Video: Externalities

Positive Externalities of Consumption

Although some scientists (and self-labeled "experts") question the effectiveness and risk of inoculations (i.e. shots), many people argue that providing vaccinations against various diseases like H1N1 and the mumps prevents such illness from occurring. If I pay to get a shot for H1N1 because I do not want this flu, then I also will not pass this flu to those around me. However, those around me did not have to pay for my inoculation even though they reap the benefits. Therefore, the marginal social benefit of inoculations is greater than the marginal private benefit which does not include society's benefit from less infectious people (MSB > MPB). This is an example of a positive externality of consumption.

The free market for inoculations sees equilibrium at quantity Q1 (and price P1) which is below the socially efficient level of output Q*. Between Q1 and Q*, MSB > MSC and a potential welfare gain is possible (yellow triangles).


What can the government do to intervene in this market failure to achieve this potential welfare gain? First, they could subsidize the consumption of such forms of health care to make the consumption of such goods/services cheaper. In the graph, this is shown by the orange MSC + subsidy curve which reduces the price of inoculations (to P2) and increases quantity to the socially efficient level Q*. However, when governments spend money on subsidies, there is always the argument that this money could have been spent elsewhere (opportunity cost).

Another option would be to spend taxpayer money for a positive ad campaign that would encourage the community to get inoculated against various diseases like H1N1. The aim of this campaign would be to increase consumers' private benefit / utility for consuming vaccinations because they would feel better about protecting themselves against disease. Graphically, this is shown by the orange arrow indicating a rightward shift of MPB towards MSB (and thus Q*). Of course, the opportunity cost argument would apply here as well and often some members of the community are very critical of vaccinations.

Other possible government interventions include forcing the public to get inoculated which might violate civil rights.

Negative Externalities of Consumption

The link between the consumption of tobacco products like cigars and heart / lung disease is indisputable. When individuals smoke cigars, they are compromising their own health and the health of those around them who inhale the smoke. Therefore, smoking is (unfortunately) an excellent example of a negative externality of consumption.

In a free market, consumers as utility-maximizers will consume cigars where their marginal private benefit equals marginal social cost (= S). They do not have to consider the cost of their consumption of cigars on the rest of the community through smoking-related illness and increased public health care receipts. If social efficiency were occurring, the market would be in equilibrium at a quantity level Q* as opposed to the greater Q1. Instead, there is a welfare loss (red triangles) since between Q1 and Q*, MSC > MSB and the market is thus not Pareto optimal. We observe a negative externality of consumption between MPB and MSB (purple arrow).


To address this market failure of a negative externality of consumption of cigars, the government could take several courses of action. First, they could place a tax on cigars in order to increase their price which would drive down the quantity sold and consumed. This is shown above by the broken blue line which corresponds to a return to the socially optimal level of output Q* and a higher price of P2. The government could then use this tax revenue to alleviate stress on the health care system from smoking-related illnesses. Of course, there will be debate on how to spend such money, to what extent smokers have the right to smoke and to what means smokers who face inelastic demand for tobacco products will go to procure cheaper product.

Second, the government could implement a negative ad campaign featuring anti-smoking commercials on television / radio and graphic posters of smoking-related illness on billboards along motorways and in written press. The aim of such an ad campaign would be to reduce smokers' private benefit from smoking by reducing their utility of tobacco consumption. After all, does looking at a black, diseased lung make you feel eager or happy to light up another smoke? This is illustrated above by the horizontal blue arrow and a leftward shift of the MPB curve towards MSB (and, thus, Q* which is socially efficient). However, such a campaign costs (taxpayer) money so the opportunity cost argument will be in play.

Otherwise, the government could simply ban tobacco products. But how would that affect stakeholders in the economy?

