Socially optimum output

1. Previously, we saw that the demand and supply curves could be understood as the representation of the private benefits and costs associated with consumption and production, where:
   1. Marginal Private Benefit (MPB): the additional benefit to the consumers from consuming an extra unit of good
   2. Marginal Private Cost (MPC): the additional cost to the producers from producing an extra unit of good.
2. These marginal private benefits and costs guide consumer and producer decisions on how much to demand and supply.
3. However, private benefits and costs don't always align with the social benefits and costs that society obtains from consuming and producing a good or service.
4. Therefore, economists make a distinction between the Marginal Private Benefits/Cost and the Marginal Social Benefits/Cost.
5. Reflecting society as a whole, the socially optimal output occurs at a production level where Marginal Social Benefit (MSB) equals the Marginal Social Cost (MSC):

$$MSB=MSC$$

where:

1. Marginal Social Benefit (MSB) is the additional benefit to the society from consuming an extra unit of good.
2. Marginal Social Cost (MSC) is the additional cost to the society from producing an extra unit of good.

In Figure 1, it can be seen that in absence of externalities:

1. The demand curve ($D$) represents both Marginal Private Benefit (MPB) and the Marginal Social Benefit (MSB) at the same time
2. The supply curve ($S$) represents both Marginal Private Cost (MPC) and the Marginal Social Cost (MSC) at the same time
3. Thus the social optimum output is reached at their intersection, at quantity $Q_{opt}$. This level of output achieves allocative efficiency.

However, Figure 1 depicts a free market where there are no externalities.

In reality, most of the times there are externalities, which alter the allocation of resources and can be:

1. Positive production externalities.
2. Positive consumption externalities.
3. Negative production externalities.
4. Negative consumption externalities.

Positive externalities of production and consumption and welfare loss

Positive Production Externalities

1. Goods and services with positive production externalities have a positive impact in society when produced.
2. This is because the Marginal Social Cost of production is lower that the Marginal Private Cost of production.

1. Figure 2 above showcases the representation of a positive production externality:
   1. The market is producing at the equilibrium set by the marginal private benefits and marginal private costs, reflected by the demand and supply curves. This market equilibrium occurs at:
      1. Quantity $Q_m$.
      2. Price $P_m$.
   2. However, there is an externality, and so the effects to society of producing good $x$ are different than the private ones.
   3. In this case, the externality is positive and of production, meaning that there is a positive spillover effect on society from the production of good $x$.
   4. This is occurs because the marginal costs to society of each unit produced are lower than the marginal private costs faced by producers.
   5. Resultantly, the MSC curve is below the MPC curve, separated by the value of the externality.
   6. As we say, the socially optimal level is determined by $MSB=MSC$, and so the intersection of the MSB and MSC curves yields:
      1. The socially optimum output quantity ($Q_{opt}$).
      2. The price $P_{opt}$.
   7. However, this social desirable quantity ($Q_{opt}$) is higher than what is being produced by the market ($Q_m$): $Q_{opt}>Q_{m}$.
2. Therefore, due to the positive production externality, the free market fails by under allocating its resources, and producing below socially optimal level.

Welfare Impact of Positive Production Externalities

1. Since there is a misallocation of resources, in the form of under allocation in this case, this means that the market fails to achieve allocative efficiency, hence there will be a welfare loss.
2. In the diagram we can observe that:
   1. At the current production level, the DWL is equal to the area $\frac{(MSB-MSC)\times(Qopt-Qm)}{2}$.
   2. If the externality is corrected, the society will gain this area as part of their welfare.
3. The externality can be corrected though:
   1. Direct Government Provision
   2. Subsidies

Direct Government Provision

In, Figure 4, it could be seen that by direct government provision, the supply curve will shift to the right, closer to the $Q_{opt}$ level, hence correcting the externality and achieving efficient allocation of resources.

Subsidies

In Figure 5, it could be seen that by providing a subsidy, the government shift the MPC curve to the right, closer to the socially optimal level, which slowly eliminates the externality, as the production increases.

Positive Consumption Externalities (PEC)

Understanding positive consumption externality helps in understanding situations where a good for which consumption has positive impacts on others, is being under consumed.

