Download Econ 387 In-Class Work: Negative External Market Effects on the

Econ 325 In-Class Work: Negative External Market Effects on the Environment from Pollution
Marginal Private Benefits (MPB) are the additional benefits derived by consumers from another unit of
the product ⇒ Demand / consumer willingness to pay. Note that if these are the only benefits from this
good (i.e.: no one outside the market participants benefits from its consumption), then private (within
market benefits) are equivalent to total or social benefits. Here, MPB ⇔ MSB.
Marginal Private Costs (MPC) are the additional production costs associated with producing another unit
of the product ⇒ Supply / supplier willingness to accept.
Marginal External Costs (MEC) are additional costs incurred by a third party as a result of the production
and consumption of another unit of the good.
Marginal Social Costs (MSC = MPC + MEC) are the total additional costs associated with the production
and consumption of another unit of the good.
Example: Consider the production of bushels of beans (in hundreds) by Farmer Bob. Bob sells his beans
in a competitive market. The supply of beans describes the relationship between the market price of beans
and the quantity of beans Bob is willing to provide to market, and accurately represents the marginal
private costs (MPC) of production. (Recall that competitive firms always adjust output until price is
equal to marginal cost, so the relationship between price and quantity supplied -- the supply curve -- is
therefore the marginal cost curve). The market demand for beans describes the relationship between the
market price of beans and the quantity of beans demanded. (Recall that rational consumers will continue
to purchase a good until the marginal benefit from the good is equal to its price, so the relationship
between price and quantity demanded -- the demand curve -- is therefore the marginal benefit curve).
Assume that the data below represent the costs of production and the benefits from consumption of Bob’s
beans. Assuming there are no benefits from these beans other than those realized by consumers, we can
treat MPB as MSB.
Q
0
1
2
3
4
5
MSB
950
800
650
500
350
200
MPC
200
300
400
500
600
700
→ Write the equations representing MSB and MPC as a function of quantity of beans.
→ Plot the data below, and determine the efficient price and quantity.
$
1000
900
800
700
600
500
400
300
200
100
0
1
2
3
4
5
Q
To maximize his profits, Bob wants his bean plants to be big and strong. He therefore treats his fields
with fertilizers which contain nitrogen and phosphorus. Bob is not violating any laws by engaging in this
practice. Whenever it rains, or Bob otherwise irrigates his crops, excess nitrogen and phosphorus run-off
the surface of the soil and end-up in a nearby river. The excess nutrients in the water serve to feed algae,
which consume oxygen in the water as they grow. This leaves less oxygen for fish. Suppose that for
each 100 bushels of beans Bob produces, there are $250 worth of damages to recreational anglers who
fish in the river. (Question to think about for later: how can we come-up with such a number?)
→ Write an expression for the marginal external cost associated with the production of beans, and
plot the MEC function on your graph above.
→ Write an expression for the marginal social cost associated with the production of beans, and
plot the MSC function on your graph above.
→ What are the socially efficient price and quantity of beans?
→ Considering the full costs of the beans, what can we conclude about the market-determined
price and quantity?
→ Calculate the social gains realized when the market price and quantity are changed to the
socially optimal levels.
→ What is the underlying cause of the negative externality?
The Coase Theorem states that any establishment of well-defined property rights can eliminate the
inefficiency associated with an externality if bargaining between the affected parties is feasible and lowcost. The ability of the affected parties to bargain for the property rights causes them to consider the true
social costs of any actions in their decisions. Because the affected parties would have to consider the true
costs of their actions, the externality would be internalized. That is, the private costs and/or benefits
would be adjusted to equal the social costs and/or benefits. For the pollution example, one means of
correcting the externality would be to guarantee clean water to the public by banning the cause of the
pollution. Essentially, this would be giving the rights to clean streams to all citizens (the third party
affected by the pollution) and stipulating that the rights were guaranteed.
→ Would banning bean production be an efficient means of correcting the externality associated
with pollution by bean-producers? Why or why not?
Thinking ahead:
Should anything be done to remedy this problem? If yes, what
should be done, and how should it be accomplished?