Question

Consider the market for electricity. In 2015, 33% of electricity in the US was produced by burning coal. Burning coal to create electricity pollutes the air and can cause health problems for humans and animals. Draw the market supply and demand for electricity and determine the level of output produced by a competitive market, labeling it Q1. Next, show the externality in the market for electricity and determine the socially optimal amount of electricity, labeling it Q*. Shade the area of deadweight loss associated with a competitive electricity market. Briefly describe two ways that the government could possibly intervene to move the market to the socially optimal level.

Draw your own graph on a piece of paper (don't download a graph from the internet).
Clearly label all axes lines and areas.

Answer 1

When producing electricity burns coals it creates pollution which is an external cost to the society. This external cost results in a social cost higher than the private costs.

The diagram drawn represents market for electricity. The demand is D which is equal to private marginal cost equalling social marginal costs (since there are no social benefits). While Sp is private marginal cost. At competitive equilibrium D intersects Sp and equilibrium is determined at Q1 quantity and P1 price.

The externality creates higher social costs. So social cost curve is above private supply. The Social cost curve repesents a sum of PMC and Externality. Hence social optimum is determined at that level where demand equals social cost curve Ss. The corresponding equilibrium quantity and price is Q* and P*. The deadweight loss is a shaded triangle representing social welfare loss.

Two methods the governement could use to bring equilibrium to the socially optimum level are -

1. Per unit tax - Such a tax increases the marginal cost of production. This results in a leftward shift of Sp curve to Ss curve. The government must choose the tax in such a way that Sp shifts exactly to Ss curve. This way social costs are internalized

2. Imposing regulations - The goverment can regulate the quantity of electricity produced to the socially optimum output level of Q* to bring social optimum.