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CRC Economics 1
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CRC Economics 2
ExercisesEcon 304
Chapter 10
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CRC Economics 3
Do you know …
how externalities affect a market?
why externalities cause social inefficiency?
what governments do to deal with externalities?
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CRC Economics 4
Definitions
Market• D = MPB• S = MPC• E = equilibrium point,
where (MPB = D) = (MPC = S)• Pe = market (equilibrium) price• Qe = market (equilibrium) output
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CRC Economics 5
Definitions
Society Dsoc = MSB = MPB + MEB = D + MEB Ssoc = MSC = MPC + MEC = S + MEC Esoc = social equilibrium point,
where MSB = MSC Psoc = social (equilibrium) price, or
socially optimal price Qsoc = social (equilibrium) output, or
socially optimal output
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CRC Economics 6
1. How externalities affect a market?
No externalities Negative production externalities Positive production externalities Negative consumption externalities Positive consumption externalities Exercises
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CRC Economics 7
a. A market without externalities
P
Q
D
S
Suppose that originally the market looks like the graph below and that there are no externalities.
What is the market price? Market output? Socially optimal price? Socially optimal output?
EPe
Qe
= MPC
= MPB
= Ssoc = MSC
= Dsoc = MSB
= Esoc
= Psoc
= Qsoc
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CRC Economics 8
No externalities, i.e. MEB = MEC = 0
Dsoc = MSB = MPB + MEB = D + MEB = D Ssoc = MSC = MPC + MEC = S + MEC = S Esoc = E Psoc = Pe Qsoc = Qe With no externalities, a free market is
socially efficient.
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CRC Economics 9
b. A market with externalities
P
Q
D
S
Suppose that originally the market looks like the graph below and that there are negative production externalities.
EPe
Qe
= MPC
= MPB
Ssoc = MSC
= Dsoc = MSB
Esoc
Qsoc
Psoc MEC
What is the market price? Market output? Socially optimal price? Socially optimal output?
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CRC Economics 10
c. A market with externalities
P
Q
D
S
Suppose that originally the market looks like the graph below and that there are positive production externalities.
EPe
Qe
= MPC
= MPB
Ssoc = MSC
= Dsoc = MSB
Esoc
Qsoc
Psoc
MEB
What is the market price? Market output? Socially optimal price? Socially optimal output?
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CRC Economics 11
d. A market with externalities
P
Q
D
S
Suppose that originally the market looks like the graph below and that there are positive consumption externalities.
EPe
Qe
= MPC
= MPB
= Ssoc = MSC
Dsoc = MSB
Esoc
Qsoc
Psoc
MEB
What is the market price? Market output? Socially optimal price? Socially optimal output?
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CRC Economics 12
e. A market with externalities
P
Q
D
S
Suppose that originally the market looks like the graph below and that there are negative consumption externalities.
EPe
Qe
= MPC
= MPB
= Ssoc = MSC
Dsoc = MSB
Esoc
Qsoc
Psoc MEC
What is the market price? Market output? Socially optimal price? Socially optimal output?
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CRC Economics 13
f. Exercises
P
Q
D
S
Suppose that originally the market looks like the graph below and that there are externalities.
EPe
Qe
= MPC
= MPB
Qsoc
Psoc
Can you tell the type of externalities that affects this market?
Qsoc < Qe => negative externalities
Esoc
Esoc on S => consumption
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CRC Economics 14
f. Exercises
P
Q
D
S
Suppose that originally the market looks like the graph below and that there are externalities.
EPe
Qe
= MPC
= MPB
Qsoc
Psoc
Esoc
Qsoc > Qe => positive externalities
Esoc on D => production
Can you tell the type of externalities that affects this market?
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CRC Economics 15
2. Why do externalities cause social inefficiency?
Social efficiency occurs at Esoc, where (Dsoc = MSB) = (Ssoc = MSC)
At Esoc, society achieves socially optimal output Qsoc at socially optimal price Psoc.
The presence of externalities cause Qsoc to be different from Qe.
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CRC Economics 16
With externalities, i.e. MEB <> 0 and/or MEC <> 0
Dsoc = MSB = MPB + MEB = D + MEB <> D
Ssoc = MSC = MPC + MEC = S + MEC <> S
Esoc <> E Psoc <> Pe Qsoc <> Qe With externalities, a free market is socially
inefficient.
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CRC Economics 17
3. What governments do to deal with externalities?
Positive externalities => Qsoc > Qe, i.e. too little is being produced in markets.
Governments give subsidies to raise Qe. Negative externalities => Qsoc < Qe, i.e.
too much is being produced in markets Governments impose taxes to reduce Qe.
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CRC Economics 18
Summary
Production externalities
Positive
MEB > 0
Ssoc < S
Negative
MEC > 0
Ssoc > S
Consumption externalities
Positive
MEB > 0
Dsoc > D
Negative
MEC > 0
Dsoc < D
Qsoc > Qe Qsoc < Qe Qsoc > Qe Qsoc < QeQe is too small Qe is too large Qe is too small Qe is too large
Subsidies Taxes Subsidies Taxes
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CRC Economics 19