1. In the diagram could be seen
   1. The representation of positive consumption externality
      1. Since the externality is due to consumption, the supply curve represents both MSC and MPC.
      2. Since this is a market with externalities, the socially optimal level is determined by $MSB=MSC$, hence the optimal quantity is $Q_{opt}$, and the optimal price is $P_{opt}$
   2. Hence the market under allocates the resources for the production of the good as $Q_{m}<Q_{opt}$

Welfare impact of Positive Consumption Externalities (PEC)

1. In the Diagram it could be seen that:
   1. At the current production level, the DWL is equal to the area $\frac{(MSB-MSC)\times(Qopt-Qm)}{2}$.
   2. If the externality is corrected, the society will gain this area as part of their welfare.
2. The Externality can be correct through:
   1. Government legislation and regulation
   2. Education and awareness creation
   3. Nudges (HL only)
   4. Direct government provision
   5. Subsidies

Use of legislations, regulations, education, and nudges in response to PEC

1. Government legislation and regulation
   1. Legislation can be used to encourage the use of goods with positive externalities.
   2. As can be seen in the diagram, the MPB curve shifts to the right, closer to the MSB curve to correct the externality.
2. Education and awareness creation
   1. Educate people about the positive effects of certain goods, hence increasing its use.
3. Nudges (HL Only)
   1. Encourage the use of goods with positive spillovers through persuasion.

Direct government provision

1. Certain goods with high third party positive effects, such as healthcare should not only be provided by the market, but by government as well.
2. This as observed in the graph, increase the supply by shifting it to the right, until the social optimum quantity $Q_{opt}$ is reached, and externality is corrected.

Subsidies

1. Similar to direct government provision however, it can be done more efficiently by market firms due to competition.
2. These also increase the supply to the point where the production reaches $Q_{opt}$.
3. Note that the price decreases as well.

Merit Goods

Merit goods are essentially under provided because:

1. Low income household are not able to buy the goods that they desire, hence the low demand decreases its provision in the market.
2. Goods such as education have positive externalities, hence they are always under provided, as there can always be more of them.
3. Many consumers are unaware about the beneficial effects of certain goods, hence do not demand those goods.

Negative Externalities: Overproduction of Demerit Goods

Negative Production Externalities

These externalities lead to an overproduction in a market, which causes market failure.

As it can be seen in the diagram:

1. The current level of production $Q_m$, is greater than socially optimal level $Q_{opt}$ ($Q_m>Q_{opt}$), therefore there is overallocation of resources
2. The externality is represented by the distance between MSC and MPC

Welfare Impacts of Negative Production Externalities

Since the market level of production is not at socially optimal level, there is a welfare loss for the society.

In Figure 12, we observe that:

1. There is a welfare loss represented by the shaded area.
2. This means that for every unit consumed above $Q_{opt}$, the society loses welfare.

In order to correct these externalities, there are various approaches:

1. Market Based Policies
   1. Indirect Pigouvian taxes
   2. Carbon taxes
   3. Tradable permits
2. Collective Self Governance
3. Education and Awareness Creation
4. International Agreements
5. Government legislation and Regulation

Demerit Goods

1. Demerit goods being socially not desirable, produce negative externalities:
   1. This can be due to the fact that consumers do not take into consideration long term impacts of those goods
   2. Also because consumers are not fully aware of the impacts that these goods have
2. If the government does not try to regulate the market for merit goods:
   1. there will be an overproduction of it, causing a misallocation of resources, hence a market failure.

Common Pool Resources: The Tragedy of the Commons

Characteristics of Common Pool Resources

The defining characteristics of common pool resources are:

1. Rivalrous: When one person’s use of a resource reduces the availability of that resource for others.
2. Non-excludable: No individual can be excluded from using this resource

The Tragedy of the Commons

Unsustainable production creating negative externalities

1. Nowadays a lot of practices are using many natural resources at an unsustainable rate, which does not allow for their regeneration and depletes them in long term.
2. As a result:
   1. Negative externalities are being created which harms the environment.
   2. Economies or households relying these resources become worse off as they are not able to use that resource at the same rate anymore.