Topic16_Externality

Efficient solution would be at the point where mbq

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efficient solution would be at the point where MB(Q) = MSC(Q). Thus the free competitive market leads to the excessive negative externality causing activities. 8 Inefficiency of Competition with Externality

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Market Solution Vs. Optimal Solution Q 0 MB, MD Q MARKET D = MB MC Q OPT Optimal Solution 9 Market eqlbm MSC = MC+MEC A B B D H G F E Results: 1. Q market > Q optimal 2. Q optimal > 0.
Welfare Analysis Competitive Market Solution : MB(Q) = MC(Q) Consumer Surplus, CS = A+B+C+D Producer Surplus, PS = F+G+H Harm to the environment, EC = C+D+H+G+E Total Surplus = CS+PS- EC = A+B+F-E Optimal Solution: MB(Q) = MSC(Q) CS = A PS = B+C+F+G EC = G+C Total Surplus = A+B+F Thus DWL = TS (optimal) TS(market) = E 10

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Policy Solutions Pigouvian Taxes or subsidies The government can solve the problem caused by a negative externality by imposing a Pigovian tax ( t = MEC at Q opt ) on the producer (or consumer). This tax (on producer) will increase the MC of production of the factory by the tax amount and as a result shifts the MC of production (after tax) to the left by the tax amount. This tax induces the producer to reduce the equilibrium quantity to Q optimal , and thus eliminates the DWL. 11