Social Welfare Analysis---Negative Externalities

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Social Welfare Analysis--Negative Externalities


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Social Welfare Analysis : Social Welfare Analysis Negative Externalities

PowerPoint Presentation : Price Of _____ Market for ______ Quantity of ______ Qe P e D*= MPB S* = MPC “A” T he production and consumption of this good produces a “negative externality”. There is a cost in producing and consuming this good that is not included in the market price of this good. In other words, neither t he buyer nor the seller are paying for any negative effects the production OR the use of this good imposes on “Third Parties” (others not directly involved with the transaction). Examples : Pollution from an SUV that makes breathing harder for asthmatics. Noise from night club next door to you. Bad smells from a neighborhood restaurant.

PowerPoint Presentation : Price Of _____ Market for ______ Quantity of ______ Qe P e D*= MPB S* = MPC “A” This cost imposed on Third Parties outside the transaction is known as an “ External Cost ” and it is not absorbed into the “ Private Cost “ of Production. The Private Cost of Production reflects ONLY the cost of combining societal resources into the making of a good and not any residual costs the production might impose on others. This is embodied in the market supply curve “ S*=MPC ” highlighted in RED .

PowerPoint Presentation : Price Of _____ Market for ______ Quantity of ______ Qe P e D*= MPB S* = MPC “A” Bottom line : There is a cost to society that is not absorbed into the private market production of this good (along our supply curve “S*= MPC”). We want to see what the market would ACTUALLY look like if we were to include this S ocial Cost into the production of the good. ARE YOU READY???

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ D*= MPB S* = MPC T he market price of our good is $1.00 (“ Pe = $1.00”) and the market quantity in Equilibrium is 100. We produce 100 units of this good and each one has a market price paid by buyers of $1.00 and the cost of producing the good is $1.00 for producers (assume break-even).

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ $1.50 $.50 D*= MPB S* = MPC Assume we can quantify the external, social cost imposed by the production of this good that is NOT currently reflected in S* = MPC and that cost is $.50 per unit. This means that producing 100 units of the good should now cost $.50 per unit more than it did before at $1.00. So the total cost (hence the price the producer must receive to produce those 100 units) is $1.50

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ $1.50 $.50 D*= MPB S* = MPC What is true at 100 units and $1.50 is going to be true at ALL OTHER POINTS along our market supply curve “ S*=MPC” as well.

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ $1.50 $.50 $.50 D*= MPB S* = MPC

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ $1.50 $.50 $.50 $.50 D*= MPB S* = MPC

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ $1.50 $.50 $.50 $.50 S 1 = MSC D*= MPB S* = MPC KEY POINT : Connect those n ew points that now INCLUDE t he external cost and we create n ew supply curve “ S 1 = MSC ” MSC stands for “ Marginal Social Cost”. It is the market supply curve that INCLUDES the cost imposed on society due to the negative externality as well as the private cost of producing the good

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ 75 $1.25 “B” D*= MPB S* = MPC S 1 = MSC Using basic supply and demand Analysis, we can see our market Is in equilibrium at Point “B” at a price of $1.25 and market Quantity of 75 because including The social cost of $.50 has shifted the “S*= MPC” Curve to the LEFT and it has become the “ S 1 = MSC ” curve now.

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ 75 $1.25 “B” D*= MPB S* = MPC S 1 = MSC IMPORTANT POINT: Because we include the social cost of $.50 per unit of producing this good we can assume the more SOCIALLY OPTIMAL (or desirable) Quantity of this good is 75 and a more SOCIALLY OPTIMAL Price for this good is $1.25--- Less of this good at a higher price than before. Read that again so you understand it!

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ 75 $1.25 “B” D*= MPB S* = MPC S 1 = MSC IMPORTANT POINT: Because the market does not internalize the external cost we can conclude this market is producing too much of this good (100 as opposed to 75) at too low a price ($1.00 as opposed to $1.25. Read that again to make sure you understand it!!

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ 75 $1.25 “B” D*= MPB S* = MPC S 1 = MSC What you observe here in this graph is the difference between what “IS” (Equilibrium at Point “A”) and what “ SHOULD BE ” (Equilibrium at Point “B”). In other words, Point A is what the market is actually producing and Point B is what is more Socially Optimal if ALL costs to society were included. What we want to identify now is the “ Social Welfare Lost ” (Dead Weight Loss (DWL)) to society for NOT including the External Costs.

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ $1.50 75 $1.25 “B” D*= MPB S* = MPC S 1 = MSC “C” To do this, we need to back up to the original graph showing the initial inclusion of the external costs of $.50 for producing 100 units of the good---Point “C”.

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ $1.50 75 $1.25 “B” D*= MPB S* = MPC S 1 = MSC “C” Focus on the vertical distance between “A” and “C”. At point “C” the cost of producing the 100 unit is $1.50 BUT the Benefit buyers receive is only worth $1.00 (Point “A” along D* = MPB curve). Including the External Costs makes the cost of the producing the good GREATER than the benefit received from consuming the good.

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ $1.50 75 $1.25 “B” D*= MPB S* = MPC S 1 = MSC “C” KEY POINT: Notice the SAME thing occurs as you move along S1 = MSC between Points “C” and “B” AND as you move along D*=MPB between points “A” and “B”. At every point the cost exceeds the benefit . When we reach “B” the PRIVATE benefit at a price of $1.25 of consuming 75 units of the good equals the Private + the SOCIAL costs of producing the good, also $1.25.

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ $1.50 75 $1.25 “B” D*= MPB S* = MPC S 1 = MSC “C” Let’s fill in that IMPORTANT area where all this action took place. This area is represented b y the GOLD triangle. MAJOR TAKEAWAY: Everywhere along the S1 = MSC between “B” and “C” and everywhere along D* =MPB between “B” and “A” represents production and consumption that WOULD NOT TAKE PLACE if the external cost were included in the Private cost of production because the cost exceeds benefit all along those points.

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ $1.50 75 $1.25 “B” D*= MPB S* = MPC S 1 = MSC “C” This area represented by the GOLD Triangle identifies Social Welfare Lost or Dead Weight Loss (DWL)

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ 75 $1.25 “B” D*= MPB S* = MPC S 1 = MSC “C” Click FORWARD one slide to see the market WITHOUT including the external cost Of a Negative Externality.

PowerPoint Presentation : Market for ________ Quantity of _______ 100 P e = $1.00 “A” Price Of _____ D*= MPB S* = MPC Click BACKWARD one slide to see the market WITH the external costs included To account for the Negative Externality.

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