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We can see a general lesson here. If firms were required to pay the social costs of pollution, they would create less pollution but produce less of the product and charge a higher price. In the next module, we will explore how governments require firms to take the social costs of pollution into account.
Economic production can cause environmental damage. This tradeoff arises for all countries, whether high-income or low-income, and whether their economies are market-oriented or command-oriented.
An externality occurs when an exchange between a buyer and seller has an impact on a third party who is not part of the exchange. An externality, which is sometimes also called a spillover, can have a negative or a positive impact on the third party. If those parties imposing a negative externality on others had to take the broader social cost of their behavior into account, they would have an incentive to reduce the production of whatever is causing the negative externality. In the case of a positive externality, the third party is obtaining benefits from the exchange between a buyer and a seller, but they are not paying for these benefits. If this is the case, then markets would tend to under produce output because suppliers are not aware of the additional demand from others. If the parties that are generating benefits to others would be somehow compensated for these external benefits, they would have an incentive to increase production of whatever is causing the positive externality.
Show the market for cigarettes in equilibrium, assuming that there are no laws banning smoking in public. Label the equilibrium private market price and quantity as Pm and Qm. Add whatever is needed to the model to show the impact of the negative externality from second-hand smoking. (Hint: In this case it is the consumers, not the sellers, who are creating the negative externality.) Label the social optimal output and price as Pe and Qe. On the graph, shade in the deadweight loss at the market output.
Refer to [link] . The externality created by the production of refrigerators was $100. However, once both the private and additional external costs were taken into consideration, the market price increased by only $50. If the external costs were $100 why did the price only increase by $50 when all costs were taken into account?
[link] , shows the supply and demand conditions for a firm that will play trumpets on the streets when requested. Qs 1 is the quantity supplied without social costs. Qs 2 is the quantity supplied with social costs. What is the negative externality in this situation? Identify the equilibrium price and quantity when only private costs are taken into account, and then when social costs are taken into account. How does taking the externality into account affect the equilibrium price and quantity?
| P | Qd | Qs 1 | Qs 2 |
|---|---|---|---|
| $20 | 0 | 10 | 8 |
| $18 | 1 | 9 | 7 |
| $15 | 2.5 | 7.5 | 5.5 |
| $12 | 4 | 6 | 4 |
| $10 | 5 | 5 | 3 |
| $5 | 7.5 | 2.5 | 0.5 |
Johnson, Oscar William. “Back on Track: Earth Day Success Story; The Chattanooga Choo-Choo No Longer Spews Foul Air.” Sports Illustrated . April 30, 1990. http://www.si.com/vault/1990/04/30/121923/back-on-track-earth-day-success-story-the-chattanooga-choo-choo-no-longer-spews-foul-air.
U.S. Energy Information Administration. “Total Energy: Monthly Energy Review.” U.S. Department of Energy . Accessed December 19, 2013. http://www.eia.gov/totalenergy/data/monthly/.
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