Notesale: Turn your study into money

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They are usually measured by the market price of the resources that the firm uses
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For example, the private costs of a consumer who smokes
would be the money he spends on cigarettes
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On the other hand, private benefits refer to the utility or benefit derived by the users, that is, the
person who generates the economic activity
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Indeed, §when a private firm carries out production, it does consider only its private costs and private
benefits
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In other words, an externality is a situation where the production (or consumption) of a
good directly affects the production (or the utility derived by the consumers) of another good
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In other words, externalities create a divergence between private and social costs and
benefits
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Externalities can be either negative (undesirable) or
positive (desirable)
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On the other hand, whenever other people are affected adversely, there said to be external
costs
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Indeed, when a private firm carries out production, it does consider
only its private costs
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These damages are evaluated in the form of costs known as external costs
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External costs can also occur in
consumption, for example, when people use their cars, other people suffer from their exhaust, the added
congestion, the noise, etc
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It includes private costs and external costs
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In other
words, for the society's point of view, the price system must take into account both private costs «and
external costs
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It refers to the benefit from
production (or consumption) experienced by people other than the producer (or consumer)
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For example, imagine a bus company that spends
money training its bus drivers
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The latter
benefit without incurring additional cost of training
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Social benefit refers to, the full benefit to society from consumption and production of any good
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Social benefit (SB) = Private benefit (PB) + External benefit (EB)
In marginal terms (when each additional unit of good is produced),
Marginal Social benefit (MSB) =Marginal Private benefit (MPB) + Marginal External benefit (MEB)

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SOCIALLY OPTIMUM LEVEL OF OUTPUT AND MARKET FAILURES:
If MSB > MSC, then it is said to be socially efficient to produce more (or to consume) more
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It follows,
therefore, that if MSB = MSC, then the current level is optimum (socially equilibrium)
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However, in the real world, the market rarely leads to social efficiency
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This is due to externalities,
whether adverse or beneficial, which cause market failure because they lead to allocation of resources
that are non-optimal from the society's point of view
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Hence, private producers produce too much of commodities that generate
harmful externalities because they bear none of the costs suffered by others
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This can be illustrated as follows:

The MPC curve represents the supply curve of the industry, and assumes no external benefit,
MSB is also the MPB and the demand curve for the industry
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MSC lies above MPC as MSC includes both MPC and
MEC
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Thus, in terms of socially
efficiency, there is an overproduction of goods which generate negative externalities
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In the same sense, activities which generate positive externalities can also bring welfare loss
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This is illustrated as follows:

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The MSB is greater than the MPB since there are external benefits
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In other words, when there are positive externalities, there is a tendency for
underproduction of the product in question
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From the above expose, it can be deduced that whenever there are external benefits, there will be
too little produced or consumed
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The market will not equate marginal social benefit and marginal social
cost
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Marginal
social benefit will not equal marginal social cost
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Hence, the government has a number of instruments it can use to change the way markets operate
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The more efficient method to correct these imperfections is taxes and subsidies
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The government should impose a tax on each unit of output, where the amount of tax is equal to
the amount of pollution (MEC)
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This means the government will make the externality to enter into the firm's own calculations of its
private costs and benefits
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Assume, for
example, that a chemical plant emits smoke and thus pollutes the atmosphere
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This can be illustrated as follows:

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The firm produces output 0QE where MPC = MPB (demand = supply), and in doing so, it takes
no account of the external pollution costs it imposes on society
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The
firm will have to pay an amount equal to the external costs it creates
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Similarly, in the case of positive externality, the government has to grant subsidies equal to the
MEB
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The market reaches equilibrium at
output OQE
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Hence, the government
has to encourage the consumption of such good so that the whole society will benefit and grant subsidies
on education
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Effectiveness of implementing taxes and subsidies:
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It forces firms to take on board the full social costs and benefits of their
actions
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For
example, the bigger the external cost of a firm's actions, the bigger the tax can be
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Firms are encouraged to find socially better ways of producing
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The more a firm can reduce its pollution, the more
taxes it can save
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Drawbacks of implementing taxes and subsidies:
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Given that costs and
revenues differ substantially from one firm to another, separate tax and subsidy rates would be needed
for each firm
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It is very difficult to
estimate the value of the MEC and MEB in monetary terms
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Imposition of polluting tax to cure negative externalities may also lead to inflationary pressure in

the country
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Other measures:
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Various polluting activities could be banned or restricted
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Regulatory bodies - Having identified possible cases where action might be required, the

regulatory body would probably conduct an investigation and then prepare a report containing its finding
and recommendations
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Nationalisation - Firms with associated externalities could be taken into public ownership and

