB = MSB = $20 Because MEB = Zero AR MOHAMED. a & cSThus, for positive externalities such as these, with a marginal value that declines with output, competitive markets fail to perform efficiently only at low levels of output. e Fora positive externality, the marginal external benefit is added to marginal private benefit to internalize the externality. e Internalizing externality leads to a change in the price to reflect full marginal social cost or benefit of a good. e Fora positive externality, the marginal external benefit is added to marginal private benefit ¢ to internalize a positive externality: \isB = MPC + MEB To achieve this objective, the government must make a payment equal to the marginal external benefit of the good or service. OMAR MOHAMED BFigure 3.5. A Corrective Subsidy Price, Benefit, and Cost e In our example: MEB = $20 per vaccine e Let's assume that the government announces that it will pay each vaccinated person a subsidy of $20. e This subsidy adds $20 to the MPB of each vaccine. e The demand curve for vaccines shifts rightward from D = MPBi to D’ = MPBi + $20 = MSB e As the demand for vaccinations rises, the market equilibrium moves from point U to point V where, P = 30, Q= 12 © The net price is now $30 - $20 = $10 per inoculation. © The fall in the net price to consumers causes a rise in the quantity demanded to 12 million per year, the efficient output (because now MSB = MSC = $30. © Subsidy Payment = RVXY = 20$ x 12 million = $240 million © The subsidy is paid from tax revenues )MAR MOHAMED wiTRANSLATOR, Confronting : 22 Spillover : gate i Externalities : Asta o) 80 Internalize : Stasi! Accrue: Si Adversely: yah Borne; Jase Pollutants; sl Adjusted : tsi Reflect: Se Emitting: Sas : Vaccination : cuit Host : inate Contagion : 5 Outbreaks : ti Subsidy : 42 (OMAR MOHAMED.