Notes
Externalities
An externality is a cost or benefit that affects people outside a transaction.
- Negative externality (pollution): the marginal social cost (MSC) is greater than the marginal private cost (MPC). The market produces too much and charges too little. Fix: a Pigouvian (per-unit) tax equal to the external cost, or regulation.
- Positive externality (vaccines, education): the marginal social benefit (MSB) is greater than the marginal private benefit (MPB). The market produces too little. Fix: a per-unit subsidy.
- The socially optimal quantity is where $MSB = MSC$. The difference from the market quantity creates deadweight loss.
Public goods
- Public goods are nonexcludable (you can't keep nonpayers out) and nonrival (one person's use doesn't reduce another's), like national defense or streetlights.
- The free-rider problem means private markets underprovide them, so government often provides them.
- Private goods are excludable and rival. Common resources are rival but nonexcludable (fisheries), leading to the tragedy of the commons.
Income inequality
- The Lorenz curve shows the share of income earned by shares of the population. The farther it bows from the line of equality, the more unequal the income.
- The Gini coefficient ranges from 0 (perfect equality) to 1 (perfect inequality).
- Taxes: progressive (higher-income people pay a higher percentage), proportional (same percentage), regressive (lower-income people pay a higher percentage, like sales taxes on necessities).
- Transfer programs and progressive taxes reduce inequality.
Government intervention and its costs
Antitrust laws limit monopoly power. Regulations and price controls can fix failures but can also create inefficiency (government failure).
Practice
A cost falls on people outside the market.
Producers don't pay the full social cost.
It makes producers pay the social cost.
Benefits spill over to others.
National defense is a classic example.
So private firms won't provide enough.
It's also called a flat tax.
Income is concentrated among few people.
Free response
Write your answer first, then open the scoring guide.
Free-response question
A chemical plant releases pollution into a river, harming fishermen downstream.
(a) Compare the market quantity of chemicals produced with the socially optimal quantity. Explain.
Show the answer and scoring guide
The market quantity is greater than the socially optimal quantity, because the plant doesn't pay the cost of pollution, so its private marginal cost is below the marginal social cost.
Check off the points you earned:
(b) Identify a government policy that would move the market toward the socially optimal quantity, and explain how it works.
Show the answer and scoring guide
A per-unit tax equal to the marginal external cost. It raises the plant's private cost to equal the social cost, so it produces less.
Check off the points you earned:
(c) Explain what happens to deadweight loss after the policy.
Show the answer and scoring guide
Deadweight loss is eliminated (or reduced), because output moves to where marginal social benefit equals marginal social cost.
Check off the points you earned: