ECON7002

Lecture 6
Government Intervention in Markets

University of Queensland
Semester 1 2021
References for Lecture

• Essentials of Economics, 4th Edition (HGLO)

• Chapter 11: Government Intervention in the Market

Impact of a Monopoly on Economic Efficiency
• Recall that a Perfectly Competitive Market is allocatively efficient
• Every unit that has a positive Marginal Economic Surplus (i.e. with a marginal
benefit to consumer that exceeds the marginal cost of production) is
produced, such that economic surplus (or total surplus) is maximized.
• Are Monopolies also allocatively efficient or do Monopolies result in
deadweight loss to society?

• We can examine this issue by comparing the perfect competition

market outcome with the monopoly market outcome.
• I.e. let us consider what happens if a market changes from being perfectly
competitive to being a monopoly.
Under Perfect Competition
P Recall that in Perfectly Competitive Markets
The MC curve is also the Supply Curve.
Competitive Market Supply:
𝑀𝐶(𝑄)

Competitive Market Competitive Market Equilibrium occurs

Equilibrium Price 𝑃𝐶 : at the intersection of market demand and
supply (MC) curves

𝐷𝑒𝑚𝑎𝑛𝑑: 𝑃(𝑄)

Q
𝑄𝐶 Competitive Market
Equilibrium Quantity
Under Perfect Competition
P Recall that in Perfectly Competitive Markets
The MC curve is also the Supply Curve.
Competitive Market Supply:
𝑀𝐶(𝑄)

Competitive Market
Consumer Surplus

𝑃𝐶 :
Competitive Market
Producer Surplus

𝐷𝑒𝑚𝑎𝑛𝑑: 𝑃(𝑄)

Q
𝑄𝐶
 Under Monopoly
P
Variables with subscript 𝑀 refers to
Monopoly outcome:
E.g. 𝑃𝑀 refers to the market price charged
by a monopoly.
𝑀𝐶(𝑄)
Variables with subscript 𝐶 refers to
Competitive Market outcome:
E.g. 𝑃𝐶 refers to the market price if the
market is perfectly competitive
𝑃𝑀

𝑃𝐶

𝑀𝐶(𝑄𝑀 )

𝐷𝑒𝑚𝑎𝑛𝑑: 𝑃(𝑄)

𝑀𝑅(𝑄)
Q
𝑄𝑀 𝑄𝐶
 Under Monopoly
P
Under Monopoly

Total Consumer Benefit (TB):

Area(A+B+C+D+E)
𝑀𝐶(𝑄)
Total Consumer Expenditure
=Total Firm Revenue (TR):
Area(B+C+D+E) A
Variable Cost of Production (VC): 𝑃𝑀
Area(E)
B
F
Under Perfect Competition 𝑃𝐶
C G
Consumer Surplus: 𝐴𝑟𝑒𝑎(𝐴 + 𝐵 + 𝐹)
Producer Surplus: 𝐴𝑟𝑒𝑎(𝐶 + 𝐷 + 𝐺) 𝑀𝐶(𝑄𝑀 )
Total Surplus:
𝐴𝑟𝑒𝑎(𝐴 + 𝐵 + 𝐶 + 𝐷 + 𝐹 + 𝐺) D
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑃(𝑄)

E
𝑀𝑅(𝑄)
Q
𝑄𝑀 𝑄𝐶
 Under Monopoly
Under Monopoly
P

Consumer Surplus (CS):

𝑇𝐵 − 𝑇𝑅 = 𝐴𝑟𝑒𝑎 𝐴
𝑀𝐶(𝑄)
Consumers pay higher prices and obtain a lower
quantity of products:
Consumer surplus decreases under Monopoly CS
compared to Perfect Competition.
𝑃𝑀
Producer Surplus (PS):
𝑇𝑅 − 𝑉𝐶 = 𝐴𝑟𝑒𝑎 𝐵 + 𝐶 + 𝐷
Since 𝑩 > 𝑮, Producer Surplus Increases under 𝑃𝐶 DWL
Monopoly compared to Perfect Competition.
PS
𝑀𝐶(𝑄𝑀 )
Total Surplus (TS):
𝑇𝐵 − 𝑉𝐶 = 𝐴𝑟𝑒𝑎(𝐴 + 𝐵 + 𝐶 + 𝐷)
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑃(𝑄)
Deadweight Loss (DWL):
𝐴𝑟𝑒𝑎(𝐸 + 𝐹)
Total Surplus decreases under Monopoly compared
𝑀𝑅(𝑄)
to Perfect Competition.
Monopolies are Allocatively inefficient due to the Q
presence of deadweight loss. 𝑄𝑀 𝑄𝐶
 Under Monopoly
The Deadweight Loss under Monopoly occurs due to
P
the market power of the monopoly.

• Recall that when 𝑄 units is produced by suppliers

and sold to consumers, 𝑀𝐶(𝑄)
Total Surplus is the difference between the
total benefits to consumers of buying 𝑄 units and
the variable cost of producing 𝑄 units.
𝑇𝑆(𝑄) = 𝑇𝐵(𝑄) – 𝑉𝐶(𝑄)
𝑃𝑀 = 𝑀𝐵(𝑄𝑀 )
• Hence marginal surplus of the 𝑄 𝑡ℎ unit is
𝑀𝑆 𝑄 = 𝑀𝐵 𝑄 − 𝑀𝐶(𝑄)
𝑃𝐶 DWL
• Further recall that consumers are willing to pay up
to 𝑀𝐵 𝑄 for the 𝑄 𝑡ℎ unit, hence 𝑃 𝑄 = 𝑀𝐵(𝑄).
• I.e. the demand curve is also the marginal 𝑀𝐶(𝑄𝑀 )
benefit curve.

• Hence whenever 𝑃 𝑄 > 𝑀𝐶(𝑄), the marginal 𝐷𝑒𝑚𝑎𝑛𝑑: 𝑃(𝑄)

surplus of the 𝑄 𝑡ℎ unit is positive – i.e. producing
this unit will increase total surplus.
𝑀𝑅(𝑄)
Q
𝑄𝑀 𝑄𝐶
 Under Monopoly
The Deadweight Loss under Monopoly occurs due to
P
the market power of the monopoly.

Notice that the market power 𝑃 𝑄𝑀 > 𝑀𝐶(𝑄𝑀 ) of

the monopoly implies that: 𝑀𝐶(𝑄)
• Units between 𝑄𝑀 and 𝑄𝐶 are not produced, even
though the Marginal Economic Surplus of these
units is positive (since 𝑀𝐵 > 𝑀𝐶 for these units).
𝑃𝑀 = 𝑃(𝑄𝑀 )
• Producing these units would have increased total
surplus
𝑃𝐶 DWL
• Not producing these units resulted in the loss of
total surplus society could have enjoy
(i.e. the DWL) 𝑀𝐶(𝑄𝑀 )

• Takeaway:
In general, 𝐷𝑒𝑚𝑎𝑛𝑑: 𝑃(𝑄)
Firms with Market Power will result in DWL.

𝑀𝑅(𝑄)
Q
𝑄𝑀 𝑄𝐶
Summary of effects of Monopolies on Welfare
1. Monopoly causes a reduction in Consumer Surplus
2. Monopoly causes an increase in Producer Surplus
3. Monopoly causes deadweight loss – which represents a reduction in economic (allocative) efficiency.

• How large are the efficiency losses due to monopoly?

• Since there are few monopolies, the total loss of efficiency due specifically to deadweight losses caused by monopolies is small, relative to the
size of the overall economy.

• However, only firms in perfectly competitive markets do not possess market power
- and since there are very few perfectly competitive markets
– MOST firms have some level of market power.
• Since firms with market power will price above marginal cost
– some level of deadweight loss will occur in markets for almost every good or service!
• Which is why governments in market economies usually have policies promoting competition in markets – which are aimed at
reducing firms’ market power.
Regulating Market Power
• Market Power reduce consumer surplus and reduce economic efficiency
• Hence most governments have policies that regulates the behavior of monopolies – i.e. to reduce the DWL
associated with market power.
• These policies also regulate anti-competitive behaviors such as
• Collusion by groups of firms to fix prices and behave as monopolies.
• Predatory Pricing
• Resale Price Maintenance

• The Australian Competition and Consumer Commission (ACCC) is the body in Australia that regulates
Monopoly and Anti-Competitive Behavior.
• Also responsible for approval of mergers.

• Please refer to p 230 to 233 of HGLO.

• Also see the ACCC Media Release page for a long list of actions taken against anti-competitive behaviours by firms in
Australia.
Regulating Monopolies
How can a government reduce economic inefficiencies of monopolies
specifically?
1. Eliminate the Monopoly
• Reduce barriers to entry
• E.g. Time limits on Patents – allows generic medicines after expiration of patents.
• Force Monopolies to breakup
• example: Breakup of the Bell System, a monopoly of telephone services in the US
• Prevent Monopolies from forming,
by regulating mergers of firms in the same industry.

2. Regulate Prices charged by Monopolies

Please Note
• The following slides cover Price Regulation of Monopolies

• Marginal Cost Pricing:

Legally requiring Monopolies to charge prices that equal
their marginal cost of production (I.e. 𝑃 = 𝑀𝐶)
• Average Cost Pricing:
Legally requiring Monopolies to charge prices that equal
their average total cost of production (I.e. 𝑃 = 𝐴𝑇𝐶)
• These topics will be covered in Tutorial 5.
• Please use the following slides as reference when preparing for Tutorial 5.
 Forcing a Monopoly to Charge P=MC
Suppose a Monopoly is forced to price its P
product at marginal cost.

𝑃 = 𝑀𝐶 𝑀𝐶(𝑄)

How many units will a Price-regulated

Monopoly produce and what price will it
charge?

Sidenote: The MR curve is no longer 𝑃𝑅 = 𝑀𝐶 𝑄𝑅

relevant here, since the price the
Monopolist can charge is no longer
completely determined by the Demand
curve.
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑃(𝑄)

Q
𝑄𝑅
 Forcing a Monopoly to Charge P=MC
Suppose a Monopoly is forced to price its product
P
at marginal cost.

𝑃 = 𝑀𝐶
𝑀𝐶(𝑄)
Should the Monopolist produce 𝑸𝟎 < 𝑸𝑹 ?

At 𝑄0 , the monopolist can charge 𝑃0 = 𝑀𝐶 𝑄0 .

Producer Surplus is 𝐴𝑟𝑒𝑎(𝐴)

• Since MC is increasing, the firm can increase 𝑃𝑅 = 𝑀𝐶 𝑄𝑅

both output and price by increasing output to
𝑄𝑅 and charging 𝑃𝑅 , increasing Producer Surplus
to 𝐴𝑟𝑒𝑎(𝐴 + 𝐶).
C
𝑃0 = 𝑀𝐶(𝑄0 )
• Takeaway, if the firm is producing 𝑄0 < 𝑄𝑅 , it can A 𝐷𝑒𝑚𝑎𝑛𝑑
increase producer surplus (eq. profits) by D Increasing output
increasing output to 𝑄𝑅 from 𝑄0 to 𝑄𝑅
B increases PS
Q
𝑄0 𝑄𝑅
 Forcing a Monopoly to Charge P=MC
Suppose a Monopoly is forced to price its product
P
at marginal cost.

𝑃 = 𝑀𝐶
𝑀𝐶(𝑄)
Should the Monopolist produce 𝑸𝟏 > 𝑸𝑹 ?

