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Economic Externalities

Economic Externalities

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Published by CarolineCarol
For example, in the scenario to follow: Suppose a steel mill releases pollution into a river as a by-product of its manufacturing process. Additionally, a downstream resort relies on the recreational use of the river for its business.

• We also assume that the steel mill recognizes only the direct costs of steel production, and not the costs associated with a polluted river.
• Therefore, the costs associated with pollution (additional water treatment, diminished river use, and lost business) must be absorbed by the resort.
• These costs and the economic efficiency implications of this externality are illustrated in the following graph



• The steel mill’s marginal cost curve (MC steel mill) does not include pollution costs
• The social marginal cost curve (MC social) includes all production costs: those recognized by the steel mill plus those associated with pollution. The social marginal cost curve is higher than the steel mill’s marginal cost curve because it includes pollution costs.

• The steel mill’s marginal cost curve (MC steel mill) does not include pollution costs
• The social marginal cost curve (MC social) includes all production costs: those recognized by the steel mill plus those associated with pollution
• The social marginal cost curve is higher than the steel mill’s marginal cost curve because it includes pollution costs.
• Given no outside intervention, the steel mill will maximize its profit by producing quantity X’ at price P’
• This is because we assume that the steel mill recognizes only its own marginal cost curve (MC steel mill)
• Recall the equi-marginal condition - the steel mill’s profit is maximized where its marginal cost (MC steel mill) equals its marginal benefit (Demand)
• However, the economically efficient level of production is quantity X* at price P*
• The area delineated in the graph by the points A, B, and C is the total reduction in overall net benefits that is caused by the steel mill’s failure to recognize the costs of pollution
• Note that given this externality, the steel mill faces a different price for pollution (zero) than does the resort (positive), which violates the equi-marginal condition

This result illustrates the following economic efficiency implications – given no outside intervention:
• The production of steel is too high (X’ > X*)
• The price of steel is too low (P’ • Too much pollution is produced since the full cost of its release into the environment is not recognized
• In this situation (and unlike the perfectly competitive market), individual rationality does not imply social rationality

Consider the example of the steel mill and resort from the last presentation
The following graph illustrates the steel mill’s gain, and the resort’s loss, of profits resulting from the production of steel


• The steel mill’s total profit gain from steel production equals the area under the marginal profit gain line out to the level of production
• Therefore, if the steel mill has the right to produce at any level, X” would be chosen since that level maximizes the steel mill’s total profit gain
• At that level, the steel mill’s total profit gain from steel production equals areas A + B + C
• The resort’s total profit loss from steel production equals the area under the marginal profit loss line out to the level of production
• Therefore, if the resort has the right to be free from harm, X’ would be chosen since that level minimizes the resort’s total profit loss.
• At that level, the resort’s total profit loss from steel production is zero

However, X* maximizes the net profit gain for both the steel mill and the resort. Consider the following net profit gain calculations.











The net profit gain for X* (A) is greater than that for either X’ (zero) or X” (A-D).

• Indeed, the net profit gain for both parties is maximized where marginal profit gain equals marginal profit loss
• Therefore, X* is an economical
For example, in the scenario to follow: Suppose a steel mill releases pollution into a river as a by-product of its manufacturing process. Additionally, a downstream resort relies on the recreational use of the river for its business.

• We also assume that the steel mill recognizes only the direct costs of steel production, and not the costs associated with a polluted river.
• Therefore, the costs associated with pollution (additional water treatment, diminished river use, and lost business) must be absorbed by the resort.
• These costs and the economic efficiency implications of this externality are illustrated in the following graph



• The steel mill’s marginal cost curve (MC steel mill) does not include pollution costs
• The social marginal cost curve (MC social) includes all production costs: those recognized by the steel mill plus those associated with pollution. The social marginal cost curve is higher than the steel mill’s marginal cost curve because it includes pollution costs.

• The steel mill’s marginal cost curve (MC steel mill) does not include pollution costs
• The social marginal cost curve (MC social) includes all production costs: those recognized by the steel mill plus those associated with pollution
• The social marginal cost curve is higher than the steel mill’s marginal cost curve because it includes pollution costs.
• Given no outside intervention, the steel mill will maximize its profit by producing quantity X’ at price P’
• This is because we assume that the steel mill recognizes only its own marginal cost curve (MC steel mill)
• Recall the equi-marginal condition - the steel mill’s profit is maximized where its marginal cost (MC steel mill) equals its marginal benefit (Demand)
• However, the economically efficient level of production is quantity X* at price P*
• The area delineated in the graph by the points A, B, and C is the total reduction in overall net benefits that is caused by the steel mill’s failure to recognize the costs of pollution
• Note that given this externality, the steel mill faces a different price for pollution (zero) than does the resort (positive), which violates the equi-marginal condition

This result illustrates the following economic efficiency implications – given no outside intervention:
• The production of steel is too high (X’ > X*)
• The price of steel is too low (P’ • Too much pollution is produced since the full cost of its release into the environment is not recognized
• In this situation (and unlike the perfectly competitive market), individual rationality does not imply social rationality

Consider the example of the steel mill and resort from the last presentation
The following graph illustrates the steel mill’s gain, and the resort’s loss, of profits resulting from the production of steel


• The steel mill’s total profit gain from steel production equals the area under the marginal profit gain line out to the level of production
• Therefore, if the steel mill has the right to produce at any level, X” would be chosen since that level maximizes the steel mill’s total profit gain
• At that level, the steel mill’s total profit gain from steel production equals areas A + B + C
• The resort’s total profit loss from steel production equals the area under the marginal profit loss line out to the level of production
• Therefore, if the resort has the right to be free from harm, X’ would be chosen since that level minimizes the resort’s total profit loss.
• At that level, the resort’s total profit loss from steel production is zero

However, X* maximizes the net profit gain for both the steel mill and the resort. Consider the following net profit gain calculations.











