Question

Give an example of what you think is a positive and a negative externally. Draw both a positive and negative graphs of both and explain briefly the Op and Os and Cost effects with these different MPC and MPS Supply firms.

Answer 1

Externality: There are many situations in real life when cost and benefits,which are supposed to be paid by the third parties,are not paid by them.Such spill-over of costs or benefits are called externalities.

Example of positive externality : It can be market for education.The more education a person receives,the greater the social benefits since more educated people tend to be more enterprising,resulting giving greater economic value to their community.

Negative Externality: Pollution, as no one owns the air and they are not the private property of anyone ,so airplane may pollute the air without fear of being taken to court.

In a real world situation,the government takes action through taxation in case of negative externalities and subsidies in case of positive externalities which can bring similar result in the following way:

We know that a competitive market has equilibrium when MCx= PC where X is output MC= Marginal cost P= price

Let production of X create pollution so that the society bears external cost Then

MSCx = MCx+ MEC MEC = Marginal external costs MSC= Marginal social cost

For competitive solution= MSCx. = Pc

In diagram 1, the private optimal output is X0 where MCx = Px.But MSCx> MCx.So tax =TE, so that socially optimal output is at X1,i.e., P= MSCx.

in diagram 2,due to positive externality MC > MSC so that the government gives subsidy = Marginal External Benefits (MEB), NE1. Accordingly output increases to X1.