• If the Monopoly produce 𝑄1 units 𝑀𝐶(𝑄1 )

It is allowed to charge 𝑃 = 𝑀𝐶(𝑄1 ),
but Quantity Demanded by consumers will be
less than 𝑄1 . Decreasing output
𝑃𝑅 = 𝑀𝐶 𝑄𝑅 E from 𝑄1 to 𝑄𝑅
• In order to Sell all 𝑄1 units, the firm will need
to charge 𝑃1 . A increases PS
• 𝑇𝑅 𝑄1 = 𝐶 + 𝐷 + 𝐺
B F
• 𝑉𝐶 𝑄1 = 𝐵 + 𝐷 + 𝐸 + 𝐹 + 𝐺 𝑃1
So Producer Surplus will be: C 𝐷𝑒𝑚𝑎𝑛𝑑
• 𝑃𝑆 𝑄1 = 𝑇𝑅 − 𝑉𝐶 = 𝐶 − (𝐵 + 𝐸 + 𝐹)
• The Monopoly is better off producing at 𝑄𝑅 D G
where 𝑃𝑆 𝑄𝑅 = 𝐴 + 𝐶.

• Takeaway: If the monopoly is producing 𝑄1 >

Q
𝑄𝑅 , it should decrease output to 𝑄𝑅 𝑄𝑅 𝑄1
 Forcing a Monopoly to Charge P=MC
P
Suppose a Monopoly is forced to price its
product at marginal cost.

𝑃 = 𝑀𝐶 𝑀𝐶(𝑄)
How many units will a Price-regulated
Monopoly produce and what price will it
charge?
Monopoly’s Profit Maximizing
If the price regulated Monopoly produces: pricing and output with
𝑃𝑅 Regulation requiring 𝑃 = 𝑀𝐶
• 𝑄0 < 𝑄𝑅 , it can increase profits (and
producer surplus)
by Increasing output to 𝑄𝑅
𝑃0
• 𝑄1 < 𝑄𝑅 , it can increase profits by 𝑃1 𝐷𝑒𝑚𝑎𝑛𝑑: 𝑃(𝑄)
Decreasing output to 𝑄𝑅

• Hence the profit-maximizing level of output Δ𝑃𝑆 > 0 Δ𝑃𝑆 > 0

is 𝑸𝑹 and the firm will charge 𝑃𝑅 = 𝑀𝐶(𝑄𝑅 )
the highest price allowed.
Q
𝑄0 𝑄𝑅 𝑄1
 Forcing a Monopoly to Charge P=MC
P

Notice that by producing 𝑄𝑅 and charging Monopoly’s pricing

𝑃𝑅 , the price regulated monopoly is and output without
𝑀𝐶(𝑄)
producing at the Competitive Market Price Regulation
Equilibrium (where the Demand and Supply
Curves intersect).
• 𝑃𝑅 equals the competitive market Monopoly’s pricing
𝑃𝑀
equilibrium price and output with
• 𝑄𝑅 equals the competitive market Regulation requiring 𝑃 = 𝑀𝐶
𝑃𝑅
equilibrium quantity

So forcing the Firm to charge a price equal 𝑀𝐶(𝑄𝑀 )

to its Marginal Cost eliminates all
Deadweight Loss. 𝐷𝑒𝑚𝑎𝑛𝑑: 𝑃(𝑄)

Equivalently, removing the Monopoly’s

𝑀𝑅(𝑄)
market power has resulted in an
allocatively efficient market outcome. Q
𝑄𝑀 𝑄𝑅
Regulating Natural Monopolies
• Natural Monopolies exhibit very low variable costs relative to fixed costs – hence
experience economies of scale across a broad range of possible outputs.
• In particular, in Natural Monopolies, the ATC curve intersects the Demand curve
at a point where the ATC is still decreasing (i.e. at a quantity at which economies
of scale still exists.
• This implies that if price regulators require a Natural Monopoly to engage in
marginal cost pricing (i.e. set 𝑃 = 𝑀𝐶) in order to eliminate all deadweight loss
• The Natural Monopoly will incur Economic Losses
• and exit the market in the long run
• resulting in the loss of an economically valuable good or service from the overall economy.
 Marginal Cost Pricing for a Natural Monopoly
will Result in Economic Losses
𝐷𝑒𝑚𝑎𝑛𝑑

At the efficient market price and

output, the firm incurs a loss on
every unit, since 𝑃𝐸 < 𝐴𝑇𝐶(𝑄𝐸 ). 𝑀𝐶

Thus marginal cost pricing rules

will result in the natural monopoly
incurring an Economic Loss
𝐴𝑇𝐶

𝐴𝑇𝐶(𝑄𝐸 ) Marginal Cost Pricing regulations

Will force the Monopoly to supply at
the efficient market (i.e. competitive market)
𝑃𝐸
Price (𝑃𝐸 ) and Quantity (𝑄𝐸 )
𝑀𝑅
Q
𝑄𝐸
Average Cost Pricing for Natural Monopolies
• Marginal Cost Pricing (MCP) rules will result in elimination of DWL in
the short-run
• But resulting Economic Losses will force the firm out of the market in
the Long-run – and no firm will want to take its place if the MCP
regulation remains in place.
• This results in the loss of a valuable market – i.e. if the market
disappears, all economic surpluses associated with the market is lost.
• So regulators face a tradeoff between
• Economic Efficiency - reducing deadweight loss as much as possible
• Viability of the Market - keeping the monopoly from incurring losses and
exiting the market.
Average Cost Pricing for Natural Monopolies
• Regulators can require the Monopoly to charge a price equal to its Average
Total Cost of production (Average Cost Pricing)
𝑃 = 𝐴𝑇𝐶
• Under Average Cost Pricing:
• Π = 𝑃 − 𝐴𝑇𝐶 𝑄 = 0. The Monopolist earns 0 economic profits and does not have
incentives to exit the market.
• The Monopolist will charge the lowest possible price required to keep the firm
economically viable – reducing DWL as much as possible given the requirement to
prevent market exit by the monopoly.
• In the real world, “average cost pricing” policies are complicated. The regulated price
and output is often agreed beforehand between the government and the natural
monopoly.
 Average Cost Pricing for a Natural Monopoly
will Result in 0 Economic Profits
P

𝐷𝑒𝑚𝑎𝑛𝑑
Average Cost Pricing
regulations will cause the
Monopoly to supply 𝑄𝑅 units
at the price 𝑃𝑅 𝑀𝐶
Average Cost Pricing Regulation
will result in 0 Economic profits
since 𝑃𝑅 = 𝐴𝑇𝐶(𝑄𝑅 )
𝐴𝑇𝐶
𝑃𝑅 = 𝐴𝑇𝐶(𝑄𝑅 )

Some Deadweight loss will persist

with Average Cost Pricing

Q
𝑄𝑅
Average Cost Pricing Reduces Deadweight Loss
compared to Unregulated Natural Monopoly
P Unregulated Monopoly will produce 𝑄𝑀 units and
charge 𝑃𝑀 .
𝐷𝑒𝑚𝑎𝑛𝑑
Average Cost Pricing reduces Price and increase
Quantity Available compared to the unregulated
monopoly, reducing DWL from A+B to B.
𝑃𝑀
𝑀𝐶

𝐴𝑇𝐶
A
𝑃𝑅 = 𝐴𝑇𝐶(𝑄𝑅 )

B
𝑀𝑅
Q
𝑄𝑀 𝑄𝑅
Markets can be efficient
without Government Intervention
Over the past lectures:
• We have seen that competitive markets without government
intervention can be Allocatively Efficient:
• Produce an equilibrium level of output that maximizes total surplus
• No shortage nor excess: At the equilibrium,
Every buyer can buy as much as he wants at the market price
Every seller can sell as much as it likes
• At the equilibrium level of output 𝑄 ∗ ,
𝑀𝐵 𝑄 ∗ = 𝑀𝐶(𝑄 ∗ )
• the marginal surplus (𝑀𝑆 = 𝑀𝐵 − 𝑀𝐶) of the last unit produced equals 0
• Every unit with positive marginal surplus is produced
– no units with negative surplus is produced.
Markets can be efficient
𝑃

𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝐶(𝑄)
∗ ∗ ∗
𝑀𝑆 𝑄 = 𝑀𝐵 𝑄 − 𝑀𝐶 𝑄 =0

𝑀𝑆 = 𝑀𝐵 − 𝑀𝐶 < 0
𝑀𝑆 = 𝑀𝐵 − 𝑀𝐶 > 0 Producing these units
Producing these units Decrease Total Surplus
Increase Total Surplus

𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝐵(𝑄)
𝑄
𝑈𝑛𝑖𝑡𝑠 𝑡ℎ𝑎𝑡 𝑎𝑟𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝑄∗ 𝑈𝑛𝑖𝑡𝑠 𝑡ℎ𝑎𝑡 𝑎𝑟𝑒 𝑁𝑂𝑇 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑
Why do Governments Intervene in Markets?
• If markets can be allocatively efficient:
• Why is the government such a big part of the economy,
even in market economies like Australia?
• The government expenditure share of GDP is 23 to 26% in Australia – i.e. 23 to 26% goods and services
produced in Australia are purchased by the Australian government.
• Many goods and services are provided by the government
– e.g. national defence, law enforcement, public education etc.
• Why does the government regulate markets –
i.e. by placing restrictions on the behavior of firms in private markets
• the Consumer and Competition Act (2010) empowers the Australian Competition and Consumer
Commission (ACCC) to investigate and prosecute anti-competitive behavior by firms – see HGLO p 231
• Wouldn’t government participation and intervention in markets
reduce efficiency in the overall economy?
Economic Bases for Government Intervention
Most economists agree that government intervention in some markets may be necessary for the
following reasons:

1. Maintaining or enforcing competition (discussed last week)

• Most markets are not perfectly competitive
• Governments need to regulate such markets to ensure they behave as close to perfectly competitive markets
as possible to increase efficiency.
2. Regulate Natural Monopolies (discussed last week)
3. Ensure Outcomes that society accepts as being fair
e.g. ensure that workers receive a living wage etc.
See Chapter 12 if interested (not examinable)
4. Macroeconomic Stabilization (to be discussed later in the course)
Economic Bases for Government Intervention
5. Presence of Externalities: when market activities affect third parties
(i.e. people who are neither buyers nor sellers)
6. Common Resources: Non-excludable goods or services
7. Public Goods: Non-excludable and Non-rivalrous goods or services
8. Information Asymmetry
9. Legal system and Rule of Law to ensure enforcement of contracts

• Market Failure: the failure of markets to achieve economic efficiency

• Most of these reasons (except Reasons 3 and 4) for government intervention relate to market
failure when these issues are significant factors in markets.
• Reasons 5 to 7 for Government intervention in markets
will be the topic of this week’s lecture.
• Information Asymmetry and the Rule of Law will not be examinable.
Agenda
• Externalities
• Common Goods and Public Goods
Externalities
• Personal Freedom of choice is important both in our daily lives,
as well as in markets
• People should have the ability to choose actions that are best for themselves
• But should everyone be completely free to do whatever they want?
• Not if their actions affect others negatively, right?
• For example, should I be allowed to light up a cigarette in a cinema?
• I’ll get to enjoy a sneaky cigarette (don’t tell my wife)
• But others get exposed to my second-hand smoke.
• Why shouldn’t the Cinema operator allow me to smoke?
Externalities
• If I decide to smoke (if I consume a cigarette), I am not the only
person affected by my decision
• The person seating next to me will be a Third Party
(someone who is not directly involved in my decision to smoke)
• But the Third Party will be (negatively) affected by my decision
• A Negative Externality is associated with my smoking
• A cost suffered by a third party
 Externalities
• Similarly, many market
transactions will impact
third parties
• Someone who is neither
a buyer nor a producer
• Someone who is “external” to
the market transaction.
• For example, a decision to clear
large portions of the Amazon
rainforest for agriculture will have
negative consequences for people
uninvolved in logging or farming.
Externalities
• An Externality associated with a good or service
• is a cost or benefit that
• affects someone who is not directly involved (a third party)
• in the production or consumption of the good or service

