Notes on Micro-economics

Chapter 14-1 : Efficiency, Equity and the Government

1. Divergence between Private and Social Costs (benefit)

When a person engages in an activity that affects the well-being of an external party but neither
pay nor receives any compensation for that effect, an externality arises.

2. Negative externality
(i) A negative externality (detrimental externality) exists when a person’s action imposes costs
on other parties, but the person does not give any compensation.
(ii) With the existence of external cost, there is a divergence between private and social costs.

Social cost = private cost + external cost

(iii)
Private cost the cost borne by the person who takes the action
External cost the cost borne by the affected parties who do not receive any compensation
Social cost the cost borne by society as a whole

(iv) Examples of negative externality: Smoking, pollution, traffic congestion

3. Positive externality (Beneficial externality)

(i) A positive externality (beneficial externality) exists when a person’s action generates benefits
to other parties, but the person does not receive any compensation.
(ii) With the existence of external benefit, there is a divergence between private and social benefits.

Social benefit = private benefit + external benefit

(iii)
Private benefit the benefit gained by the person who takes the action
External benefit the benefit gained by the affected parties who do not pay for it
Social benefit the benefit received by society as a whole
(iv) Examples of positive externality: Education, research and development

4. Social optimality and market failure

(i) Social optimality
Social optimality is achieved when:
MSB = MSC
(ii) When there is no externality:

MSB = MPB
MSC = MPC

(iii) When externality exists, the output determined in the market (where MPC = MPB)
will either be higher or lower than the socially optimal level (where MSC = MSB).

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5. Market failure: negative externality and positive externality
Negative externality Positive externality
(i) MSC is greater than MPC. (i) MSB is greater than MPB
(ii) Market equilibrium quantity is greater (ii) Market equilibrium quantity is smaller than
than socially optimal quantity. socially optimal quantity.
(iii) At the market equilibrium, MSC is (iii)At the market equilibrium, MSB is greater than
greater than MSB. MSC.
(iv) There is over-production/ (iv) There is under-production/
over-consumption of the good. under-consumption of the good.

6. The condition for efficiency under externality is:

(i) Marginal social benefit (MSB) = Marginal social cost (MSC)
(ii) When there is an external cost, MSB < MSC and overproduction exists.
(iii) When there is an external benefit, MSB > MSC and underproduction exists.

7. Solutions to the problem of externalities

7.1 Government solutions
(i) A unit tax can solve the problem of negative externalities.

A unit tax MPC  Output  to efficient level

(ii) A unit subsidy can solve the problem of positive externalities.

A unit subsidy MPC  Output  to efficient level

(iii) The government may restrict a firm’s negative externality to a certain output level directly by
regulation or the government may ask it to move to other places.
(iv) Public ownership: When the government owns or takes over a firm that generates externalities,
it can choose to produce at the efficient output level.

7.2 Market solutions

(i) If private property rights are well-defined and transaction costs are zero
→ Market exchange → Solves the externality problem
(ii) If the cost of the solutions > the deadweight loss caused by the externalities
→ ‘Doing nothing’ may be the best choice