Question

What might be an example of an external cost associated with the oil production (including oil transportation) described in the mock interview? If a firm’s price of its product did, in fact, include all external costs, how would this change production decisions?

Answer 1

An external cost associated with oil production including oil transportation is air pollution. Combustion of fuel oil and gasoline produces air pollutants that contribute to urban smog, acid rain, and global climate change.

The general public who are not directly related to oil production and oil transportation has to pay a substantial price for the adverse effects caused by air pollution arising in the form of the purchase of emission controls, destruction of recreation values and increased treatment of diseases.

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If the firm's price of its product includes all external costs, the cost per unit of oil would increase. This would cause, the leftward shift in the supply curve. The firm would lower the supply at each price or would increase the availability of supply at higher prices.

If there are no externalities, the equilibrium output level, Q_E, corresponding to the intersection of the demand and market supply curves, represents the socially optimal output level.

However, when pollution, a negative externality is present, the market supply curve doesn’t represent the good’s true production cost. The true cost is now represented by the supply curve that includes the externality.

In this situation, the good’s true cost equals the firms’ marginal cost curves represented by the market supply plus the marginal cost of the negative externality. As a consequence, marginal true cost results in the true supply curve with the externality being higher than the market supply.

Assuming the demand curve remains the same, the market’s socially optimal output level is Q_S corresponding to the intersection of demand and the supply curve with externality. The corresponding price consumers pay to cover the full cost of production is P_S.