• Externalities can be either

• Positive: If the activity benefits third parties
• Negative: If the activity imposes costs on third parties
• Occur due to Consumption of a good or service
• Occur due to Production of a good or service
Examples of Externalities
Positive
Production Production of Medicine:
Associated Research useful
in advancing medical science
Consumption Education:
A more educated workforce is
more productive – leading to
higher living standards for
everyone.
Vaccines!
Negative
Coal-power Electricity Generation:
Produces 𝐶𝑂2 as a pollutant that
contributes to global warming
Smoking:
Second-hand smoke is harmful to
bystanders.
Demand in Perfectly Competitive Markets
Recall that in perfectly competitive markets
• Consumers wish to maximize Consumer Surplus (CS), the difference between
Total Benefits to consumers (TB) and Total Consumer Expenditure (𝑇𝑋 = 𝑃𝑄)
𝐶𝑆 = 𝑇𝐵 − 𝑃𝑄
• Maximizing Consumer Surplus requires that marginal consumer surplus (𝑀𝐶𝑆)
equal 0.
𝑀𝐶𝑆 = 𝑀𝐵 − 𝑃 = 0
• Implying that consumers will demand a quantity 𝑄𝐷 at which
𝑃 = 𝑀𝐵 𝑄𝐷

• Takeaway, the Marginal Benefit (to consumer) curve is also the Demand Curve.
Demand and Marginal Benefits
𝑃
At the market price of 𝑃,
Consumers will choose Quantity
Demanded (𝑄𝐷 ) at which
𝑀𝐵 𝑄𝐷 = 𝑃.

This is true for all prices, hence the

MB curve is also the Demand curve.

Area A Also note that Benefits to Consumers

when they buy 𝑄𝐷 units is the area
𝑃 𝑀𝐵(𝑄𝐷 ) under the Demand/MB curve
𝑇𝐵 𝑄𝐷 = 𝐴𝑟𝑒𝑎 𝐴 + 𝐵

Area B

𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝐵(𝑄)
𝑄
𝑄𝐷
Supply in Perfectly Competitive Markets
Recall that in perfectly competitive markets
• Producers wish to maximize Producer Surplus (PS), the difference between Total Revenue (𝑇𝑅 = 𝑃𝑄) and
Variable Costs of Production (𝑉𝐶)
𝑃𝑆 = 𝑇𝑅 − 𝑉𝐶
• Maximizing Producer Surplus requires that
marginal producer surplus (𝑀𝑃𝑆) equal 0.
𝑀𝑃𝑆 = 𝑃 − 𝑀𝐶 = 0
• Since 𝑃𝑆 = Π + 𝐹𝐶, and 𝐹𝐶 is a constant, maximizing 𝑃𝑆 is the same as maximizing Π.

• Implying that Producers will supply a quantity 𝑄𝑆 at which

𝑃 = 𝑀𝐶 𝑄𝑆
• Takeaway, the Marginal Cost (to producer) curve is also the Supply Curve.
Supply and Marginal Cost
𝑃 At the market price of 𝑃,
Producers will choose Quantity
Supplied (𝑄𝑆 ) at which
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝐶(𝑄) 𝑀𝐶 𝑄𝑆 = 𝑃.

This is true for all prices, hence the MC

curve is also the Supply curve.

Also note that (Variable) Cost to

Producers when they produce 𝑄𝑆 units
is the area under the Supply/MC curve
𝑃 𝑀𝐶(𝑄𝑆 ) 𝐴𝑟𝑒𝑎 𝐴

𝐴𝑟𝑒𝑎 𝐴
= 𝑉𝐶 𝑄𝑆

𝑄
𝑄𝑆
Efficiency of Competitive Market Equilibrium
without Externalities
• Without externalities:
market transactions only affect the market participants:
• Consumers (Buyers) and Producers (Sellers) and no one else.
• Hence Total (Social) Surplus is the sum of
Consumer Surplus and Producer Surplus

𝑇𝑆 = 𝐶𝑆 + 𝑃𝑆
= 𝑇𝐵 − 𝑃𝑄 + 𝑃𝑄 − 𝑉𝐶
= 𝑇𝐵 − 𝑉𝐶

• Important to Note: Total Surplus is Benefits to Society Less Cost to Society.

Efficiency of Competitive Market Equilibrium
without Externalities
• Maximizing Total Surplus (to achieve economic efficiency) requires
that Marginal Surplus at the market equilibrium output 𝑄 ∗ equal 0

𝑀𝑆 𝑄 ∗ = 𝑀𝐵 𝑄 ∗ − 𝑀𝐶 𝑄 ∗ = 0
⇒ 𝑀𝐵 𝑄 ∗ = 𝑀𝐶(𝑄 ∗ )

• I.e. The efficient level of output is where the 𝑀𝐵 and 𝑀𝐶 curves

intersect.
• Equivalently where the consumer demand and producer supply
curves cross – in the ABSENCE OF EXTERNALITIES
Efficient Market outcome, where MC=MB.
𝑃

𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝐶(𝑄)
∗ ∗ ∗
𝑀𝑆 𝑄 = 𝑀𝐵 𝑄 − 𝑀𝐶 𝑄 =0

𝑀𝑆 = 𝑀𝐵 − 𝑀𝐶 < 0
𝑀𝑆 = 𝑀𝐵 − 𝑀𝐶 > 0 Producing these units
Producing these units Decrease Total Surplus
Increase Total Surplus

𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝐵(𝑄)
𝑄
𝑈𝑛𝑖𝑡𝑠 𝑡ℎ𝑎𝑡 𝑎𝑟𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝑄∗ 𝑈𝑛𝑖𝑡𝑠 𝑡ℎ𝑎𝑡 𝑎𝑟𝑒 𝑁𝑂𝑇 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑
Effect of Externalities
• Note: The explanation in these slides differs slightly from the one
provided in the HGLO textbook.
• Specifically, the HGLO textbook draws a distinction between
• positive (negative) externalities of consumption and
• positive (negative) externalities of production.
• But many other textbooks only considers whether an externality is
positive or negative in terms of effects on market efficiency.
• I subscribe to this view, as it results in the same conclusions but the
explanation is a lot more intuitive.
Effects of Externalities: Total Social Surplus
• An efficient market outcome is one that maximizes Total Surplus to
Society – rephrase (for this topic) as Total Social Surplus (TSS)
• Total Social Surplus is Social Benefits (TSB) less Social Costs (TSC)
𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶
• The goal for any society should be to maximize Total Social Surplus.
∗
• Hence the Efficient market Output 𝑄𝐸𝑓𝑓 is one
that maximizes Total Social Surplus (NOT CS or PS).
∗
• For the Nerds (non-examinable☺): 𝑄𝐸𝑓𝑓 = arg max𝑄≥0 𝑇𝑆𝑆(𝑄)
Effects of Externalities: Total Social Surplus
• Marginal Social Surplus (MSS) – intuitively the additional social surplus gained
when one more unit is produced.
Δ𝑇𝑆𝑆
𝑀𝑆𝑆 = ⇒ Δ𝑇𝑆𝑆 = 𝑀𝑆𝑆 ⋅ Δ𝑄
Δ𝑄
• I.e. when Δ𝑄 = 1, then the increase in TSS is Δ𝑇𝑆𝑆 = 𝑀𝑆𝑆.
𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶
Δ𝑇𝑆𝑆 Δ𝑇𝑆𝐵 Δ𝑇𝐶𝑆
⇒ = −
Δ𝑄 Δ𝑄 Δ𝑄
⇒ 𝑀𝑆𝑆 = 𝑀𝑆𝐵 − 𝑀𝑆𝐶
• Marginal Social Surplus is Marginal Social Benefits (MSB) Less Marginal Social Cost (MSC).
Effects of Externalities: Total Social Surplus
∗
• At the Efficient market Output 𝑄𝐸𝑓𝑓 ,
Total Social Surplus is maximized.
• Neither increasing Δ𝑄 > 0 nor decreasing (Δ𝑄 < 0) can increase TSS.
∗ Δ𝑇𝑆𝑆
• Hence at 𝑄𝐸𝑓𝑓Marginal Social Surplus (𝑀𝑆𝑆 ≔
, ) must equal 0
Δ𝑄
∗ ∗ ∗
𝑀𝑆𝑆 𝑄𝐸𝑓𝑓 = 𝑀𝑆𝐵 𝑄𝐸𝑓𝑓 − 𝑀𝑆𝐶 𝑄𝐸𝑓𝑓 =0
∗ ∗
⇒ 𝑀𝑆𝐵 𝑄𝐸𝑓𝑓 = 𝑀𝑆𝐶(𝑄𝐸𝑓𝑓 )
• Marginal Social Benefit (MSB) must equal Marginal Social Cost (MSC) at the
∗
efficient level of market output (𝑄𝐸𝑓𝑓 ).
Effects of Externalities: Social Benefits
• Social Benefits (TSB) includes benefits to everyone in society
• Private Benefits (𝑃𝐵) that accrue to the consumer of the good or service
• External Benefits (𝐸𝐵) that is enjoyed by third parties;
• If there are positive externalities, external benefits exist: 𝐸𝐵 > 0
• If no positive externalities, then 𝐸𝐵 = 0 then Social Benefit only includes private benefits (𝑇𝑆𝐵 = 𝑃𝐵).
𝑇𝑆𝐵 = 𝑃𝐵 + 𝐸𝐵
Δ𝑇𝑆𝐵 Δ𝑃𝐵 Δ𝐸𝐵
⇒ = +
Δ𝑄 Δ𝑄 Δ𝑄
⇒ 𝑀𝑆𝐵 = 𝑀𝑃𝐵 + 𝑀𝐸𝐵

• Marginal Social Benefits (MSB) is the sum of

• Marginal Private Benefits (MPB) (to the consumer) and
• Marginal External Benefits (MEB) enjoyed by third parties.
Effects of Externalities: Social Benefits

• Note: Marginal Private Benefits (in the presence of externalities) is the

same as the concept of Marginal Benefits we have used in previous
lectures.
• Here, we include the term “Private” to denote the benefits Buyers
(consumers) receive in order to distinguish the benefits buyers receive
from their purchases, from the “external” benefits enjoyed by third parties.
• In scenarios without externalities, there are no external benefits, so total
benefits to society is simply benefits to consumers, so there is no need to
distinguish between total benefits to society and benefits to consumers.
Effects of Externalities: Demand
• Consumers only care about Private Benefits of consumption
• Doesn’t get to share the External Benefits that third parties enjoy
𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝐶𝑆 = 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 (𝑃𝐵) − 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 (𝑃 ⋅ 𝑄𝐷 )
• Even with externalities, Consumers’ goal: Maximize Consumer Surplus
• by choosing quantity demanded 𝑄𝐷 at which marginal consumer surplus is 0
𝑀𝐶𝑆 𝑄𝐷 = 𝑀𝑃𝐵 𝑄𝐷 − 𝑃 = 0
• or equivalently, where marginal private benefits equal market price
𝑃 = 𝑀𝑃𝐵(𝑄𝐷 )
• This is exactly what happens even if no externalities exists.
• Takeaway: Consumers’ Marginal Private Benefits Curve is also their Demand curve.
• Intuitively, Consumers only consider their own (marginal) private benefits when choosing how much to buy.
Demand and Marginal Private Benefits
𝑃