Positive Externalities of Production

In this example, a computer company decides to enroll all of its employees in a workshop that aims to improve their efficiency through the development of more advanced skills. The workshop increases the private costs of the computer firm (MPC on the graph above), but the workers' skillset improves which is a benefit to other computer firms that haven't paid for such training and to the community at large. Therefore, as seen on the graph, the MPC for the firm is greater than the overall MSC because the MSC subtracts the benefit to society from the firm's private costs. Here, the firm is producing at quantity Q1 and charges price P1. However, this output level is less than the socially optimal level of output Q* and, between Q1 and Q*, there is a potential welfare gain (illustrated by the yellow triangles) because MSB > MSC.

If the government wants to achieve this welfare gain, they could subsidize firms that decide to provide such training to their employees. By making training cheaper, the firms' private costs decline. This is shown by a rightward shift of the MPC towards MSC. Yet, there is always an opportunity cost when governments use tax revenues to subsidize firms and it is difficult to calculate an appropriate subsidy. The government could also provide its own training, but the same evaluation that can be applied to giving subsidies applies here as well (i.e. costs of training).

Negative Externalities of Production

The graph above illustrates a negative externality of production of paper. To make paper, paper mills often have to use harsh chemicals like chlorine and sulfur-based products which, if released into the environment, are very harmful to ecosystems. Unfortunately, the production of paper continues to pollute worldwide to this day. These are called external costs of production of paper.

Without any government intervention, the paper mill would only be concerned about their private costs of production (indicated by MPC). Thus, the firm would produce where their MPC curve meets the marginal social benefit (MSB) curve at quantity Q1 and price P1. However, the firm's private costs do not include the social costs of production (MSC) of pollution described above. If the firm were producing where MSC = MSB (Pareto optimality / socially efficient level of output), then they would be producing quantity Q* at price P*. This is not occurring in the free market, and this negative externality of production is indicated by the distance between MPC and MSC (see purple arrow). The red traingles represent the welfare loss to society (where MSC > MSB).


Above, we see one possible solution to the negative externality of production for paper. If the government intervenes to correct this market failure by taxing the polluting paper mill, the firm's marginal private costs increase. This is illustrated by a leftward movement of the MPC curve towards the MSC curve (the magnitude which depends on the amount of the tax; the bigger the tax, the closer to MSC). In this case, the quantity falls to Q2 from Q1 which coincides with a reduction (but not elimination) of the welfare loss to society illustrated by the red traingle.

Other solutions - legislation to punish polluting firms, tradeable emission permits

Evaluation - How much and who should the government tax? What impacts will the tax have on the production process / employment / stakeholders? What are the opportunity costs of these tax revenues? Usefulness of tradeable emission permits?

Video: Market Failures

Merit goods and demerit goods...what's the difference?

A merit good, which will be underprovided and thus underconsumed if the market is left to it's own devices, are goods or services that governments believe are important for society and include sports centers, public schools, and (public) healthcare. Merit goods cause positive externalities, and governments intervene by providing the g/s themselves or by subsidizing private firms for provision. Of course, when governments spend money, the issue of opportunity cost comes into play and an evaluative discussion can occur.

A demerit good, which will be overprovided and thus overconsumed if the market is left to it's own devices, are goods or services that governments believe are harmful for society and include illicit drugs, cigarettes and alcohol. Demerit goods cause negative externalities, and governments intervene by restricting the g/s through taxation or negative ad campaigns or by subsidizing programs aimed at reducing/eliminating consumption. Again, when governments spend money, the issue of opportunity cost comes into play and an evaluative discussion can occur.

Video: Public goods

Public goods : Non-excludable? Non-rivalrous? Help!

A public good can either be consumed by everyone or by no one. In other words, there is no change in cost when one more person consumes the good. A well-known example is that of national defense. Everyone in Switzerland is protected by the Swiss Army (not to be confused with the Vatican's funny-dressed Swiss Guard). If one more person comes to Switzerland, there is no change in cost to defend him/her.

Public goods are non-excludable and non-rivalrous. To be non-excludable means it is impossible to stop someone from consuming a good or service once it's been providable. The opposite is true if the good is excludable. To be non-rivalrous means that consumers are not competing for the same g/s and, thus, all can enjoy the g/s at the same time. The opposite is true if the good is rivalrous.

