Question

2. (c) Use a graph for the natural gas market and assume there is a relatively constant cost in the long run at $4 per cubic foot. Suppose there is a negative externality of $2 per cubic foot. Briefly explain how negative externalities distort otherwise well-functioning competitive markets and lead to market failure. (d) Briefly describe the impact of the imposition of a Pigouvian tax on natural gas that might resolve the market failure due to negative externalities.

Answer 1

(c) The unit cost will be equivalent to Private Marginal cost (PMC). Therefore, PMC is $4. Market equilibrium is at intersection of Marginal Benefit (MB) and PMC curves, at point A with market price P0 (= $4) and market quantity Q0. However, the negative externality will increase PMC by $2 per unit, therefore Social Marginal Cost (SMC) will be equal to (PMC + Externality cost) = $(4 + 2) = $6. Socially efficient outcome is at point B where MB intersects SMC, with higher (socially efficient) price P1 = $6) and lower (socially efficient) quantity Q1. Therefore, negative externalities distort competitive market by causing market failure due to over-production in market outcome, unless the externality is internalized.

(d) The Pigouvian tax equal to the vertical distance between SMC and PMC (= $2) at socially efficient output level Q1 will increase price to P1 and decrease quantity to Q1, therefore resulting in efficient outcome and removing market failure, as shown below.