Question

What divergences arise between equilibrium output and efficient output when (a) negative externalities and (b) positive externalities are present? How might government correct these divergences? Cite an example (other than the text examples) of an external cost and an external benefit. LO4.4

Short answer

Negative externalities lead to overproduction; positive externalities lead to underproduction. Government interventions such as taxes and subsidies can correct these divergences.

Step-by-step solution

Understanding Equilibrium vs Efficient Output

In a market economy, equilibrium output is determined by the intersection of supply and demand curves, while efficient output takes into account all externalities and aims to achieve the maximum social welfare. Divergences occur when externalities exist, causing market outcomes to differ from socially optimal outcomes.

Analyzing Negative Externalities

Negative externalities occur when the production or consumption of a good causes harm to a third party. In such cases, the equilibrium output is higher than the efficient output. This is because the external costs are not reflected in the market price, leading to overproduction. For example, pollution from a factory can harm the environment and public health, which are not considered in the factory's cost structure.

Analyzing Positive Externalities

Positive externalities occur when the production or consumption of a good provides benefits to third parties. Here, the equilibrium output is lower than the efficient output because the extra benefits to society are not reflected in the market price. For example, a homeowner who maintains a beautiful garden enhances the neighborhood's aesthetic value, benefiting others who do not pay for these benefits.

Government Intervention for Negative Externalities

Governments can correct the divergence in negative externalities by imposing taxes equivalent to the external cost. This is known as a Pigovian tax. It aligns the private costs with social costs, reducing production to the efficient output level. For example, a carbon tax can be imposed on companies that pollute.

Government Intervention for Positive Externalities

Government can provide subsidies to producers or consumers to address positive externalities, encouraging more production or consumption to reach efficient output. For instance, subsidies for renewable energy production can help increase investments in clean energy technologies.

Key concepts

Equilibrium Output

In the world of economics, equilibrium output is a key concept. It represents the point where the quantity of goods demanded by consumers matches the quantity supplied by producers. This occurs at the intersection of the supply and demand curves in a free market. At this point, the market is considered cleared, with no excess supply or demand. However, equilibrium output does not always consider the broader impacts on society, particularly when externalities are present.

In the absence of externalities, equilibrium output often aligns with what is socially optimal. But when externalities, such as pollution or education, are not accounted for, it leads to a divergence from what would be ideal for society as a whole.

Efficient Output

Efficient output is what economists strive for when considering the production and consumption of goods. This concept goes beyond equilibrium output by including the impact of externalities.

Efficient output occurs when resources are allocated in a way that maximizes social welfare. In other words, it accounts for both the private and external costs or benefits of goods and services. When negative externalities, like pollution, are involved, efficient output is usually less than equilibrium output as it accounts for harm caused to third parties. On the flip side, for positive externalities like education, efficient output is often more than equilibrium output since it considers the additional benefits to society.

Achieving efficient output requires adjusting market actions to reflect these external costs and benefits.

Negative Externalities

Negative externalities are unintended adverse effects resulting from the production or consumption of commodities. These external costs are often not considered in the market price, leading to overproduction.

For instance, industrial pollution harms the environment and community health, yet these costs are not borne by the factory producing the pollution. This misalignment means that the equilibrium output exceeds the efficient output. When negative externalities are present, the social cost of goods is higher than the private cost reflected in prices, requiring intervention to correct the imbalance.

Government interventions, like imposing taxes equivalent to the external cost—known as Pigovian taxes—can reduce production levels to align with efficient output.

Positive Externalities

Positive externalities yield benefits to others that are not captured by the market transaction.

These additional benefits mean that the equilibrium output is lower than the efficient output, as the market fails to reflect the true societal value of the goods or services. For example, public parks and green spaces not only provide recreation but also improve community well-being and environmental quality. However, since those who enjoy these benefits do not directly pay for them, the market may underproduce such amenities.

To address this, governments can offer subsidies to encourage more production or consumption, aligning the output closer to the efficient level, thereby enhancing social welfare.

Government Intervention

Government intervention becomes essential when externalities lead to discrepancies between equilibrium and efficient output.

In the case of negative externalities, governments can impose taxes to internalize these external costs, ensuring that the true cost of production is reflected in the market price. These taxes discourage overproduction and reduce the negative impact on society.

Conversely, for positive externalities, subsidies can be provided to stimulate increased production or consumption. This financial support helps reflect the additional societal benefits in market dynamics.

Through such interventions, governments play a crucial role in correcting market failures and guiding the economy towards a more socially optimal output level, balancing both private and public interests effectively.