In this section we consolidate the preceding explanation and analysis by looking at how a government can use indirect taxes and subsidies to correct the market failures that result from externalities, the underconsumption of merit goods and the over-consumption of demerit goods.
If the consumption of a good or service is associated with a positive externality the demand curve for the good will fail to take this into account, and will only reflect the private benefits enjoyed by consumers. That is, individuals only consider their private benefit from
consuming the good and the market demand curve measures the marginal private benefit derived from the good. In this case, because of the positive social benefit, the marginal social benefit curve will lie to the right of the demand curve. Such a good is a merit good and the position of the two curves is shown in Figure 6.11.
Figure 6.11: The marginal social benefit curve and positive externalities (merit goods)
Conversely, if the good is a demerit good, its marginal social benefit curve will lie to the left of its demand curve because of its negative externality. This is shown in Figure 6.12.
Benefits and costs
£s
Output Supply Positive
externality
Demand
(Marginal Private Benefit)
Marginal Social Benefit
Figure 6.12: The marginal social benefit curve and negative externalities (demerit goods)
A similar situation prevails with the negative externalities that can arise with production. The supply curve for a good or service only takes account of the private costs incurred by the producer of the good. The social costs created by any negative externalities during the process of production, such as water or atmospheric pollution, are ignored by the firm. In this case the firm's supply curve, which measures the marginal private cost of production, lies below the marginal social cost curve that adds the cost of the negative externality to the private costs. This is shown in Figure 6.13.
Figure 6.13: The marginal social cost curve and negative externalities
Benefits and costs
£s
Output Demand Negative
externality
Supply
(Marginal Private Cost)
Marginal Social Cost
Benefits and costs
£s
Output Supply Negative
externality
Demand
(Marginal Private Benefit)
Marginal Social Benefit
In some cases the production process for a good or service creates a positive externality and the firm's supply curve fails to reflect the social cost of producing the good. For example, the smelting of aluminium involves large amounts of energy and creates waste heat. In the UAE the waste heat from the aluminium plants is used to distil sea water into fresh water that is then used for irrigation. Unfortunately such examples of positive externalities in production are much less common than the negative externalities due to pollution. Figure 6.14 illustrates the situation in which production creates a positive externality and the marginal social cost curve lies below the supply curve.
Figure 6.14: The marginal social cost curve and positive externalities
Now we can combine the curves shown here and analyse the action required from government to correct the market failures that result from externalities in production and consumption. Figure 6.15 illustrates how a subsidy can be introduced when the marginal social benefit from a good exceeds the marginal private benefit. In the absence of a government subsidy, the free market equilibrium is where the demand and supply curves, which are also the marginal private benefit and cost curves, intersect at point E. At this point too little is being produced and consumed when account is taken of the marginal social benefits. The private market equilibrium quantity is Q1which is less than the socially optimum level of output Q2, determined at the point where the marginal private and social costs are equal, point G.
Benefits and costs
£s
Output Demand Positive
externality
Supply
(Marginal Private Cost)
Marginal Social Cost
Figure 6.15: Subsidies and the socially optimum production level
To achieve the socially optimum level of production and consumption (Q2), where the marginal social benefit equals the marginal private cost of production at G, the government should pay firms a production subsidy of GH per unit produced. The subsidy is equal to the value of the externality which is the difference between the marginal social and marginal private benefits at point G.
In the situation where there is a negative externality in production, because the marginal social cost of production exceeds the marginal private cost, firms overproduce the good in relation to the socially optimum level of production and consumption. Output, if left to the free market is Q1, which exceeds the social optimum level of Q2. To correct the market failure the government needs to make firms take account of the negative externality they are
responsible for creating. The solution in this case is to impose an indirect tax on each unit of output equal to the difference between marginal social and private costs at the point where the marginal social cost curve intersects the marginal private benefit curve. This requires a tax of EF per unit. This is illustrated in Figure 16.16.
Benefits and costs
£s
Output
Demand = Marginal Private Benefit Supply = Marginal Private Cost (MPC)
MPC – Subsidy of GH per unit
Marginal Social Benefit (MSB)
Q1 Q2
E
H G
Figure 6.16: Taves and the socially optimum production level
Review Points
This is one of the most important units in the Study Manual. If you have not mastered its content you are unlikely to be able to achieve a satisfactory level of understanding of economics. Because of the fundamental role of the forces of supply and demand in the determination of prices in markets, and their significance for the behaviour of firms, and government intervention in markets, you need to make absolutely certain that you fully understand the content of this unit if you want to pass the examination in this subject.
It is absolutely vital, before you continue with the next study unit, that you should go back to the start of this one and check that you have achieved the learning objectives and feel confident in undertaking demand and supply curve diagram analysis. If you do not think that you understand fully each of the learning outcomes you should spend more time reading the relevant sections.
You can test your understanding of what you have learnt, and your ability to use demand and supply curve analysis, by attempting to answer the following questions. Check all of your answers with the unit text.
1. In a free market, is the equilibrium market price determined by:
(i) demand alone (ii) supply alone
(iii) the interaction of demand and supply (iv) government intervention?
2. If the supply curve is upward sloping, other things remaining unchanged, will a rightward shift in market demand result in:
(i) a decrease in the equilibrium price and quantity supplied, or (ii) an increase in the equilibrium price and quantity supplied?
Benefits and costs
£s
Output
Demand = MPB Supply = MPC Marginal Social Cost (MSC)
+ unit tax of EF per unit
E
F
Q1 Q2
3. If the demand curve is downward sloping, other things remaining unchanged, will a rightward shift in the supply curve result in:
(i) a decrease in the equilibrium price and an increase in the quantity supplied, or (ii) an increase in the equilibrium price and quantity supplied?
4. The following diagram shows the initial equilibrium position, Q1, in the market for a normal good and a second demand curve D2.
Could the rightward shift in the demand curve be the result of:
(i) a decrease in the price of a substitute good (ii) an increase in the incomes of consumers
(iii) the introduction of an indirect tax on the good by the government?
5. Explain the meaning of the following:
(i) externality (ii) social cost (iii) social benefit.
6. If consumption of a good yields a positive external benefit, is the good referred to as:
(i) a demerit good, or (ii) a merit good?
7. In the absence of intervention by the government, if the social marginal cost of a good exceeds its marginal private cost is the good:
(i) overproduced (ii) under-consumed?
Quantity of output Price
Supply
D1
D2
Q2 Q1
0
8. Explain the meaning of the following:
(i) price floor (ii) price ceiling (iii) output quota.
9. The following diagram shows the free market equilibrium position, Q1, for a merit good.
To achieve a socially optimal level of production and consumption of the good should the government intervene in the market and:
(i) pay producers a subsidy of AB per unit (ii) tax producers AB per unit produced (iii) impose a price ceiling of P2
(iv) impose a price floor of P1? B Price
Supply = marginal private cost = marginal social cost
D1= marginal private benefit
D2= marginal social benefit A
P2
Quantity of output Q2
Q1 0
P1