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| Graphing Exercise: Externalities An externality is a cost or benefit accruing to a person or group of people who are external to a market transaction. When this occurs, the market fails to provide an allocatively efficient quantity of the good or service. Too little is produced in the case of spillover benefits; too much in the case of spillover costs. In some instances, government intervention may be required to correct the market failure. Exploration: Governing BusinessNow click here to view an interactive exercise. This will open a new browser window. Then answer the questions below. This exercise is from the website for Begg and Ward Economics for Business. If you have clicked on the link above and cannot see the interactive exercise, you may need to install a free Java plugin for you internet browser. Click here for the plugin. The graph shows a typical competitive market in equilibrium. Private benefits and costs are reflected in the demand and supply curves labeled D and S, respectively. The price is £50 and 40 units are sold each period. Click anywhere inside the boxes labeled Spillover Benefit or Spillover Cost and enter a value. External benefits are assumed to accrue to consumers while external costs are assumed to accrue to producers. If there are external benefits, the curve labeled Dt illustrates the total benefit to society of each successive unit of the good - the private benefit plus the spillover benefit.Likewise, the curve labeled St reflects the total marginal cost of the good - the private and the spillover cost - in the event of a spillover cost. To simulate a government policy, drag either the demand curve or the supply curve in the appropriate direction to correct for the market failure, then click on the New Equilibrium button to observe the market adjust to the policy. Click Reset to restore the initial values. 1. Suppose production of this good imposes external costs of £10 for each unit produced. Does this cause an over or an underallocation of resources to production of this good? How might the government respond to correct this market failure? AnswerClick inside the Spillover Cost box and enter a value of £10. The supply curve labeled St reflects the total costs - the spillover costs plus the private costs. The current quantity of 40 exceeds the efficient quantity. To correct this overallocation of resources, government may tax either consumers or producers. To observe the effect of a tax on producers, drag the supply curve to the left to simulate a tax on producers. The tax creates an excess demand for the product at the current consumer price of £50. Click on the New Equilibrium button to observe the market process to eliminate the shortage. Price rises, and consumers purchase less. Alternatively, the government may impose the tax on consumers of this product. Click Reset and then enter £10 in the Spillover Cost box again. This time, correct the externality by dragging the demand curve to the left to simulate a tax on consumers. There is now an excess supply of the good at the £50 producer price. Click on the New Equilibrium button to observe a falling producer price and falling quantity supplied. 2. Suppose production of this good provides an external benefit of £10 for each unit produced. What is the efficient quantity in this market? How might the government respond to correct this market failure? AnswerClick Reset to restore the initial equilibrium. Click inside the Spillover Benefit box and enter £10. The total demand curve which includes the spillover benefit lies above the private demand curve, intersecting the supply curve at a quantity of 45. To achieve this quantity, either consumers or producers must be subsidized. To illustrate the effects of a consumer subsidy, drag the demand curve up to match Dt, creating a shortage at the current producer price of £50. Click on the New Equilibrium button to observe the producer price rising to £55, prompting them to increase production to 45. Alternatively, drag the supply curve to the right to illustrate the effects of a producer subsidy. This creates a surplus at the current consumer price of £50. Click on the New Equilibrium button to observe the consumer price falling to £45, again bringing quantity demanded to 45. |