Here are some helpful terms and examples

excludable/rivalrous : private goods, i.e. cars and cheese
excludable/non-rivalrous : club goods, i.e. satellite radio
non-excludable/rivalrous : common goods, i.e. fish, deer
non-excludable/non-rivalrous : public goods, i.e. national defense, a dam

What is the theory of contestable markets?

Here in the village of Leysin, Switzerland, there is one firm that sells kebabs. The owner of this restaurant therefore has a monopoly on the sale of kebabs on this mountain. So why can't he produce where MC = MR to achieve abnormal profits by restricting output and charging high prices like a typical monopoly? Short answer: the theory of contestable markets. Because barriers to entry / exit are low for kebab shops, it is very possible that a competitor from the village or the valley will open his/her own kebab shop to start competing away some of the original owner's profits. For this theory to work, there must be low barriers to entry and exit. Therefore, this seeming monopolist must assume more competitive behavior to avoid the kebabs sharks that are looming in the area.

Consumer and Producer Surplus = Community Surplus

In this graph, we can see the equilibrium price of the good is $5.00 and the quantity demanded / supplied is 10 million. The blue triangle above the price line and below the demand curve represents consumer surplus. Consumer surplus is the benefit consumers get from being able to purchase a good or service at a price lower than what they were expecting to pay. In this example, we can see that at a price of $8.50, two million units of the good would be demanded. However, those consumers only have to pay $5.00, and thus they get a benefit from paying less than that which they were prepared. The same is true for the six million units demanded at a price of $6.50. Therefore, the entire blue triangle represents the total consumer surplus for this particular good.

The red triangle below the price line and above the supply curve represents producer surplus. Producer surplus is the benefit producers get from being able to receive a price for a good or service higher than what they were expecting. In this example, we can see that at a price of $1.50, two million units of the good would be supplied. However, those producers get to receive $5.00, and thus they get a benefit from receiving more than that which they were expecting. The same is true for the six million units supplied at a price of $3.50. Therefore, the entire red triangle represents the total producer surplus for this particular good.

Together with consumer surplus, we have the total economic benefit of the transaction, or community surplus (red plus blue triangles). With equilibrium quantity Q* and price P* determined by the forces of supply and demand, there is no way to make one person better off by making someone else worse off. This is called Pareto optimality and means that resources have been allocated efficiently.

This analysis allows us to see supply and demand in a different way. If we consider the supply curve to be the sum of the firms' costs of production for a good or service, we can consider how these costs apply to the community at large and call this the marginal social cost (MSC) curve. If we consider the demand curve to be the sum of consumers' utility in consuming a good or service, we can consider how these benefits apply to the community at large and call this the marginal social benefit (MSB) curve. These terms replace standard supply (S) and demand (D) in market failure analysis.

What is price discrimination?

Price discrimination happens when firms charge different people different prices for the exact same good or service. For example, a student at Shorewood High School gets to pay $8 to see "Billy Elliot" whereas I (an adult) have to pay $12 to see the exact same (amazing) movie at the exact same time.

1st degree price discrimination: when different people pay different prices for the same product because they have different price elasticities of demand; the value of the good is subjective and people are willing to pay different prices depending on their desire.
example: (identical) goods at the flea market in Lausanne

2nd degree price discrimination: when different people pay different prices for the same product because they purchase different amounts; the more consumers buy, the less (per unit) they have to pay.
example: Coca-Cola's purchase of sugar versus your purchase of sugar (per unit).

3rd degree price discrimination: when different people pay different prices for the same product because they fit into different market segments like age or location. The market segmentation is derived by different price elasticities of demand (i.e. students have more elastic demand than adults due to their having much less disposable income).
example: student discount at a sporting event

Economics du jour

Price discrimination of the 2nd degree in the Daily Bulletin!

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