Dr Louise Fitzgerald

Education Development Unit

ECON1101
In-class Test, Week 8

The goals of Test 2

Knowledge (ASB Learning Goal)

Explain the assumptions of standard models of microeconomics.
Explain the different market environments in which individual, social and government
decisions are made.
Explain the reasons for and outcomes of government intervention in the economy.
Critical thinking and problem solving (ASB Learning Goal)
Use the standard models of microeconomics to determine the outcome of changes in a
variety of economic variables.
To use simple mathematical models to calculate the result of changes in the economy.
Written communication (ASB Learning Goal
Construct written work which is logically and professionally presented

Sample Question

A chemical manufacturing company uses a production process which takes clean water,
at no cost from a river and then releases it back as dirty water into a lake where a
commercial fishing fleet operates.
1. Use a simple demand and supply diagram to help explain with reference to the
paragraph above why the existence of externalities means that the market will
provide an inefficient outcome.
2. Use your diagram to help explain what policies the government might use to correct
the externality.

The marker will be looking for:

Criteria
Accuracy and relevance
of information

Information is appropriately and accurately selected to

fully answer the question.

Structure and relations

in text

Text is well-structured, coherent with logically

sequenced sentences and appropriate transitions.
Text adds meaning to the diagram through
elaboration and interpretation.

Use of diagram, graph

Diagram is clearly set out and labelled, curves with

correct shape and slope. The diagram is located in
the appropriate part of the text.

Clarity, grammar,
spelling

All sentences are complete and grammatically correct.

Expression is clear i.e. appropriate terms and,
academic language is used throughout. There are
minimal spelling errors.

Model answer: well structured, coherent, logically sequenced.

This topic has not yet been taught and is being used as an example only
An externality is an unintended cost or benefit which spills over to people other than
those who undertook that activity The paragraph above is referring to the presence
of a negative externality in the production process. This means that the producer of
the good is creating spill-over costs on to other agents in the market. In this case by
polluting the river he is reducing the fishing stock and thereby affecting the catch and
the revenue of the fishing industry. He is creating costs which fall on to another
producer.
Efficiency in the market refers to the fact that when there is a perfectly competitive
industry with perfect knowledge and when the demand curves captures all the
benefits and the supply curve captures all the costs; the operation of the price
mechanism leads to a Pareto efficient situation where one person cannot be made
better off without another person being made worse off. This also means that
economic surplus is maximised. A position that is not efficient is inefficient.

Use a simple demand and supply diagram to help explain

The diagram below depicts the market when an externality is present

why the existence of externalities means that the market will provide an
inefficient outcome
On the diagram above, PMC is the Private l Marginal Costs while SMC represents the
Social Marginal Costs (which is PMC with the external costs added). These external
costs are the costs which are created by the chemical company but which are borne
by the fishing industry.
The demand curve (D) is both the Private Marginal Benefit curve and the Social
Marginal Benefit curve because there are no externalities in consumption.
An efficient allocation of resources occurs when the Social Marginal Costs (SMC) equal
Social Marginal Benefits (SMB). At this point welfare is maximised. On the diagram
this occurs where Price is Ps and output is Qs.
Producers only consider their own costs and benefits and so produce where Private
Marginal Benefits equals Private Marginal Costs. On the diagram this occurs at
output level Qp and Price Pp.
As a result the producer is producing too much and selling at a price that is too low. This
results in an inefficient use of resources and economic welfare is not maximised. The
loss in welfare is shown by the triangle A on the diagram.

Use your diagram to help explain what policies the government might use
to correct the externality.
There are a number of government policies that could be used to correct the
externality
First, the government could tax the chemical company an amount equal to the level of
the externality. In this way the polluter is forced to internalise the external cost. This
would raise the cost curve of the chemical company by an amount equal to the tax.
On the diagram this would be shown by an upward shift of the PMC curve so that it
equals the SMC curve. As a result, the firm would now produce at the efficient level of
Qs and charge a price of Ps. The economic surplus would be maximised and there
would be no dead weight loss.
Second, the government could put a quota on the production of the chemical company
so that it only emitted a fixed amount of pollution. In this case the firms supply curve
would become perfectly inelastic at the output level which is efficient. This is shown
in the diagram above by Si.
Alternatively, the government could zone chemical companies so that they could not
manufacture near rivers. This policy can however, not be shown on a diagram.