Question

Why are spillover costs and spillover benefits also called negative and positive externalities? Show graphically how a tax can correct for a negative externality and how a subsidy to producers can correct for a positive externality. How does a subsidy to consumers differ from a subsidy to producers in correcting a positive externality?

Short answer

Spillover costs and benefits are called negative and positive externalities, respectively, because the bearer of these effects is not a part of the market exchange and is an external party.

The two graphs explaining the effect of a tax and a subsidy are as follows:

Effect of a tax:

A backward shift in the supply curve decreases the output to reach an optimal level.

Effect of a subsidy on a producer:

A forward shift in the supply curve increases the output to reach an optimal level.

The difference is a subsidy to a consumer increases consumer’s demand, and a subsidy to producers increases supply.

Step-by-step solution

Step 1. Spillover costs and benefits as externalities

Spillover costs are the negative effects of an economic activity that are passed on to the people who are not directly involved in any market transaction related to a good or service. These are external costs borne by an external party, and thus spillover cost is called a negative externality.

For example, the air pollution created by a factory puts external costs on people living nearby in terms of bad health or lung problems from the smoke.

Spillover benefits are the positive effects of an economic activity that are passed onto people who are not directly involved in any market transaction related to a good or service. These are external benefits enjoyed by an external party who did not make any payment. Thus, spillover benefit is called a positive externality.

For example, a higher educated person will result in greater production and awareness in the society that will benefit others as well who did not pay for his education.

Step 2. Correction of a negative externality using taxes

In the following diagram, the initial market equilibrium is achieved at point “a” where the supply curve S intersects with the demand curve D. However, the output level Q is not the optimal level as the external costs are not reflected in the supply curve. The intersection of the supply curve S1 and the demand curve results in an optimal level equilibrium at point “b”, where the efficient output level is Q1.

The difference between Q and Q1 is the overproduction caused due to negative externality, and triangle abc gives the efficiency loss.

An imposition of a tax t (Pigouvian Tax) increases the marginal cost of a firm. As a result of this higher cost of production, the firm’s supply curve shifts back to S1, and the equilibrium quantity decreases to Q1, which is an optimal level. The tax corrects the problem of overproduction by including the external costs in the form of the cost of production.

Step 3. Correction of a positive externality using subsidies given to producers

In the following diagram, the initial market equilibrium is achieved at point “a” where the supply curve S intersects with the demand curve, D. However, the output level Q is not the optimal level as the external benefits are not reflected in the supply curve. The intersection of the supply curve S2 and demand curve results in an optimal level equilibrium at point “d”, where Q2 is the efficient level of output.

The difference between Q and Q2 is the underproduction caused due to positive externality, and the efficiency loss is given by triangle ade.

A subsidy is given to producers reduces the marginal cost of a firm. As a result of this lower cost of production, the firm’s supply curve shifts forward to S2, and the equilibrium quantity increases to Q2, which is an optimal level. The subsidy corrects the problem of underproduction by including the external benefits in the form of reduced cost of production.

Step 4. Difference between a subsidy to consumers and a subsidy to producers

A subsidy to consumers increases the demand and shifts the demand curve forward, whereas a subsidy to producers increases the supply and shifts the supply curve forward. The end effect leads to the production of an optimal level of output Q2.

The effect of a subsidy to consumers is explained using the diagram given below:

A subsidy to consumers reduces the price for consumers. This increases demand and shifts the demand curve from D to D1. A new equilibrium is achieved at point “q”, where the new demand curve (D1) intersects the supply curve S. As a result, the output level increases to reach its optimal level Q2.