Question

Please answer these questions in full with details!

1. Define positive and negative externalities; describe examples of each. What types of government policies may be appropriately applied in cases of externalities? Explain a “corrective tax”.

2.. Define and explain the relationship between Total Revenue, Total Cost, Profit, Marginal Product, Marginal Cost, and Marginal Revenue. What is the difference between “economic profit” and “accounting profit”? What is the relevance of “opportunity costs”?

Answer 1

1. Externality:

It includes both external cost and external benefit. In other words, there can be negative or positive externality. In the case of negative externality, action of an economic agent creates cost for others. For example: Smoker causes cost for non smoker.

On the other hand, in the case of positive externality action of an economic agent create benefits for others for which it does not receive anything in return. For example: Beautiful flowers in the garden creates fresh environment for passersby. The term externalities refer to both external cost and external benefit.

Taxation on production of negative externality is appropriate policy to internalize externality. Corrective tax is the tax which is levied to internalize the externality created by firm in the industry.

2. Total Costs: Total cost is the sum of total fixed cost and total variable cost. TC is parallel to TVC. It shows that the difference between TC and TVC is constant i.e. TFC.

Marginal Cost: It is the additional cost which is incurred by the producer to produce an additional unit of commodity.

MC = Change in TC / Change in Q

Marginal Revenue: It is the additional revenue which is received by the firm by producing an additional unit of commodity.

MR = Change in TR / Change in Q

Total Revenue: It is equal to the product of price and quantity sold by firm.

TR = Price x Quantity

Relationship between TC and MC:

1) TC increases at an increasing rate when MC is increasing.

2) TC increases at a constant rate when MC is constant.

3) TC increases at a diminishing rate when MC is decreasing.

Profit is the difference between Total revenue of firm and total cost of firm. When TR > TC then firm earns profit and if TC > TR then firm is earning losses.

Accounting Profit = Total Revenue - Total cost which includes explicit cost

Economic Profit = Total Revenue - Total cost including explicit and implicit cost

Implicit costs are the opportunity cost. Opportunity cost is the value of next best alternative foregone.