Question

Give an example of a market/industry where a negative externality in present.

a. What is the difference between the private, unregulated, market output (Q)/price (P) and the optimal, regulated, market output (Q)/price (P). Explain why/how this difference comes about. Use and explain private cost, social cost, and external cost.

b. Explain the source of dead weight loss in such a market. Interpret this dead weight loss.

c. Provide two policy solutions to this problem. Use a command-and-control option and a market-based option.

Answer 1

Suppose a factory is set up on the river side and releases toxic waste into the river, whose water is consumed by people living downstream.

The release of toxic waste in the river is making the water poisonous and thus imposing a negative external cost on to the people living in the downstream villages.

This makes the marginal private supply curve different from marginal social cost curve.

This is because marginal social cost = marginal private cost + external cost

The graph would look somewhat like below:

A) Private unregulated output is calculated at the point marginal private cost curve cuts marginal private benefit curve

This takes place at point Q1

Optimal regulated output is calculated at the point marginal social cost curve cuts the marginal private (or social) benefit curve

This takes place at point Q

As one can see, negative externality leads to overproduction in unregulated markets.

B) Since the optimal output is less than free market output level, it leads to welfare loss or dead weight loss in the economy, as highlighted triangle in graph above.

C) Two policy approaches:

Command and control: Set market allowable output at Q1 and then allow firms to trade permits with each other to keep market output fixed at Q1

Impose tax equal to external cost on to the producers, which would shift the private cost curve to the left to social cost curve, thereby reducing output to socially optimal level