According to The World Bank, 16 of the 20 most polluted cities
in the world are in China. A plan to lift Beijings shroud of
pollution ahead of the Olympic Games includes stopping half of Beijings 3.3 million vehicles and shutting down chemical plants, power stations and foundries to cut emissions by 30%.
(a) Using appropriate examples, explain and illustrate the terms externality and public goods. [10] (b) Assess whether the measures stated above is the best way to curb pollution in China. [15] (a) Using appropriate examples, explain and illustrate the terms externality and public goods. [10] INTRODUCTION Define market failure Failure of unregulated free market to achieve efficient allocation of resources and/or other social goals Two examples of sources of market failure: externalities and public goods DEVELOPMENT Externalities Definition: third-party effects arising from production or consumption of a good or service, for which the third-party neither pays nor receives any compensation There can be negative or positive externalities (a) Using appropriate examples, explain and illustrate the terms externality and public goods. [10] (a) Using appropriate examples, explain and illustrate the terms externality and public goods. [10] DEVELOPMENT Negative externalities An example of negative externalities is ___. In the pursuit of self-interest, producers of ___ will only consider their own private costs, ignoring external cost imposed on society, such as ___. As shown in the diagram, this creates a divergence between MSC and MPC of the distance of the MEC You may want to assume constant or increasing MEC (a) Using appropriate examples, explain and illustrate the terms externality and public goods. [10] DEVELOPMENT Negative externalities Assuming that that MSB = MPB, the free market results in an overproduction of ___, above the socially optimal level of output (___) where MSB = MSC. The resulting deadweight loss of area ___ indicates an inefficient allocation of resources in the free market. 6 A E E 1 Quantity Price 0 MPB = MSB MPC
Q
R Socially ideal output = 0R Actual output = 0Q Overproduction Welfare Loss to Society (DWL) MSC = MPC + MEC MEC What you need to know Deadweight loss is the decrease in total society surplus that results from an inefficient level of production Introduction to Negative Externalities 7 A E E 1 Quantity Price 0 MPB = MSB MPC
Q
R Welfare Loss to Society (DWL) MSC = MPC + MEC MEC How to draw the diagram Introduction to Negative Externalities 1. Draw MPC and MPB diagram 2. Indicate Qty (free market) 3. Draw MSC 4. Indicate MEC 5. Indicate Qty (socially optm) 6. Highlight DWL 8 Practice time: Activity - Smoking Introduction to Negative Externalities 1. Identify good / service as one with negative externalities
The consumption of cigarettes; smoking creates negative externalities which are costs spilled over to 3 rd parties not involved in the consumption of the good. 9 Practice time: Activity - Smoking Introduction to Negative Externalities 2. Identify MEC such that MSC > MPC
In such an activity, there incurs external cost on 3 rd parties and this external cost is not taken into account by private consumers of cigarettes. This causes the marginal social cost of smoking to be greater than the marginal private cost due to the marginal external cost burdened on 3 rd parties.
This marginal external cost comes in the form of 2 nd hand smoke which non-smokers inhale, possibly leading to health problems such as lung cancer. 10 Practice time: Activity - Smoking Introduction to Negative Externalities 3. Explain that when left to a free market, production (consumption) will be at MPB=MPC
When left to the free market, a smoker will choose to consume cigarettes to the point where his marginal private benefit is equal to his marginal private cost.
In this case, his satisfaction and happiness will determine his marginal private benefit and the cost of the cigarettes as well as the health damage to himself makes up his marginal private cost. 11 Practice time: Activity - Smoking Introduction to Negative Externalities 4. Explain that societys welfare will instead be at MSB=MSC
However, societys welfare is not maximised in this case as the socially optimum level of consumption should be where marginal social benefit to society is equal to the marginal social cost. Because the external cost to 3 rd parties are not considered in a smokers consumption of cigarettes, marginal social cost is thus greater than marginal private cost. 12 Practice time: Activity - Smoking Introduction to Negative Externalities 5. Identify over production of good
Thus, an over-consumption of cigarettes occur, whereby qty when left to the free market is higher than where it is allocatively efficient for society. 13 Practice time: Activity - Smoking Introduction to Negative Externalities 6. Explain dead weight loss is observed and thus society is not at allocative efficient point.