𝑃 𝑀𝑃𝐵 𝑄𝐷 = 𝑃

𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄)
𝑄
𝑄𝐷
Effects of Externalities: Social Costs
• Social Costs (TSC) includes costs incurred by everyone in society
• Private Costs (𝑃𝐶) incurred by the producer of the good or service
• External Costs (𝐸𝐶) suffered by third parties;
• If there are negative externalities, external costs exist: 𝐸𝐶 > 0
• If no negative externalities, then 𝑇𝑆𝐶 = 𝑃𝐶.
𝑇𝑆𝐶 = 𝑃𝐶 + 𝐸𝐶
Δ𝑇𝑆𝐶 Δ𝑃𝐶 Δ𝐸𝐶
⇒ = +
Δ𝑄 Δ𝑄 Δ𝑄
⇒ 𝑀𝑆𝐶 = 𝑀𝑃𝐶 + 𝑀𝐸𝐶

• Marginal Social Cost (MSC) is the sum of

• Marginal Private Cost (MPC) incurred by the producer and
• Marginal External Cost (MEC) imposed on third parties.
Effects of Externalities: Social Costs

• Note: Marginal Private Costs (in the presence of externalities) is the same
as the concept of Marginal Costs we have used in previous lectures.
• Here, we include the term “Private” to denote the costs incurred by sellers
(producers) in order to distinguish the cost to producers from the cost to
third parties (i.e. External Costs).
• In scenarios without externalities, there are no external costs, so social cost
to society is simply the private variable costs of production, so there was
no need to distinguish between Social Cost and Private Costs.
Effects of Externalities: Supply
• Producers only care about Private Costs of Production
• Since producers don’t have to pay the external costs imposed on third parties.
𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑟 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝐶𝑆 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑃 ⋅ 𝑄𝑆 − 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡𝑠 (𝑃𝐶)
• Note: Private Costs here actually refers to the Variable Costs (VC) of Production.
• Producers’ goal: Maximize Producer Surplus (eq. Profits)
• by choosing quantity supplied 𝑄𝑆 at which marginal producer surplus (𝑀𝑃𝑆) is 0
𝑀𝑃𝑆 𝑄𝑆 = 𝑃 − 𝑀𝑃𝐶(𝑄𝑆 ) = 0
Note: Recall that in perfectly competitive markets, Marginal Revenue equals Price (𝑀𝑅 = 𝑃).
• or equivalently, where marginal private costs equal market price
𝑃 = 𝑀𝑃𝐶(𝑄𝑆 )
• Takeaway: Producers’ Marginal Private Cost Curve is also their Supply curve.
• Intuitively, Producers only consider their own (marginal) private costs when choosing how much to supply.
Supply and Marginal Cost
𝑃

𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄)

𝑃 𝑀𝑃𝐶 𝑄𝑆 = 𝑃

𝑄
𝑄𝑆
Effects of Externalities
• Intuition: In markets, buyers and sellers are “Selfish”.
• Producers only care about Private Costs of Production
• Supply curve is the Marginal Private Cost (MPC) curve
• Consumers only care about Private Benefits to Consumption
• Demand curve is the Marginal Private Benefit (MPB) curve
• The market outcome is determined only by the decisions of buyers
and sellers, since third parties are not directly involved in transaction.
• As in any competitive market (with or without externalities),
∗
market equilibrium output 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 is where Demand meets Supply.
Effect of Positive Externalities on Market
Efficiency
• Suppose the market for public transportation services is competitive.
• The use of public transport has positive externalities.
• For example, if many people choose to take the bus to work instead of driving, there will be less cars on the
road, reducing traffic congestion and reducing travel times for other road users (third parties).
• Since third parties (other road users) benefit from the use of public transportation – there is a
positive externality (𝐸𝐵 > 0).
• Hence Marginal External Benefits exist (𝑀𝐸𝐵 > 0).
• For simplicity, assume that 𝑀𝐸𝐵 = $2 for every single public transport trip.
• Further assume (for simplicity) that there are no negative externalities associated with public transportation,
such that 𝑀𝐸𝐶 = 0.
𝑀𝑆𝐵 = 𝑀𝑃𝐵 + 𝑀𝐸𝐵
𝑀𝑆𝐶 = 𝑀𝑃𝐶
 Market Efficiency with Positive Externality
𝑃
• In the competitive market:
• Demand is determined by buyers’
marginal private benefits
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄)
• Supply determined by sellers’ marginal
private costs

𝑀𝑆𝐵(𝑄𝑀𝑎𝑟𝑘𝑒𝑡 ) • Competitive market equilibrium

output is 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 at which
𝑀𝑆𝑆 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 𝑀𝑃𝐶 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 = 𝑀𝑃𝐵(𝑄𝑀𝑎𝑟𝑘𝑒𝑡 )
= 𝑀𝐸𝐵 > 0
• That implies that
𝑀𝑃𝐶 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 𝑀𝑆𝐵 𝑄 = 𝑀𝑃𝐵 𝑄 + 𝑀𝐸𝐵 𝑀𝑆𝑆 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
= 𝑀𝑃𝐵(𝑄𝑀𝑎𝑟𝑘𝑒𝑡 ) 𝑀𝐸𝐵 = $2
= 𝑀𝑆𝐵 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 − 𝑀𝑆𝐶 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
= 𝑀𝑃𝐵 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 + 𝑀𝐸𝐵
−𝑀𝑃𝐶 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄) = 𝑀𝐸𝐵 > 0
Demand reflects consumers’
Private benefits

𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Positive Externality:
Market Efficiency at Competitive Market Equilibrium
𝑃
𝑇𝑆𝐵 = 𝑃𝐵 + 𝐸𝐵
𝑇𝑆𝐶 = 𝑃𝐶
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄)
𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶
= 𝑃𝐵 + 𝐸𝐵 − 𝑃𝐶

• Total Private Costs (𝑃𝐶) is

Variable Cost of production –
Area under 𝑀𝑃𝐶 curve
𝑀𝑆𝐵 𝑄 = 𝑀𝑃𝐵 𝑄 + 𝑀𝐸𝐵
𝑀𝐸𝐵 = $2 • Total Private Benefit (𝑃𝐵) is
Area under 𝑀𝑃𝐵 curve
• Total External Benefit is
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄) 𝑀𝐸B × 𝑄
Demand reflects consumers’ • Area between the 𝑀𝑆𝐵 and 𝑀𝑃𝐵
Private benefits curves.
𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Positive Externality:
Market Efficiency at Competitive Market Equilibrium
𝑃
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡 (𝑃𝐶 𝑜𝑟 𝑉𝐶):
Area C
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐶𝑜𝑠𝑡𝑠(𝑇𝑆𝐶):
𝑇𝑆𝐶 = 𝑃𝐶 + 𝐸𝐶 = 0
Area C
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 (𝑃𝐵):
A Area B+C
D • 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 (𝐸𝐵):
Area A
E 𝑀𝑆𝐵 𝑄 = 𝑀𝑃𝐵 𝑄 + 𝑀𝐸𝐵 • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝑇𝑆𝐵 :
B 𝑀𝐸𝐵 = $2
TSB = 𝑃𝐵 + 𝐸𝐵
Area A+B+C
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝑇𝑆𝑆 :
C F Demand reflects consumers’ 𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶
Private benefits Area (A+B+C) – C = A+B
𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Positive Externality:
Market Efficiency at Competitive Market Equilibrium
𝑃
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡 (𝑃𝐶):
Area C
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐶𝑜𝑠𝑡𝑠(𝑇𝑆𝐶):
𝑇𝑆𝐶 = 𝑃𝐶 + 𝐸𝐶 = 0
Area C
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 (𝑃𝐵):
A Area B+C
D • 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 (𝐸𝐵):
Area A
E 𝑀𝑆𝐵 𝑄 = 𝑀𝑃𝐵 𝑄 + 𝑀𝐸𝐵 • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝑇𝑆𝐵 :
B 𝑀𝐸𝐵 = $2
TSB = 𝑃𝐵 + 𝐸𝐵
Area A+B+C
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝑇𝑆𝑆 :
C F Demand reflects consumers’ 𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶
Private benefits Area (A+B+C) – C = A+B
𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Positive Externality:
Market Efficiency at Competitive Market Equilibrium
𝑃
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡 (𝑃𝐶):
Area C
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐶𝑜𝑠𝑡𝑠(𝑇𝑆𝐶):
𝑇𝑆𝐶 = 𝑃𝐶 + 𝐸𝐶 = 0
Area C
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 (𝑃𝐵):
A Area B+C
D • 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 (𝐸𝐵):
Area A
E 𝑀𝑆𝐵 𝑄 = 𝑀𝑃𝐵 𝑄 + 𝑀𝐸𝐵 • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝑇𝑆𝐵 :
B 𝑀𝐸𝐵 = $2
TSB = 𝑃𝐵 + 𝐸𝐵
Area A+B+C
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝑇𝑆𝑆 :
C F Demand reflects consumers’ 𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶
Private benefits Area (A+B+C) – C = A+B
𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Positive Externality:
Market Efficiency at Competitive Market Equilibrium
𝑃
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡 (𝑃𝐶):
Area C
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐶𝑜𝑠𝑡𝑠(𝑇𝑆𝐶):
𝑇𝑆𝐶 = 𝑃𝐶 + 𝐸𝐶 = 0
Area C
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 (𝑃𝐵):
A Area B+C
D • 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 (𝐸𝐵):
Area A
E 𝑀𝑆𝐵 𝑄 = 𝑀𝑃𝐵 𝑄 + 𝑀𝐸𝐵 • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝑇𝑆𝐵 :
B 𝑀𝐸𝐵 = $2
TSB = 𝑃𝐵 + 𝐸𝐵
Area A+B+C
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝑇𝑆𝑆 :
C F Demand reflects consumers’ 𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶
Private benefits Area (A+B+C) – C = A+B
𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Positive Externality:
Market Efficiency at Competitive Market Equilibrium
𝑃
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡 (𝑃𝐶):
Area C
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐶𝑜𝑠𝑡𝑠(𝑇𝑆𝐶):
𝑇𝑆𝐶 = 𝑃𝐶 + 𝐸𝐶 = 0
Area C
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 (𝑃𝐵):
A Area B+C
D • 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 (𝐸𝐵):
Area A
E 𝑀𝑆𝐵 𝑄 = 𝑀𝑃𝐵 𝑄 + 𝑀𝐸𝐵 • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝑇𝑆𝐵 :
B 𝑀𝐸𝐵 = $2
TSB = 𝑃𝐵 + 𝐸𝐵
Area A+B+C
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝑇𝑆𝑆 :
C F Demand reflects consumers’ 𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶
Private benefits Area (A+B+C) – C = A+B
𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
 Positive Externality:
Market Efficiency at Competitive Market Equilibrium
𝑃
• Is the Competitive Market Equilibrium
economically efficient?
• Is Total Social Surplus maximized at 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 ?
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄)

• At the competitive market equilibrium

𝑀𝑆𝐵 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 level of output 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
• Marginal Social Benefits is greater than Marginal
Social Costs
𝑀𝑆𝑆 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 = 𝑀𝐸𝐵 > 0
𝑇𝑆𝑆 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
𝑀𝑆𝐵 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 − 𝑀𝑆𝐶 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 = 𝑀𝐸𝐵 > 0
𝑀𝑆𝐶 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 𝑀𝑆𝐵 𝑄 = 𝑀𝑃𝐵 𝑄 + 𝑀𝐸𝐵
• So Marginal Social Surplus is positive
𝑀𝐸𝐵 = $2 𝑀𝑆𝑆 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 > 0
• Total Social Surplus can be increased further by
increasing output!
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄)
Demand reflects consumers’
Private benefits • What is the Efficient Level of Output?
𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
 Efficient Output with Positive Externality
𝑃
• What is the Efficient Level of Output?

𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) 𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶

𝑀𝑆𝑆 = 𝑀𝑆𝐵 − 𝑀𝑆𝐶
𝑀𝑆𝑆 𝑄𝐸𝑓𝑓 = 0
• At the efficient level of output 𝑄𝐸𝑓𝑓 ,
𝑀𝑆𝐵 𝑄𝐸𝑓𝑓 Marginal Social Surplus (MSS) must be 0
= 𝑀𝑆𝐶(𝑄𝐸𝑓𝑓 ) 𝑀𝑆𝑆 𝑄𝐸𝑓𝑓 = 0
⇒ 𝑀𝑆𝐵 𝑄𝐸𝑓𝑓 = 𝑀𝑆𝐶(𝑄𝐸𝑓𝑓 )
𝑀𝑆𝐵 𝑄 = 𝑀𝑃𝐵 𝑄 + 𝑀𝐸𝐵 • If 𝑀𝑆𝑆 > 0, TSS is increasing
𝑀𝐸𝐵 = $2 • If 𝑀𝑆𝑆 < 0, TSS is decreasing

• The Efficient Level of Output is where

𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄) the Marginal Social Benefits equals
Demand reflects consumers’ Marginal Social Costs!
Private benefits

𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡 𝑄𝐸𝑓𝑓
Efficient Output with Positive Externality
𝑃
At the efficient level of output 𝑄𝐸𝑓𝑓

𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄)
• External Benefits:
Area A+D+E
• Private Benefits:
A Area B+C+F
D
• Private Costs = Total Social Costs:
E 𝑀𝑆𝐵 𝑄 = 𝑀𝑃𝐵 𝑄 + 𝑀𝐸𝐵
Area C+E+F
B 𝑀𝐸𝐵 = $2
• Total Social Surplus
𝑇𝑆𝑆 = 𝑃𝐵 + 𝐸𝐵 − 𝑇𝑆𝐶
Area A+B+D
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄)
C F Demand reflects consumers’
Private benefits

𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡 𝑄𝐸𝑓𝑓
 Positive Externality: Total Social Surplus
at Efficient Level of Output (𝑄𝐸𝑓𝑓 )
𝑃

𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄)

𝑀𝑆𝐵 𝑄𝐸𝑓𝑓
= 𝑀𝑆𝐶(𝑄𝐸𝑓𝑓 )
𝑇𝑆𝑆 𝐸𝑓𝑓

𝑀𝑆𝐵 𝑄 = 𝑀𝑃𝐵 𝑄 + 𝑀𝐸𝐵

𝑀𝐸𝐵 = $2

𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄)
Demand reflects consumers’
Private benefits

𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡 𝑄𝐸𝑓𝑓
 Positive Externality:
Competitive Market Output is Inefficient
𝑃
• Is the Competitive Market Equilibrium
economically efficient?
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) • No - if there are positive externalities
associated with the good or service,
too little of the good or service will be
produced at the competitive market
𝑀𝑆𝐵 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
equilibrium.
𝑄𝑀𝑎𝑟𝑘𝑒𝑡 < 𝑄𝐸𝑓𝑓
DWL
𝑇𝑆𝑆 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 • Deadweight loss exist because there
are many units with 𝑀𝑆𝑆 > 0
𝑀𝑆𝐶 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 𝑀𝑆𝐵 𝑄 = 𝑀𝑃𝐵 𝑄 + 𝑀𝐸𝐵 (between 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 and 𝑄𝐸𝑓𝑓 ) that are
𝑀𝐸𝐵 = $2
not produced at the competitive
equilibrium.
• The additional social benefits of these units
𝑀𝑆𝑆 > 0 exceeds the additional social costs of
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄)
for these producing these units
units Demand reflects consumers’
Private benefits • Producing these units will have increased
total social surplus.
𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡 𝑄𝐸𝑓𝑓
Effect of Negative Externalities
on Market Efficiency
• Suppose the market for coal is competitive.
• The extraction and burning of coal for power has negative externalities
• Burning coal for power generates 𝐶𝑂2 , which contributes to climate change
• Major climate change will reduce agricultural productivity,
increasing cost of food for future generations
• Since third parties (future generations) suffer external costs from use of coal
• Marginal External Costs exist (𝑀𝐸𝐶 > 0).
• For simplicity, assume that 𝑀𝐸𝐶 = $3 for every unit of coal extracted and utilized.
• Further assume that there are no positive externalities associated with coal, such that
𝑀𝐸𝐵 = 0 (i.e. any social benefits are private benefits).

𝑀𝑆𝐵 = 𝑀𝑃𝐵
𝑀𝑆𝐶 = 𝑀𝑃𝐶 + 𝑀𝐸𝐶
 Competitive Market Equilibrium
𝑃
• In the competitive market:
• Demand is determined by buyers’ marginal
𝑀𝑆𝐶 𝑄 = 𝑀𝑃𝐶 𝑄 + 𝑀𝐸𝐶 private benefits
• Supply determined by sellers’ marginal private
costs

𝑀𝑆𝐶(𝑄𝑀𝑎𝑟𝑘𝑒𝑡 ) 𝑀𝐸𝐶 = $3 • Competitive market equilibrium output is

𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 at which
𝑀𝑃𝐶 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 = 𝑀𝑃𝐵(𝑄𝑀𝑎𝑟𝑘𝑒𝑡 )
• That implies that
𝑀𝑃𝐶 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
= 𝑀𝑃𝐵(𝑄𝑀𝑎𝑟𝑘𝑒𝑡 ) 𝑀𝑆𝑆 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
= 𝑀𝑆𝐵 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 − 𝑀𝑆𝐶 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
= 𝑀𝑃𝐵 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 − 𝑀𝑃𝐶 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 + 𝑀𝐸𝐶
= −𝑀𝐸𝐶 < 0
𝐷𝑒𝑚𝑎𝑛𝑑:
𝑀𝑆𝐵 𝑄 = 𝑀𝑃𝐵(𝑄)

𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Market Efficiency with Negative Externality
𝑃
𝑇𝑆𝐵 = 𝑃𝐵
𝑇𝑆𝐶 = 𝑃𝐶 + 𝐸𝐶
𝑀𝑆𝐶 𝑄 = 𝑀𝑃𝐶 𝑄 + 𝑀𝐸𝐶
𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶
= 𝑃𝐵 − (𝑃𝐶 + 𝐸𝐶)
𝑀𝐸𝐶 = $3
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄)
• Total Private Costs (𝑃𝐶) is
Variable Cost of production –
Area under 𝑀𝑃𝐶 curve
• Total Private Benefit (𝑃𝐵) is
Area under 𝑀𝑃𝐵 curve
• Total External Cost is 𝑀𝐸𝐶 × 𝑄
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄) – Area between the 𝑀𝑆𝐶 and
𝑀𝑃𝐶 curves.
𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Negative Externality:
Market Efficiency at Competitive Market Equilibrium
𝑃
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡 (𝑃𝐶):
Area C+F
𝑀𝑆𝐶 𝑄 = 𝑀𝑃𝐶 𝑄 + 𝑀𝐸𝐶
• 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐶𝑜𝑠𝑡 (𝐸𝐶 = 𝑀𝐸𝐶 ⋅
𝑄𝑀𝑎𝑟𝑘𝑒𝑡 )
Area B+D+E
𝑀𝐸𝐶 = $3
• 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐶𝑜𝑠𝑡𝑠(𝑇𝑆𝐶):
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) 𝑇𝑆𝐶 = 𝑃𝐶 + 𝐸𝐶
A D Area B+C+D+E+F
• 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠
E
(𝑇𝑆𝐵 = 𝑃𝐵):
Area A+B+C+E+F
B
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝑇𝑆𝑆 :
F
𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶
C
Area A-D
𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Negative Externality:
Market Efficiency at Competitive Market Equilibrium
𝑃
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡 (𝑃𝐶):
Area C+F
𝑀𝑆𝐶 𝑄 = 𝑀𝑃𝐶 𝑄 + 𝑀𝐸𝐶
• 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐶𝑜𝑠𝑡 (𝐸𝐶 = 𝑀𝐸𝐶 ⋅
𝑄𝑀𝑎𝑟𝑘𝑒𝑡 )
Area B+D+E
𝑀𝐸𝐶 = $3
• 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐶𝑜𝑠𝑡𝑠(𝑇𝑆𝐶):
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) 𝑇𝑆𝐶 = 𝑃𝐶 + 𝐸𝐶
A D Area B+C+D+E+F
• 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠
E
(𝑇𝑆𝐵 = 𝑃𝐵):
Area A+B+C+E+F
B
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝑇𝑆𝑆 :
F
𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶
C
Area A-D
𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Negative Externality:
Market Efficiency at Competitive Market Equilibrium
𝑃
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡 (𝑃𝐶):
Area C+F
𝑀𝑆𝐶 𝑄 = 𝑀𝑃𝐶 𝑄 + 𝑀𝐸𝐶
• 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐶𝑜𝑠𝑡 (𝐸𝐶 = 𝑀𝐸𝐶 ⋅
𝑄𝑀𝑎𝑟𝑘𝑒𝑡 )
Area B+D+E
𝑀𝐸𝐶 = $3
• 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐶𝑜𝑠𝑡𝑠(𝑇𝑆𝐶):
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) 𝑇𝑆𝐶 = 𝑃𝐶 + 𝐸𝐶
A D Area B+C+D+E+F
• 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠
E
(𝑇𝑆𝐵 = 𝑃𝐵):
Area A+B+C+E+F
B
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝑇𝑆𝑆 :
F
𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶
C
Area A-D
𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Negative Externality:
Market Efficiency at Competitive Market Equilibrium
𝑃
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡 (𝑃𝐶):
Area C+F
𝑀𝑆𝐶 𝑄 = 𝑀𝑃𝐶 𝑄 + 𝑀𝐸𝐶
• 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐶𝑜𝑠𝑡 (𝐸𝐶 = 𝑀𝐸𝐶 ⋅
𝑄𝑀𝑎𝑟𝑘𝑒𝑡 )
Area B+D+E
𝑀𝐸𝐶 = $3
• 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐶𝑜𝑠𝑡𝑠(𝑇𝑆𝐶):
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) 𝑇𝑆𝐶 = 𝑃𝐶 + 𝐸𝐶
A D Area B+C+D+E+F
• 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠
E
(𝑇𝑆𝐵 = 𝑃𝐵):
Area A+B+C+E+F
B
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝑇𝑆𝑆 :
F
𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶
C
Area A-D
𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Negative Externality:
Market Efficiency at Competitive Market Equilibrium
𝑃
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡 (𝑃𝐶):
Area C+F
𝑀𝑆𝐶 𝑄 = 𝑀𝑃𝐶 𝑄 + 𝑀𝐸𝐶
• 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐶𝑜𝑠𝑡 (𝐸𝐶 = 𝑀𝐸𝐶 ⋅
𝑄𝑀𝑎𝑟𝑘𝑒𝑡 )
Area B+D+E
𝑀𝐸𝐶 = $3
• 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐶𝑜𝑠𝑡𝑠(𝑇𝑆𝐶):
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) 𝑇𝑆𝐶 = 𝑃𝐶 + 𝐸𝐶
A D Area B+C+D+E+F
• 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠
E
(𝑇𝑆𝐵 = 𝑃𝐵):
Area A+B+C+E+F
B
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝑇𝑆𝑆 :
F
𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶
C
Area A-D
𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Negative Externality:
Market Efficiency at Competitive Market Equilibrium
𝑃
• 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡 (𝑃𝐶):
Area C+F
𝑀𝑆𝐶 𝑄 = 𝑀𝑃𝐶 𝑄 + 𝑀𝐸𝐶
• 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐶𝑜𝑠𝑡 (𝐸𝐶 = 𝑀𝐸𝐶 ⋅
𝑄𝑀𝑎𝑟𝑘𝑒𝑡 )
Area B+D+E
𝑀𝐸𝐶 = $3
• 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐶𝑜𝑠𝑡𝑠(𝑇𝑆𝐶):
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) 𝑇𝑆𝐶 = 𝑃𝐶 + 𝐸𝐶
A D Area B+C+D+E+F
• 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠
E
(𝑇𝑆𝐵 = 𝑃𝐵):
Area A+B+C+E+F
B
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄) • 𝑇𝑜𝑡𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝑇𝑆𝑆 :
F
𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶
C
Area A-D
𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
 Negative Externality:
Market Inefficiency at Competitive Market Equilibrium
𝑃
• Is the Competitive Market Equilibrium
economically efficient when there is a
𝑀𝑆𝐶 𝑄 = 𝑀𝑃𝐶 𝑄 + 𝑀𝐸𝐶 negative externality?

