Question

Analyze graphically the economics of mobile-source pollution including the deadweight losses from the divergence of marginal private costs and marginal social costs due to both implicit subsidies and external costs.

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Answer 1

Externalities arise whenever the actions of one economic agent make another economic agent worse or better off, yet the first agent neither bears the costs nor receives the benefits of doing so. Externalities are also referred to as spillover effects, and a negative externality is also referred to as an ‘external cost’.

Some externalities, like waste, arise from consumption while other externalities, like carbon emissions from factories, arise from production.

Externalities are one example of market failure.

The reason these negative externalities, otherwise known as social costs, occur is that these expenses are generally not included in calculating the costs of production. Production decisions are generally based on financial data and most social costs are not measured that way. For example, when a firm decides to open up a new factory, it will not account for the cost that residents from pollution. As a result, a product that shouldn’t be produced, because the total expenses exceed the return, are made because social costs were not considered.

In other words, the costs of production represent individual, or private, marginal costs. The private marginal costs are lower than societal marginal costs, which also capture the true costs of the negative externalities. As a result, producers will overestimate the ideal quantity of the good to produce.

An external cost, such as the cost of pollution from industrial production, makes the marginal social cost (MSC) curve higher than the private marginal cost (MPC).

The socially efficient output is where MSC = MSB, at Q1, which is a lower output than the market equilibrium output, at Q.

Net welfare loss can exist in two situations. Firstly, it exists when the marginal cost to society of a particular economic activity is greater than the marginal benefit to society. Secondly, it can exist when the marginal benefit of a given economic activity is greater than the marginal cost.

The first situation can occur when the market produces ‘too much’, and the second when it produces ‘too little’. Trianglr ABC is welfare or deadweight loss.

Government Solutions for Negative Externalities

In these cases, government intervention is necessary to help “price” negative externalities. Governments can either use regulation (e.g. outlaw an action) or use market solutions. By instituting policies such as pollution penalties, permitting civil lawsuits by private parties to recover damages for negligent actions, and levying environmental taxes, governments can achieve two things. First, these regulations recover funds to help fix the damage caused by negative externalities. Second, these acts help put a financial price on social costs. With that information, businesses can arrive at a more accurate figure for the costs of production. Businesses can then avoid producing products whose financial and social costs exceed the financial return.

Subsidies

Whilst a tax may be imposed on generators of negative externalities, a subsidy may be granted to generators of positive externalities to ensure a higher level of consumption and production than would arise through the completely free interaction of market forces. In this case the government would have to assess the value of the marginal external benefit (i.e. the positive externality) to society and give a subsidy equivalent to this amount to consumers and this would shift the demand curve D=PMB to the right to D1=SMB. Allocative efficiency is achieved as SMB = SMC at OQ1. A similar result could be achieved by subsidising the output which would cause the supply curve to shift to the right until the socially optimum level of production is reached.