This overconsumption of cigarettes that causes society to be allocatively inefficient thus result in a dead weight loss to society, thus explaining market failure in smoking. (a) Using appropriate examples, explain and illustrate the terms externality and public goods. [10] DEVELOPMENT Positive externalities Example (e.g., vaccination) Self-interest External benefit Diagram Divergence between MSB and MPB (a) Using appropriate examples, explain and illustrate the terms externality and public goods. [10] DEVELOPMENT Positive externalities Assuming MSC = MPC Underconsumption Socially optimal level of output where MSB = MSC Deadweight loss Inefficient allocation of resources (a) Using appropriate examples, explain and illustrate the terms externality and public goods. [10] DEVELOPMENT Public Goods 2 key features: non-rivalry and non-excludability Non-rivalry: consumption of a good or service by one person does not reduce amount available to others Non-excludability: not possible or very costly to exclude a non-payer from consuming the good or service An example is ___. (a) Using appropriate examples, explain and illustrate the terms externality and public goods. [10] DEVELOPMENT Public Goods It is non-rivalrous because ___. Once produced, the marginal cost of providing ___ to the additional user is zero, meaning that the price has to be zero for allocative efficiency. It is non-excludable because ___. This leads to the free rider problem, where no one has the incentive to pay for ___. Typically, a public good will not be provided by the free market, even though people want to consume it. This represents an inefficient allocation of resources. (a) Using appropriate examples, explain and illustrate the terms externality and public goods. [10] CONCLUSION (an example) As a result of sources of market failure such as externalities and public goods, the unregulated free market will be unable to achieve an efficient allocation of resources. Hence, government intervention may be required to correct the market failure, and this will be discussed in (b). (b) Assess whether the measures stated above is the best way to curb pollution in China. [15] INTRODUCTION Clarify that pollution is a form of externality Clarify measures Stopping vehicles in Beijing Shutting down chemical plants, etc Clarify objective specified in question Curbing pollution in China Criteria for best Effectiveness Desirability Feasibility Note: best, most effective, only must consider alternatives! (b) Assess whether the measures stated above is the best way to curb pollution in China. [15] DEVELOPMENT Briefly explain the stated measures Stopping vehicles in Beijing A form of quota limit max no. of cars on roads in Beijing Diagram with perfectly inelastic supply curve Shutting down chemical plants, etc Ban on production of such goods altogether within Beijing Diagram indicating production of the good is zero (b) Assess whether the measures stated above is the best way to curb pollution in China. [15] DEVELOPMENT Advantages of the stated measures Effectiveness Meets objective of reducing pollution from cars and the industrial entities in Beijing Desirability Less congestion and pollution for non-car owners Also good for tourism and future growth Feasibility Relatively quick to implement
(b) Assess whether the measures stated above is the best way to curb pollution in China. [15] DEVELOPMENT Limitations of the stated measured Effectiveness Depends on estimation of optimal quantity (information) Does not curb pollution in China, only in Beijing Desirability May result in varying degrees of allocative inefficiency (depending on type of measures and effectiveness) Possible losses in production (from industrial entities) and productivity (for car drivers who did not obtain the permit) (b) Assess whether the measures stated above is the best way to curb pollution in China. [15] DEVELOPMENT Limitations of the stated measured Feasibility May not be sustainable over time May not be feasible across whole of China Ease of enforcement (corruption?) (b) Assess whether the measures stated above is the best way to curb pollution in China. [15] DEVELOPMENT Explain and examine pros and cons of at least two other alternatives, e.g., Education (dd-side) Long term measure May not reap immediate results Results not guaranteed (b) Assess whether the measures stated above is the best way to curb pollution in China. [15] DEVELOPMENT Explain and examine pros and cons of at least two other alternatives, e.g., Tax (ss-side) Market-based approach which internalises the externality Tax revenue can be further channelled to R&D Difficulty in estimating the right amount of tax Tradeable permits Other regulatory measures (b) Assess whether the measures stated above is the best way to curb pollution in China. [15] CONCLUSION Make a stand and justify Overall, which is the best measure? Why? Relate back to aim of curbing pollution in China Cost-benefit analysis Cost of implementation / enforcement compared with the LR and SR benefits of the measures Combination of measures