• At the competitive market equilibrium

level of output 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
𝑀𝑆𝐶 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
• Marginal Social Cost is greater than
𝑀𝑆𝑆 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) Marginal Social Benefit
= −𝑀𝐸𝐶 < 0

𝑀𝑆𝐵 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 < 𝑀𝑆𝐶 𝑄𝑀𝑎𝑟𝑘𝑒𝑡

𝑀𝑆𝐵 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
= 𝑀𝑃𝐵(𝑄𝑀𝑎𝑟𝑘𝑒𝑡 ) • Implies that Marginal Social Surplus is
negative 𝑀𝑆𝑆 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 = −𝑀𝐸𝐶 < 0
• Total Social Surplus can be increased further
by decreasing output!
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵(𝑄)

• What is the Efficient Level of Output?

𝑄
𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Efficient Output with Negative Externality
𝑃
• What is the Efficient Level of Output?

𝑀𝑆𝐶 𝑄 = 𝑀𝑃𝐶 𝑄 + 𝑀𝐸𝐶 𝑇𝑆𝑆 = 𝑇𝑆𝐵 − 𝑇𝑆𝐶

𝑀𝑆𝑆 = 𝑀𝑆𝐵 − 𝑀𝑆𝐶
• At the efficient level of output 𝑄𝐸𝑓𝑓 ,
𝑀𝐸𝐶 = $3 Marginal Social Surplus (MSS) must be 0
𝑀𝑆𝑆 𝑄𝐸𝑓𝑓 = 0
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄)
⇒ 𝑀𝑆𝐵 𝑄𝐸𝑓𝑓 = 𝑀𝑆𝐶(𝑄𝐸𝑓𝑓 )
• If 𝑀𝑆𝑆 > 0, TSS is increasing
• If 𝑀𝑆𝑆 < 0, TSS is decreasing

• The Efficient Level of Output is where

the MSB curve intersects
the MSC curve.
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵 𝑄
• If there is no positive externality, then
= 𝑀𝑆𝐵(𝑄) 𝑀𝑆𝐵 = 𝑀𝑃𝐵

𝑄
𝑄𝐸𝑓𝑓 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Efficient Output with Negative Externality
𝑃
At the efficient level of output 𝑄𝐸𝑓𝑓

𝑀𝑆𝐶 𝑄 = 𝑀𝑃𝐶 𝑄 + 𝑀𝐸𝐶

• External Costs (𝐸𝐶):
Area B
𝑀𝐸𝐶 = $3 • Private Costs (𝑃𝐶):
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄)
Area C

A D • Private Benefits = Total Social Benefits:

Area A+B+C
E • Total Social Surplus
𝑇𝑆𝑆 = 𝑇𝑆𝐵 − (𝑃𝐶 + 𝐸𝐶)
B Area A
F 𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵 𝑄
= 𝑀𝑆𝐵(𝑄)
C
𝑄
𝑄𝐸𝑓𝑓 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Negative Externality: Total Social Surplus
at Efficient Level of Output (𝑄𝐸𝑓𝑓 )
𝑃

𝑀𝑆𝐶 𝑄 = 𝑀𝑃𝐶 𝑄 + 𝑀𝐸𝐶

𝑀𝐸𝐶 = $3
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄)
𝑇𝑆𝑆(𝑄𝐸𝑓𝑓 )

𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵 𝑄
= 𝑀𝑆𝐵(𝑄)

𝑄
𝑄𝐸𝑓𝑓 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Negative Externality:
Competitive Market Output 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 is Inefficient
𝑃
• Is the Competitive Market Equilibrium
economically efficient if there are
negative externalities?
𝑀𝑆𝐶 𝑄 = 𝑀𝑃𝐶 𝑄 + 𝑀𝐸𝐶
• No - if there are negative externalities
𝑇𝑆𝑆 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 = 𝐴 − 𝐷
associated with the good or service,
𝐷𝑒𝑎𝑑 𝑊𝑒𝑖𝑔ℎ𝑡 𝐿𝑜𝑠𝑠 = 𝐷
too much of the good or service will be
𝑀𝐸𝐶 = $3
produced at the competitive market
equilibrium.
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑃𝐶(𝑄) 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 < 𝑄𝐸𝑓𝑓
A D: DWL • Deadweight loss exist because there are
many units with 𝑀𝑆𝑆 < 0 (between
𝑄𝑀𝑎𝑟𝑘𝑒𝑡 and 𝑄𝐸𝑓𝑓 ) that are produced at
the competitive equilibrium.
• The additional social costs of producing these
units exceeds the additional social benefits of
producing these units
𝑀𝑆𝑆 < 0
𝐷𝑒𝑚𝑎𝑛𝑑: 𝑀𝑃𝐵 𝑄 • Producing these units have decreased total
for these
units
= 𝑀𝑆𝐵(𝑄) social surplus.

𝑄
𝑄𝐸𝑓𝑓 𝑄𝑀𝑎𝑟𝑘𝑒𝑡
Externalities result in Market Failures
• Market Failures: Situations when free markets (i.e. markets without
government intervention) fail to produce the efficient level of output.
• When there are Positive Externalities:
𝑄𝑀𝑎𝑟𝑘𝑒𝑡 < 𝑄𝐸𝑓𝑓
Competitive markets will produce too little output at equilibrium
• When there are Negative Externalities:
𝑄𝑀𝑎𝑟𝑘𝑒𝑡 > 𝑄𝐸𝑓𝑓
Competitive markets will produce too much output at equilibrium
Government Intervention to increase market
efficiency when Externalities exist
• If competitive markets fail to produce the efficient level of output in
the presence of externalities, can the government increase market
efficiency by intervening? Yes!

• The Government can introduce Pigovian Taxes and Subsidies:

• Taxes and Subsidies meant to bring about an efficient level of output
• Recall that Taxes and Subsidies can result in deadweight loss,
but that’s if no externalities exist.
Government Intervention to increase market
efficiency when Externalities exist
• If Positive Externalities exist, Output is too Low
• Recall that Unit Subsidies will increase Market Output
• So an appropriate Pigovian Subsidy will increase Market Efficiency

• If Negative Externalities exist, Output is too High

• Recall that Unit Taxes will decrease Market Output
• So an appropriate Pigovian Tax will increase Market Efficiency
Government Intervention to increase market
efficiency when Externalities exist

Question: What is an appropriate Pigovian Tax or Subsidy

• If Positive Externality exist, an appropriate Pigovian Unit Subsidy

(𝑆𝑢𝑏) should be set to equal Marginal External Benefits (𝑀𝐸𝐵)
𝑆𝑢𝑏 = 𝑀𝐸𝐵
• If Negative Externality exist, an appropriate Pigovian Unit Tax (𝑇𝑎𝑥)
should be set to equal Marginal External Cost (𝑀𝐸𝐶)
𝑇𝑎𝑥 = 𝑀𝐸𝐶
Pigovian Subsidies with Positive Externalities
• If there are positive externalities, 𝑀𝐸𝐵 > 0:
𝑀𝑆𝐵 = 𝑀𝑃𝐵 + 𝑀𝐸𝐵
𝑀𝑃𝐵 < 𝑀𝑆𝐵
• Consumers (who decide how much to buy) only receive Marginal Private
Benefits for each additional unit purchased
• Hence Demand reflects only Marginal Private Benefits, but not Marginal Social Benefits
• Demand will be too “low”
• To achieve the efficient market output, need to cause consumers to internalize
(i.e. to also enjoy) the external benefits received by third parties
• We need to increase Consumers’ Marginal Private Benefits to a level that
equals Marginal Social Benefits.
Pigovian Subsidies with Positive Externalities
• Consider again the market for Public Transportation in which Positive Externalities exist
• 𝑀𝐸𝐵 = $2
• Let 𝑀𝑃𝐵0 refer to consumers’ Marginal Private Benefits without government intervention
Δ𝑇𝐵
• I.e. 𝑀𝑃𝐵0 is the Marginal Consumer Benefit (𝑀𝐵 = as defined in the supplementary slides) that arises from the
Δ𝑄
consumption of each additional unit of the service.
• Government sets a Pigovian Unit Subsidy paid to consumers
𝑆𝑢𝑏 = 𝑀𝐸𝐵 = $2
• For each additional unit purchased (i.e. bus trips), consumers gain
• The Marginal Private Benefit (𝑀𝑃𝐵0 ) directly associated with the additional unit
(i.e. the Private Benefits directly due to more bus trips)
• The Subsidy (𝑆𝑢𝑏) is paid by the government
• With the Pigovian Unit Subsidy, Marginal Private Benefits received by consumers increases to
𝑀𝑃𝐵1 = 𝑀𝑃𝐵0 + 𝑆𝑢𝑏
Pigovian Subsidies with Positive Externalities
• Marginal Social Benefit: 𝑀𝑆𝐵1 = 𝑀𝑃𝐵0 + 𝑀𝐸𝐵
• Pigovian Unit Subsidy: 𝑆𝑢𝑏 = 𝑀𝐸𝐵
• New Marginal Private Benefit with Subsidy
𝑀𝑃𝐵1 = 𝑀𝑃𝐵0 + 𝑆𝑢𝑏 = 𝑀𝑃𝐵0 + 𝑀𝐸𝐵
• Notice that the Pigovian Subsidy has made
• the Marginal Private Benefits enjoyed by consumers
• exactly the same as Marginal Social Benefit to society at large
𝑀𝑃𝐵1 = 𝑀𝑆𝐵

