1. AP MICROECONOMICS UNIT #6 MARKET FAILURE/ ROLE OF GOVERNMENT
Lecture 7
Correcting Negative Externalities

2. Externalities and Deadweight Loss
Inefficiency causes deadweight loss
Negative Externalities create efficiency losses due to overproduction
Positive Externalities create efficiency losses due to underproduction

3. Deadweight Loss Graph 1

4. Deadweight Loss Graph 2

5. Correcting Market Failure
Does the government have to or need to become involved?

6. Coase Theorem
Ownership of private property produces an incentive to “negotiate away” negative externalities
Ownership places a price tag on the externality and creates opportunity costs for affected groups

7. Government Correction of Externalities
Direct Control
make laws (ex. EPA rules)
Taxation for Negative Externalities
directly tax the related good (ex. Excise taxes on cigarettes)
Subsidies for Positive Externalities
Payments as incentives to producers or consumers

8. Taxes Reduce Overallocation
Directly taxing the good shifts the firm’s supply curve (MPC) to the socially optimal supply curve (MSC) to reduce overallocation

9. Negative Externality: Resolving with a Tax
Price of ST
Aluminum
Tax DT S
(MPC)
Optimum
QOPTIMUM
Equilibrium
QMARKET
Quantity of
Aluminum
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10. Subsidies Correct Underallocation
Consumers: payments to consumers would shift the demand to the socially optimal level at a higher price
Producers: payments to producers would shift the supply to the socially optimal level because they would be compensated for the additional production
Per unit subsidies are required for producers to alter production

11. Positive Externality: Resolving with a Subsidy
Price of
Education DT D
(MPB) ST
QOPTIMUM
Subsidy
QMARKET
Quantity of
Education
Copyright © South-Western

12. Another Solution Government creates a market for pollution
Sells pollution rights to producers on the open market
Rights are fixed so there is inelastic supply
Increased demand increases cost of the pollution rights
Some pollution may be necessary for MSB > MSC

13. Selling Pollution Rights

14. Government Failure
Government does not always perform its economic functions
Gap between sound economics and politics
Special-Interest Effect
Small group benefits from a government policy while a much larger group incurs individual losses
Rent-Seeking
Groups that seek special benefits from the government at taxpayers’ expense

15. Burden of Taxes Taxes are imposed on the suppliers
Increases the MC of the product
Producers shift part of the tax burdent to consumer
Equilibrium quantity declines due to higher prices

16. Elasticity and Tax Incidence14 12 10 8 6 4 2 5 15 20 25 Q P St S
Price (Per Bottle)
Quantity
(Millions of Bottles Per Month)
Tax $2 D
LO3
16-16

17. Impact of Elasticity
The more inelastic the demand, the greater the tax burden placed on consumers
The more inelastic the supply, the greater the tax burden placed on producers
Efficiency loss occurs any time there is a tax because there is less production
Deadweight Loss

18. Elasticity and Tax IncidenceP P St
Tax
Tax St S a S P1 P b a Pe Pb c P1 b De Pa c Di Q2 Q1 Q2 Q1
Elastic Demand
Inelastic Supply
Smaller efficiency loss with inelastic demand
LO3
16-18

19. Elasticity and Tax IncidenceP P St S
Tax
Tax St a Pe S a b Pi P1 P1 b Pa c Pb c D D Q2 Q1 Q Q2 Q1 Q
Elastic Supply
Inelastic Supply
Smaller efficiency loss with inelastic supply
LO3
16-19

20. Efficiency Loss of a Tax5 10 15 20 25 Q P 14 12 8 6 4 2
Tax paid
by consumers St
Tax $2 S
Price (Per Bottle)
Quantity
(Millions of Bottles Per Month)
Efficiency
loss (or
deadweight loss)
Tax paid
by producers D
LO3
16-20