Question

3. For each of these examples of externalities consider a private good market. Think whether external costs/benefits are associated with the production or consumption of the good in question. Then draw a MD-MC diagram to show the effect of this externality in a free competitive market. How does free-market output of the good/service in your example differ from the socially optimal level of output? Use your graph to illustrate the deadweight loss created by the externality in question. Example 1: A New Hampshire textile mill releases pollution into nearby wetlands, and the associated health and ecological damages are not considered in the private market. Assume that environmental damages from pollution are increasing as more and more effluent is being released. Example 2: People who purchase used (second-hand) goods buy them because of the private value/benefit they get from these goods. They also help lower the volume of waste and, as a result, reduce groundwater contamination from landfills. Example 3: Electronic waste describes discarded electrical or electronic devices. Informal disposal of electronic waste may cause serious health and pollution problems.

Answer 1

In each graph, price (P) and quantity (Q) are shown in vertical and horizontal axes, respectively. D and MPC are initial MD and MC curves intersecting at point A with market equilibrium price P0 and market equilibrium quantity Q0.

(Example 1)

The dumping of pollution creates a negative externality in production, giving rise to external cost. This shifts MPC leftward to MSC (marginal social cost) where vertical distance between MPC and MSC is the unit external cost.

Efficient outcome is at point B with efficient price P1 (higher than P0) and efficient quantity Q1 (lower than Q0). Deadweight loss equals area ABC.

MP 9.

(Example 2)

Purchase of used goods which lowers pollution creates a positive externality in consumption, giving rise to external benefits. This shifts private marginal benefit (PMB) curve rightward to SMB (marginal social benefit) where vertical distance between PMB and SMB is the unit external benefit.

Efficient outcome is at point B with efficient price P1 (higher than P0) and efficient quantity Q1 (higher than Q0). Deadweight loss equals area ABC.

Price PMC P1--- PO--- SMB PMB QO Q1 Quantity

(Example 3)

Informal disposal of e-waste creates a negative externality in production, giving rise to external cost. This shifts MPC leftward to MSC (marginal social cost) where vertical distance between MPC and MSC is the unit external cost.

Efficient outcome is at point B with efficient price P1 (higher than P0) and efficient quantity Q1 (lower than Q0). Deadweight loss equals area ABC.

MP 9.