• Since the Demand curve reflect Marginal Private Benefits to consumers

• The Subsidy has shifted the Demand curve up
to fully reflect Marginal Social Benefits!
Effect of Pigovian Subsidies with Positive Externality
𝑃 • If Positive Externalities exist,
Demand (𝐷𝑒𝑚𝑎𝑛𝑑0 ) in the
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑆𝐶 = 𝑀𝑃𝐶 absence of Subsidy only reflects
No negative externalities Marginal Private Benefits of
consumers
𝑀𝐸𝐵 • Marginal Equilibrium at
intersection of
DWL 𝐷𝑒𝑚𝑎𝑛𝑑0 and Supply
• Market Output without Subsidy is
Market Equilibrium 𝑀𝑆𝐵 = 𝑀𝑃𝐵0 + 𝑀𝐸𝐵 too low
w/o Subsidy
𝑄0 < 𝑄𝐸𝑓𝑓
• Market Output is inefficient due to
𝐷𝑒𝑚𝑎𝑛𝑑0 : 𝑀𝑃𝐵0 Deadweight Loss (DWL)

𝑄
𝑄0 𝑄𝐸𝑓𝑓
Effect of Pigovian Subsidies with Positive Externality
𝑃 • If the Government introduces a
Pigovian Subsidy that equals
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑆𝐶 = 𝑀𝑃𝐶 Marginal External Benefits
Market Equilibrium
Subsidy 𝑆𝑢𝑏 = 𝑀𝐸𝐵 No negative externalities 𝑀𝐸𝐵 = 𝑆𝑢𝑏
• Increases Marginal Private Benefits
to 𝑀𝑃𝐵1 = 𝑀𝑃𝐵0 + 𝑆𝑢𝑏
𝑀𝐸𝐵 = 𝑆𝑢𝑏
• Demand Shifts up to 𝐷𝑒𝑚𝑎𝑛𝑑1
𝐷𝑒𝑚𝑎𝑛𝑑1 : • New Market Equilibrium at
𝑀𝑃𝐵1 = 𝑀𝑃𝐵0 + 𝑆𝑢𝑏
Market Equilibrium intersection of 𝐷𝑒𝑚𝑎𝑛𝑑1 and
= 𝑀𝑆𝐵
w/o Subsidy
Increase in Demand Supply.
• New market equilibrium output is
efficient – no deadweight loss.
𝐷𝑒𝑚𝑎𝑛𝑑0 : 𝑀𝑃𝐵0

𝑄
𝑄0 𝑄1 = 𝑄𝐸𝑓𝑓
Effect of Pigovian Subsidies with Positive Externality
𝑃 With Pigovian Subsidy 𝑆𝑢𝑏 = 𝑀𝐸𝐵

𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑆𝐶 = 𝑀𝑃𝐶

Market Equilibrium
Subsidy 𝑆𝑢𝑏 = 𝑀𝐸𝐵 No negative externalities • Total Social Benefits (𝑇𝑆𝐵):
Area A+B+C+D
• Total Social Costs (𝑇𝑆𝐶)
A Area C+D
𝐷𝑒𝑚𝑎𝑛𝑑1 : • Total Social Surplus:
C 𝑀𝑃𝐵1 = 𝑀𝑃𝐵0 + 𝑆𝑢𝑏 𝑇𝑆𝑆 = 𝑇𝑆𝐵 + 𝑇𝑆𝐶
= 𝑀𝑆𝐵 Area A+B
B
𝑀𝐸𝐵 = 𝑆𝑢𝑏

D
𝐷𝑒𝑚𝑎𝑛𝑑0 : 𝑀𝑃𝐵0

𝑄
𝑄1 = 𝑄𝐸𝑓𝑓
 Effect of Pigovian Subsidies with Positive Externality
𝑃 With Pigovian Subsidy 𝑆𝑢𝑏 = 𝑀𝐸𝐵
• Consumer Surplus (CS)
𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑆𝐶 = 𝑀𝑃𝐶 = 𝐶+𝐷+𝐹+𝐺+𝐻 − 𝐺+𝐻
Market Equilibrium =𝐶+𝐷+𝐹
Subsidy 𝑆𝑢𝑏 = 𝑀𝐸𝐵 No negative externalities • Since Expenditure uses 𝑃𝐵 (pocket price of buyer)
which accounts for the subsidy, Private Benefits here
refers to Benefits that consumers enjoy as a direct
C result of consumption of the good or service, that
excludes the subsidy
A • Producer Surplus (PS)
𝑃𝑆 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡𝑠
B = 𝐵+𝐷+𝐸+𝐹+𝐺+𝐻
− 𝐸+𝐹+𝐻
E =𝐵+𝐷+𝐺
D 𝑀𝐸𝐵 = 𝑆𝑢𝑏 𝑀𝑆𝐵
F = 𝑃𝑆 − 𝑃𝐵 • Government Surplus
𝑃𝐵
(𝐺𝑆 = −𝑆𝑢𝑏 ⋅ 𝑄𝐸𝑓𝑓 )
G −(𝐵 + 𝐷 + 𝐹 + 𝐸)
𝐷𝑒𝑚𝑎𝑛𝑑0 : 𝑀𝑃𝐵0 • Surplus to Third Parties (𝑆𝑇𝑃)
H 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠
−𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐶𝑜𝑠𝑡
=𝐴+𝐵+𝐸
𝑄
𝑄1 = 𝑄𝐸𝑓𝑓
 Effect of Pigovian Subsidies with Positive Externality
𝑃 With Pigovian Subsidy 𝑆𝑢𝑏 = 𝑀𝐸𝐵
Total Social Surplus is sum of Surpluses
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑆𝐶 = 𝑀𝑃𝐶 𝑇𝑆𝑆 = 𝐶𝑆 + 𝑃𝑆 + 𝐺𝑆 + 𝑆𝑇𝑃
Market Equilibrium
Subsidy 𝑆𝑢𝑏 = 𝑀𝐸𝐵 No negative externalities =𝐴+𝐵+𝐶+𝐷+𝐺

C
A
𝑃𝑆
B

D E 𝑀𝐸𝐵 = 𝑆𝑢𝑏 𝑀𝑆𝐵

F = 𝑃𝑆 − 𝑃𝐵
𝑃𝐵
G
𝐷𝑒𝑚𝑎𝑛𝑑0 : 𝑀𝑃𝐵0
H

𝑄
𝑄1 = 𝑄𝐸𝑓𝑓
Effect of Pigovian Subsidies with Positive Externality
𝑃
The Pigovian Subsidy 𝑆𝑢𝑏 =
𝑀𝐸𝐵 ensures that the efficient
Market Equilibrium
𝑆𝑢𝑝𝑝𝑙𝑦: 𝑀𝑆𝐶 = 𝑀𝑃𝐶 output is produced
Subsidy 𝑆𝑢𝑏 = 𝑀𝐸𝐵 No negative externalities
That Total Social Surplus is
maximized.

𝑇𝑆𝑆 𝑄𝐸𝑓𝑓
𝑀𝐸𝐵 = 𝑆𝑢𝑏 𝑀𝑆𝐵

𝐷𝑒𝑚𝑎𝑛𝑑0 : 𝑀𝑃𝐵0

𝑄
𝑄1 = 𝑄𝐸𝑓𝑓
Pigovian Taxes with Negative Externalities
• If there are negative externalities, 𝑀𝐸𝐶 > 0:
𝑀𝑆𝐶 = 𝑀𝑃𝐶 + 𝑀𝐸𝐶
𝑀𝑃𝐶 < 𝑀𝑆𝐶
• Producers (who decide how much to supply) incur only Private Costs of production and does not suffer
external costs to third parties.
• Hence Supply reflects only Marginal Private Costs of suppliers, but not Marginal Social Costs to third parties
• Supply will be too high, since producers will supply less if they have to take on external costs inflicted on third
parties.
• To achieve the efficient market output, need to cause producers to internalize (i.e. to also “enjoy” /s) the external
costs suffered by third parties
• for example: by making polluting firms pay for the cost of cleaning up pollution caused, or to pay compensation
• We need to increase Producers’ Marginal Private Costs to a level that equals Marginal Social Costs.
Pigovian Taxes with Negative Externalities
• Consider again the market for Coal in which Negative Externalities exist
• 𝑀𝐸𝐶 = $3
• Let 𝑀𝑃𝐶0 refer to producers’ Marginal Private Costs without government intervention.
ΔVC
• I.e. their marginal cost of production 𝑀𝐶 =
Δ𝑄

• Government sets a Pigovian Unit Tax that must be paid buy producers
𝑇𝑎𝑥 = 𝑀𝐸𝐶 = $3
• For each additional unit produced and sold, producers incur
• The Marginal Private Cost (𝑀𝑃𝐶0 ) directly associated the production of the additional unit
(e.g. the cost of extracting that unit of coal)
• And the Unit Tax (𝑇𝑎𝑥) paid to the government
• With the Pigovian Unit Tax, Marginal Private Costs paid by Producers increases to
𝑀𝑃𝐶1 = 𝑀𝑃𝐶0 + 𝑇𝑎𝑥
Pigovian Subsidies with Negative Externalities
• Marginal Social Cost
𝑀𝑆𝐶1 = 𝑀𝑃𝐶0 + 𝑀𝐸𝐶
• Pigovian Unit Tax
𝑇𝑎𝑥 = 𝑀𝐸𝐶
• New Marginal Private Cost with Tax
𝑀𝑃𝐶1 = 𝑀𝑃𝐶0 + 𝑇𝑎𝑥 = 𝑀𝑃𝐶0 + 𝑀𝐸𝐶
• Notice that the Pigovian Tax has made
• the Marginal Private Cost incurred by producers
• exactly the same as Marginal Social Cost to society at large
𝑀𝑃𝐶1 = 𝑀𝑆𝐶

• Since the Supply curve reflects Marginal Private Costs to producers

• The Tax has shifted the Supply curve up (reduced supply) to fully reflect Marginal Social Costs!
Effect of Pigovian Taxes with Negative Externality
𝑃
• If Negative Externalities exist,
Supply (𝑆𝑢𝑝𝑝𝑙𝑦0 ) in the absence of
𝑀𝑆𝐶 = 𝑀𝑃𝐶0 + 𝑀𝐸𝐶 the Tax only reflects Marginal
Private Costs of production for
producers
𝑀𝐸𝐶 = $3 • Marginal Equilibrium at
𝑆𝑢𝑝𝑝𝑙𝑦0 : 𝑀𝑃𝐶0 intersection of
𝐷𝑒𝑚𝑎𝑛𝑑 and 𝑆𝑢𝑝𝑝𝑙𝑦0
DWL
• Market Output without Tax is too
High
𝑄𝐸𝑓𝑓 < 𝑄0
• Market Output is inefficient due to
𝐷𝑒𝑚𝑎𝑛𝑑: Deadweight Loss (DWL)
𝑀𝑆𝐵 = 𝑀𝑃𝐵
No Positive Externalities

