Externalities

Positive externalities

1. Too little is produced
2. Demand-side market failures

Negative externalities

1. Too much is produced
2. Supply side market failures

Positive externalities occur when a third person, or persons, is affected by the transaction in a positive way.  The good is underproduced when positive externalities are present.  The equilibrium output will be smaller than the efficient output because the consumer is willing to pay a price equal to the consumer’s individual marginal benefit, but no more.  Since social benefits exist in addition to the private benefit, the government must either aid the producer to encourage more output, or engage in its own production of the item with the external benefits.

Negative externalities occur when a third person, or persons, external to the transaction is affected from the transaction in a negative way.  The good is overproduced and the equilibrium output will be greater than the efficient output.  This is because the producer, who is not bearing the full cost of production, will be able to produce more at a lower price than the efficient level, which would exist if true costs were reflected in the production decision.

 

• With negative externalities borne by society, the producers’ supply curve S is to the right of (below) the total-cost supply curve St. Consequently, the equilibrium output Qe is greater than the optimal output Qo, and the efficiency loss is abc.   

• When positive externalities accrue to society, the market demand curve D is to the left of (below) the total-benefit demand curve Dt. As a result, the equilibrium output, Qe is less than the optimal output Qo, and the efficiency loss is xyz.

Government Intervention

Correct negative externalities

1. Direct controls
2. Specific taxes

Correct positive externalities

1. Subsidies and government provision

Correct negative externalities 

• Negative externalities result in an overallocation of resources.  Government can correct this overallocation in two ways: 

(1) using direct controls which reduce supply by driving up costs of production and would shift the supply curve and reduce output,

(2) imposing a specific tax, T, to the extent that the cost of producing the goods increases, which would also shift the supply curve to the left, eliminating the overallocation of resources and thus the efficiency loss.

When positive externalities are present, the equilibrium output will be smaller than the efficient output because the consumer is willing to pay a price equal to the consumer’s individual marginal benefit, but no more.  Since social benefits exist in addition to the private benefit, the government must engage in its own production of the item or aid the producer with subsidies to encourage more production.

In either case, the supply curve shifts to the right which lowers the equilibrium price and leads to a greater equilibrium output level.

 

(a) Negative externalities result in an overallocation of resources. 

(b) Government can correct this overallocation in two ways: 

1.  using direct controls, which would shift the supply curve from S to St and reduce output from Qe to Qo, 
2.  imposing a specific tax, T, which would also shift the supply curve from S to St, eliminating the overallocation of resources and thus the efficiency loss.  

Correct positive externalities 

(a)  Positive externalities result in an underallocation of resources. 

(b) This underallocation can be corrected through a subsidy to consumers, which shifts market demand from D to Dt and increases output from Qe to Q0. 

(c)  The underallocation can be eliminated by providing producers with a subsidy of U, which shifts their supply curve from St to S’t   and increases output from Qe to Q0.  This eliminates the underallocation of output

 

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