Question

If a firm's price of its product did, in fact, include all external costs, how would this change production decisions?

Answer 1

External cost incur when production or consumption of a good by an individual leads to a cost imposed on a third party. If there exist an external cost  social cost will be higher than private cost. The problem with external cost is that it leads to market failure. This is because free market doesnt take into consideration the external cost. For example, consider that we bought a car. The private cost incurred would be its purchase price, insurance, tax etc. External cost would include pollution, traffic congestion etc.

There are two types of external cost

1) positive external cost - positive effects an unrelated third party receives from a transaction. For eg, consider a beekeeper set up his unit close to farm. The farm owner gets the positive externality when bees helps him with pollination of plants.

2) Negative external cost - negative effects an unrelated third party suffers from an activity. For eg, we buying a car which cause pollution and badly affecting the environment.

MPC - marginal private cost

MEC - marginal external cost

MSC - marginal social cost ( MSC = MPC + MEC )

MPB - marginal private benefit

MEB - marginal economic benefit

MSB - marginal social benefit ( MEB + MPB )

Equilibrium is obtained when MSB = MSC. When MSB>MSC expand production since benefits are greater than the cost. When MSB<MSC reduce output to reduce inefficiencies.

In case of negative externality MSC will be greater than MPC. Therefore MSC will lie above MPC. We also assume that there is no externality associated with consumption. So. MSB = MPB. Look at the following figure, Optimal output is at q0 and price at p0. But free market would produce q1 at price p1. Thus there would be over production in the market. At point E, MPC is c0, So to increase MPC to levels of MSC government can impose tax of amount p0 - c0. This reduce output from q1 to q0. At q0 consumer pay price equals to marginal social cost. The revenue collected by the government could be used to pay compensation for the damages.

Revenue collected by the government = p0EFc0.

Net gain to the society = EFT

MSC MPC Po Posica Cof D CMPB: Mse Ouantihy

In case of positive externality, MSC<MPC, therefore MSC will lie below MPC. It is assumed that there is no externality related to consumption. So MSB = MPB. Optimal output is at point E where q0 output is produced at price p0. But free market would produce at point T, where q1 quantity is produced at price p1. The free market is producing less than what the society desires. So the government gives subsidies to produce more. At point E, price charged is p0, where as MPC is c0. But c0>p0, so the producers has to be given subsidies (c0 - p0). This increases production form q1 to q0.

Net gain to the society = STE.

Subsidy given = p0EFc0.

MPC Co MSC Po D CMPB MSB quantiy