The net profit gain for X* (A) is greater than that for either X’ (zero) or X” (A-D).

• Indeed, the net profit gain for both parties is maximized where marginal profit gain equals marginal profit loss
• Therefore, X* is an economical

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Published by: CarolineCarol on Aug 21, 2014
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ECONOMICS QUESTIONS
For example, in the scenario to follow: Suppose a steel mill releases pollution into a river as a by-product of its manufacturing process. Additionally, a downstream resort relies on the recreational use of the river for its business.
 We also assume that the steel mill recognizes only the direct costs of steel production, and not the costs associated with a polluted river.
 Therefore, the costs associated with pollution (additional water treatment, diminished river use, and lost business) must be absorbed by the resort.
 These costs and the economic efficiency implications of this externality are illustrated in the following graph
 
The steel mill’s marginal cost curve (MC steel mill) does not include pollution
costs
 The social marginal cost curve (MC social) includes all production costs: those recognized by the steel mill
plus 
 those associated with pollution. The
social marginal cost curve is higher than the steel mill’s marginal cost curve
because it includes pollution costs.
 
The steel mill’s marg
inal cost curve (MC steel mill) does not include pollution costs
 The social marginal cost curve (MC social) includes all production costs: those recognized by the steel mill
plus 
 those associated with pollution
 The social marginal cost curve is higher than
the steel mill’s marginal cost
curve because it includes pollution costs.
Steel Production
P
X
*
X'
B C
MC social MC steel mill Demand
 
ECONOMICS QUESTIONS
 Given no outside intervention, the steel mill will maximize its profit by
producing quantity X’ at price P’
 
 This is because we assume that the steel mill recognizes only its own marginal cost curve (MC steel mill)
 Recall the
equi-marginal 
 condition -
the steel mill’s profit is maximized where
its marginal cost (MC steel mill) equals its marginal benefit (Demand)
 However, the economically efficient level of production is quantity X* at price P*
 The area delineated in the graph by the points A, B, and C is the total
reduction in overall net benefits that is caused by the steel mill’s failure to
recognize the costs of pollution
 Note that given this externality, the steel mill faces a different price for pollution (zero) than does the resort (positive), which violates the equi-marginal condition This result illustrates the following economic efficiency implications
 –
 given no outside intervention:
 
The production of steel is too high (X’
> X*)
 
The price of steel is too low (P’ < P*)
 
 Too much pollution is produced since the full cost of its release into the environment is not recognized
 In this situation (and unlike the perfectly competitive market), individual rationality does not imply social rationality Consider the example of the steel mill and resort from the last presentation
The following graph illustrates the steel mill’s gain, and the resort’s loss, of profits
resulting from the production of steel
$X'X"X*ABCDSteel Production
Resort's MarginalProfit LossSteel Mill'sMarginal ProfitGain
 
ECONOMICS QUESTIONS
 
The steel mill’s
total 
 profit gain from steel production equals the area under the
marginal 
 profit gain line out to the level of production
 
Therefore, if the steel mill has the right to produce at any level, X” would be chosen since that level maximizes the steel mill’s total profit ga
in
 
 At that level, the steel mill’s total profit gain from steel production equals
areas A + B + C
 
The resort’s
total 
 profit loss from steel production equals the area under the
marginal 
 profit loss line out to the level of production
 Therefore, if the
resort has the right to be free from harm, X’ would be chosen since that level minimizes the resort’s total profit loss
.
 
 At that level, the resort’s total profit loss from steel production is zero
 However, X* maximizes the
ne
 profit gain for both the steel mill and the resort. Consider the following net profit gain calculations.
The net profit gain for X* (A) is greater than that for either X’ (zero) or X” (A
-D).
 Indeed, the net profit gain for both parties is maximized where marginal profit gain equals marginal profit loss
 Therefore, X* is an economically efficient allocation
 By subtracting profit losses from profit gains, we assume that the resort is fully compensated for its lost profit
 Since net profit gains are maximized at X*, the steel mill cannot be made better off without making the resort worse off by reducing its compensation --------------------------------------------------------------------------------------------------------------------- 1. The scenario above the steel mill was assumed to have the right to choose any level of production, regardless of its impact on the downstream resort. Suppose now that the resort has the right to be free
from all harm resulting from the steel mill’s waste disposal. What will be
the result of negotiations in this situation? 2. If
both “economic efficiency” and “cost effectiveness” have been
recommended as criteria for pollution control policies. How do these two criteria relate to each other?
X'X*X"zeroA+BA+B+CzeroBB+C+DzeroAA-D----------Allocation----------Steel Mill's Profit GainResort's Profit LossNet Profit Gain for Both

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