𝑄
𝑄𝐸𝑓𝑓 𝑄0
Effect of Pigovian Taxes with Negative Externality
𝑃
• If the Government introduces a
Pigovian Tax that equals Marginal
Market Eq with Tax 𝑆𝑢𝑝𝑝𝑙𝑦1 : External Cost
Where MSC=MSB 𝑀𝑃𝐶1 = 𝑀𝑃𝐶0 + 𝑇𝑎𝑥 𝑀𝐸𝐶 = 𝑇𝑎𝑥
= 𝑀𝑆𝐶
• Increases Marginal Private Cost to
𝑀𝑃𝐶1 = 𝑀𝑃𝐶0 + 𝑇𝑎𝑥
Decrease in Supply
𝑆𝑢𝑝𝑝𝑙𝑦0 : 𝑀𝑃𝐶0
• Supply Shifts up to 𝑆𝑢𝑝𝑝𝑙𝑦1
• New Market Equilibrium at
intersection of 𝐷𝑒𝑚𝑎𝑛𝑑 and
𝑆𝑢𝑝𝑝𝑙𝑦1 - also the intersection of
𝑀𝐸𝐶 = 𝑇𝑎𝑥 Marginal Social Cost and Marginal
Social Benefit
𝐷𝑒𝑚𝑎𝑛𝑑: • Market Output drops to 𝑄𝑒𝑓𝑓
𝑀𝑆𝐵 = 𝑀𝑃𝐵
No Positive Externalities
• New market equilibrium output is
efficient – no deadweight loss.
𝑄
𝑄0
𝑄1 = 𝑄𝐸𝑓𝑓
Effect of Pigovian Taxes with Negative Externality
𝑃
The Pigovian Tax
𝑇𝑎𝑥 = 𝑀𝐸𝐶
Market Eq with Tax 𝑆𝑢𝑝𝑝𝑙𝑦1 : ensures that the efficient output
Where MSC=MSB 𝑀𝑃𝐶1 = 𝑀𝑃𝐶0 + 𝑇𝑎𝑥
𝑄𝐸𝑓𝑓 is produced
= 𝑀𝑆𝐶
That Total Social Surplus is maximized
Decrease in Supply
𝑆𝑢𝑝𝑝𝑙𝑦0 : 𝑀𝑃𝐶0
𝑇𝑆𝑆 𝑄𝐸𝑓𝑓

𝑀𝐸𝐶 = 𝑇𝑎𝑥

𝐷𝑒𝑚𝑎𝑛𝑑:
𝑀𝑆𝐵 = 𝑀𝑃𝐵
No Positive Externalities

𝑄
𝑄1 = 𝑄𝐸𝑓𝑓
Dealing with Externalities
• We have seen that externalities will result in market failures
• That Governments can intervene to increase market efficiency by introducing Pigovian Taxes in
the case of Negative externalities and Pigovian Subsidies if Positive externalities exist.
Other ways the Government can increase market efficiency in the face of negative externalities.
• Command and Control measures – such as setting quotas that forces firms to produce the
efficient quantity of output
• though such measures are often ineffective because Government may not know what the efficient output is,
due to the lack of sufficient information
• Cap-and-Trade measures - such as tradeable emissions allowances which ensures that firms who
can limit pollutive emissions at the lowest cost does so – minimizing the cost of pollution
reduction. (The HGLO Textbook is limited on this issue, let me know if you would like to know
more, and I’ll provide you with the relevant references.)
Private Solutions to Negative Externalities
• Government Intervention may not be the only means to deal with negative
externalities
• Suppose a firm’s production is associated with negative externalities – e.g. Paper
production often requires caustic chemicals, which unscrupulous firms will dump
into rivers, resulting loss of income for fishermen downstream.
• In the absence of government intervention, it might be possible for the efficient outcome –
i.e. installation of pollution capture devices – to be achieved through negotiations between
polluting firms and affected third parties.
• Coase Theorem: If transaction costs of negotiation are low, private bargaining will
result in an efficient solution to the problem of externalities
• Please refer to Tutorial 7 for an example.
Agenda
• Externalities
• Common Goods and Public Good
Excludable vs Non-Excludable Goods
• Excludability refers to whether or not a person who does not pay for a good can be prevented
from using the good
• Intuitively, excludability depends on whether or not there are any effective ways to control access to a good
or service.

• A Good or Service is
• Excludable – if there is an effective way to prevent access to a good – for example to prevent a non-payer
from consuming the good.
E.g. A Big Mac is an excludable good – if you don’t pay for the burger,
McDonald’s won’t give you a burger to eat.
• Non-Excludable – if there is no effective way to prevent access to the good or service
• Riverfire (the annual Fireworks exhibition along Brisbane River) is Non-excludable
– there is no way to prevent people from watching the fireworks even if they are not taxpayers ☺
• The enjoyment of public safety provided by the QLD police force is Non-excludable.
Rival vs Non-Rival Goods
• Rivalry occurs when
• the consumption of a unit of a good or service by one person prevent another person from consuming the
same unit of the good or service.
• Or equivalently, consumption of one unit of a good or service reduces the quantity available to others.
• For example: Slices of Pizza
– If I eat one slice, there is one slice less for everyone else.
• A Good or Service is
• Rival – If Rivalry occurs.
Most goods such as apples, bananas, bicycles etc are Rival Goods.
• Non-Rival: Consumption by one person does not reduce availability to everyone else.
• For example, TV shows are non-rival goods – If I watch Mythbusters (Episode 248 - Duct Tape: The Return) on Netflix,
I’m not preventing anyone else from watching the same episode at the same time.
• Other examples of Non-rivalry – information/knowledge, national defence, public security, peace and quiet etc.
Types of Goods and Service
• Goods and Services can either be
• Rival or Non-rival
• Excludable or Non-Excludable
• 4 different possible combinations
Private Goods
• Private Goods are both Excludable and Rival
• One person consuming a unit of the good prevents others from using the
same unit of the good
• It is possible to prevent people who didn’t pay for the good from using it.
• Most goods and services are Private Goods – in fact we had been
implicitly assuming that the Goods and Services discussed in the
previous lectures up to this point are Private Goods.
Public Goods
• Public Goods are both Non-excludable and Non-Rival
• One person using a public good does not reduce availability to others
• It is impossible (for practical or moral reasons) to prevent non-payers from
accessing the good

• Classic example of Public Goods

• Law enforcement
• My enjoyment of security from harassment by criminals does not prevent my neighbor
from enjoying the same. (Non-Rival)
• Even non-taxpayers (e.g. tourists, international students) enjoy protection by the police
force. It will be unconscionable in Australia for a policeman to refuse to assist a non-
citizen. (Non-excludable)
• Other examples: Street lighting, Lighthouses, Breakwaters, National Defence
Public Provision of Public Goods
Since Public Goods are:
• Non-Rival
• Marginal cost of supplying a public good to another person is 0
• E.g. if street lights are already installed, it literally cost nothing for another person to benefit from the illumination of the street lights.
• The economically efficient price of Public Goods is 𝑃 = 𝑀𝐶 = 0.
• But the provision of Public Goods often requires high fixed costs (FC>0).
• Any private firm that attempts to offer Public Goods at the efficient price 𝑃 = 0 will go bankrupt, i.e. Π = 0 − 𝐹𝐶 < 0

• Non-Excludable
• Cannot prevent people enjoying Public Goods while paying nothing
• A private firm might attempt to use market power to charge 𝑃 > 𝑀𝐶 = 0 in order prevent economic losses,
but non-excludability means that most consumers will get away with paying nothing for the Public Good (i.e. to Free-ride)
• So a firm offering a public good is expected to earn 0 revenue (and hence again, incur economic losses).

• Takeaway: No private firm can profitably provide Public Goods at economically efficient levels of output.
Which is why most Public Goods are publicly provisioned – i.e. Provided by governments who fund public goods with taxes.
Quasi-Public goods
• Goods that are Excludable and Non-Rival
• Example: Cable TV, Netflix, Toll Roads
• A person who does not Pay for Netflix cannot access the service
(without leeching off a friend ;)
• A peson watching a Show on Netflix does not prevent someone else
from watching the same show at the sametime.
Common Goods or Common Resource
• Goods that are Rival and Non-excludable (which implies private cost of use =0)
• Examples: University Library books (for University students), Fishes in the sea, use of a swing at the
playground
• Extreme Case of Externalities:
• For example, borrowing a book from the Library is free (Private Cost=0)
• And the Private benefits are high –use the book to study for ECON7002 to get a good grade.
• But if I borrow a book until the end of the semester, I’m preventing others from using the same
book (due to Rivalry), which might prevent them from getting a good grade (External Cost>0)
• If there are no rules about timely returns of books, I’ll probably keep the book until the end of the
semester because I don’t experience the external cost to my classmate
• In fact, it is very likely that every student will rush to the library at the beginning of the semester hoping
to be the first to borrow textbooks and keep them until the end of the semester
• Even though it would be better if everyone took turns.
• Takeaway: The allocation of Common Resources are often inefficient.
Common Resources are very likely to be over exploited (Tragedy of the Commons)
Tragedy of the Commons
• In medieval England, “Commons” refer to a commonly shared pasture where different families in a
village have traditional rights to graze their cows
• a non-excludable resource
• Of course grass in the Commons is a rival good – grass eaten by one family’s cow is no longer available
for other cows
• So the Commons is both rival and non-excludable - a Common resource
• Without rules on usage of the Commons, it will quickly become overgrazed and useless to everyone
• For example:
If a family buys another cow and pasture it on the commons
• Gets a private benefit from the additional milk the cow will produce
• Creating a negative externality on others by reducing the amount of grass available
• Every family has an incentive to continually increase the number of cows using the commons, until the
commons become over-exploited and barren – useless to all.
• Tragedy of the Commons – the tendency for a common resource to be overused.
• Applies to other common resources like the Amazon rainforest, Fishes in the Sea
Tragedy of the Commons
• Tragedy of the Commons – the tendency for a common resource to
be overused. Applies to other common resources like:
• the Amazon rainforest
• currently being cleared at an incredible rate, because the current Brazilian government
seems unwilling to enforce laws preventing unlawful forest clearing (making land in the
Amazon a rival but non-excludable resource)
• Fishes in the ocean
• Fishes in the ocean belong to nobody, so there is no way (in the absence of regulations
or voluntary agreements) to limiting catches, so they are non-excludable
• Fishes are rival – a fish caught by one fishing boat means one less available to another
fishing boat – so fishes are common resources
• Fisheries around the world are increasingly overexploited
Overcoming Tragedy of the Commons
• Tragedy of the Commons seems to stem from one key issue:
Lack of clearly defined and enforced property rights
• If the common resource converted to private ownership
by one single person or entity
• Then the previously external cost of additional exploitation will become a private cost – and the efficient level of exploitation
should occur
• E.g. With our “Commons” example:
• If the commons is subdivided into individual family owned parcels
• the consequences to a family of pasturing additional cows will be a private cost – since additional cows will only reduce the availability
of grass on that family’s parcel of land.
• Each family will choose the optimal number of cows that balances private benefits and private costs.

• But it is not always possible to define or enforce property rights

• E.g. Impossible to define property rights over fishes swimming in international waters.
• It may not be politically possible to allocate property rights over what was previously resources available to the general
public, such as public beaches and national parks
Overcoming Tragedy of the Commons
• If it is not possible to define and allocate personal property rights over common
resources
• Governments can prevent over-exploitation of common resources by setting quotas that
limits access to the common resource
• E.g. Fishing quotas that limits the quantity of fish each fishing boat can catch
(For example, see the EU’s Common Fisheries Policy)
• Another example, a limited number of Permits required for visits to a National Park
(See quotas on Permits to climb Mt. Everest.)
• Sidenote: The use of “Commons” as an example of over-exploitation of shared common
resources has its roots as a piece of “fake news”
• as a justification for aristocrats to “enclose” previous shared commons – to transfer ownership of
the land to one individual – usually the lord of the area
• But the tragedy of the Commons is still a real issue in many (for example – traffic jams).