Question

During 2015, 33% of electricity was produced by burning coal. Coal burning to create electricity contaminates air and can cause health problems.

1. Draw the market supply/demand for electricity

2. Determine the level of output produced by a competitive market, marking it with an X

3. Display the externality in the market for electricity and determine the socially optimal amount of electricity Y.

4. Shade the area of deadweight loss associated with a competitive electricity market.

5. Describe 2 ways that the government to intervene to move the market to the socially optimal level

Answer 1

1. In the diagram below, we have shown the market for electricity :

Here, demand is the private marginal benefit curve (PMB) and supply is the private marginal cost curve (PMC).

2. Market equilibrium is attained at point A where, PMB = PMC. Here, X is the equlibrium level of quantity (as shown in the diagram above).

3. Now, if we consider the health hazards of producing electricity from burning coal, then, the social marginal cost (SMC) of producing electricity is greater than the private marginal cost (PMC). Thus, SMC is towards the left of the PMC (as shown in the diagram above). The new equilibrium is attained at point B, where, SMC=PMB. Here, Y is the socially optimum level of output.

4. The dead-weight loss associated with the negative externality is also shown in the above diagram.

5. Two ways by which government must intervene in the market to produce social optimum level of electricity are :

a. To impose taxes : Government can impose taxes (like Pigouvian tax) on the production, i.e., increase the cost of production, which will force the production move towards social optimum level.

b. To impose permits/quota : Government can impose permits or quotas on level of production. This will ensure that production is not allowed over social optimum level.