Question

The following table shows the quantities of car alarms demanded and supplied per year in a town: $$\begin{array}{ccc} \text { Price } & \begin{array}{c} \text { Quantity } \\ \text { Demanded } \end{array} & \begin{array}{c} \text { Quantity } \\ \text { Supplied } \end{array} \\ \hline \$ 75 & 800 & 0 \\ \$ 100 & 750 & 150 \\ \$ 125 & 700 & 300 \\ \$ 150 & 650 & 450 \\ \$ 175 & 600 & 600 \\ \$ 200 & 550 & 750 \\ \$ 225 & 500 & 900 \\ \$ 250 & 450 & 1,050 \end{array}$$ Without drawing a graph, determine the efficient quantity in this market under each of the following assumptions: a. Each car alarm sold creates a negative externality (noise pollution) that causes \(\$ 100\) in harm to the public. b. Each car alarm creates a positive externality (reduced law enforcement costs) that provides \(\$ 100\) in benefits to the public.

Short answer

For the negative externality, the efficient quantity would be greater than 800.For the positive externality, the efficient quantity would be 550.

Step-by-step solution

Determine efficient quantity for negative externality

Subtract the externality cost from the market price. \$100-\$100 gives \$0. However, we do not have a \$0 price in our table, the lowest is \$75. We can estimate that the quantity would be greater than 800 (the quantity at \$75) as lower prices would result in larger quantities.

Determine efficient quantity for positive externality

Add the externality benefit to the market price. \$100+\$100 gives \$200. At this price, the quantity demanded is 550.

Key concepts

Supply and Demand

Supply and demand are foundational principles in economics that describe the quantities of a product available in a market and the desire of consumers to purchase that product. These functions interact to establish a market equilibrium.

• Demand: It refers to the quantity of a good that consumers are willing and able to purchase at various prices. As prices decrease, typically, demand increases because more consumers find the product affordable.
• Supply: It refers to the amount of a product that producers are willing and able to sell at various prices. As prices increase, the quantity supplied usually increases because producers are more motivated to sell at higher prices.

In our example of car alarms, both demand and supply respond to price changes, resulting in a price where the quantity demanded equals the quantity supplied; this is the market equilibrium price. Equilibrium occurs at $175, where 600 car alarms are both demanded and supplied. This is where the market naturally balances itself.

Negative Externality

A negative externality occurs when a product or activity imposes a cost on a third party not involved in the economic transaction. In the case of car alarms, the noise pollution is an unintended side effect that affects the community negatively.
The solution to address this negative externality is detailed through the concept of social cost. The true cost of a product is not only its market price but also any harm it causes.
1. Market without Intervention: The market price is assumed without regarding external harm, potentially leading to overproduction. In our exercise, this happens when only market prices are considered, which ignore the noise pollution costs. 2. Internalizing the Externality: To address this, the cost of the negative externality ( $100 ) is subtracted from the market price to find an efficient market quantity. The social equilibrium quantity should be less than the 800 car alarms demanded at the lowest price of $75 because the harm might deter buyers. This adjustment ensures that the true societal cost of noise pollution is considered in decision-making.

Positive Externality

A positive externality occurs when a product or activity provides benefits to others who are not part of the transaction. For car alarms, these benefits arise from reduced law enforcement costs due to improved security.
Unlike negative externalities, positive externalities suggest that society might benefit from a higher consumption level than the market provides on its own.
1. Market without Intervention: Often, markets don't account for these wider societal benefits, meaning goods may be under-consumed. 2. Encouraging more Consumption: To resolve this, we add the positive externality value ( $100 ) to the market price, resulting in a new efficient market price. In our exercise, this would raise the interaction price to $200, leading to a demand of 550 car alarms. This tactic encourages more production and consumption to achieve an optimum societal benefit, aligning individual incentives with those of society.