their output controlled to take account of social costs and benefits
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Given our
limited resources, any resources used on a project in the public sector have an opportunity cost of the
benefit from the best alternative use in some other projects in the public sector
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Thus, the rational approach for the appraisal of projects in the public sector is the cost-benefit
analysis
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It differs from ordinary
investment appraisal carried by profit maximising firms in that the approach considers only private costs
and private benefits
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It is necessary
to take a wider view of the project, in the sense that the decision makers in the public sector must
consider the social costs and social benefits of the proposed projects as a guide when deciding upon the
desirability of these projects
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A project is considered to be economically feasible when the project must be capable of
producing an excess of benefits such that everyone in society could be made better off
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The process of cost benefit analysis requires that all costs and benefits be valued in monetary
terms
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However, in a world where imperfect competition, externalities
and ignorance abound, market prices will not reflect the true social costs and benefits
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These are imputed prices which are intended to reflect more
faithfully the true social costs and benefits of a project
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PRIVATE GOODS AND PUBLIC GOODS:
A private good possesses the twin characteristics of diminishability and excludability
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Once bought by someone for consumption
purposes, the amount available to others is reduced or diminished
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On the other hand, a good which is privately owned must not be legally
shared with other individual
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For instance, a good consumed
by Mr X must not be necessarily consumed by Mr Y
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In other words, private goods have property rights
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The consumption of public goods by
additional consumers does not reduce the quantity consumed by existing consumers
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The benefits of public goods are enjoyed by more
than one person at the same time
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Mr X's consumption of the light does not significantly reduce the quantity of
light available to Mr Y
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Besides, public goods are meant for all individuals or population as a whole
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This means that it is difficult to create
property rights over the public goods
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Those who have already
paid for the provision of the public goods have no means of preventing those who refuse to pay from
benefiting from their purchase (free-rider)
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Hence, the marginal cost of production for an extra person is zero
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As such, this makes public
goods unattractive to private sectors
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Therefore, not only is it
impossible to charge for the consumption of public goods, it is also undesirable
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MERIT GOODS:
Merit goods are those goods whose consumption is highly desirable for the welfare of the
citizens
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In other words, the
government believes that consumers derive greater benefit from the consumption of the merit goods than
consumers themselves perceive
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Merit goods, unlike public goods, can be supplied both by the public and private sectors
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This is because the government believes that
consumers will buy too little of the merit goods if they are provided by private enterprise at market
prices
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Thus, the government intervenes
to encourage higher consumption of such a product, and this is done through subsidies
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The case of under-consumption:
The major argument is that had the provision of merit goods been left alone to the private sector,
there would an under-consumption situation
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To avoid monopolisation of essential services:
Left alone to the private enterprise, the provision of essential services such as housing, education
and health would easily create a monopolisation of the services in question and several demerits would
be encountered
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It is not possible for any private sector to undertake the provision of merit goods because it
demands a huge amount of investment to sustain the equally high expenditure
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Hence, the
entire provision of merit goods by only the private sector is beyond the latter's productive capacity
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However, this equilibrium price
may not be the most desirable price
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The government may prefer to keep prices above or below the
equilibrium price
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IMPOSITION OF A MINIMUM PRICE:
A minimum price is established when the government passes a law imposing the lowest
permitted price at which a particular good or service can be purchased
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Thus, the minimum price
is always set above the equilibrium price
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The effect of the minimum price can be illustrated as follows:

The market equilibrium price is OP at which price the quantity demanded is equal to the quantity
supplied at Q
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At this higher price there is an excess of supply over demand given by the
extent Qs - QD
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 Demand could be raised by advertising, by finding alternatives uses for the good, by increasing
prices of its substitutes
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If the industry is subject to supply fluctuations and if industry
demand is inelastic, prices are likely to fluctuate severely
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 In the case of wages, minimum wage legislation can be introduced to increase the wages of lowpaid workers so that their standard if living rises
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Maximum price should be imposed on goods and
services whose equilibrium price is too high
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The effect of the imposition of maximum price can be illustrated
as follows:

The market equilibrium price is OP
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At this lower price there is an excess of demand
over supply (shortage) given by the extent QD - QS
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This disequilibrium will be dealt with in a variety of ways
 A rationing system can be used on the basis of "First come first serve"
 Firms decide which customers should be allowed to buy, for example, giving preference regular
customers; sell the goods based on religion or caste
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Alternatively, it may attempt to reduce demand
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For example, the government imposes a maximum price on
private sector rental housing
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NOTE:
 A minimum price will have no effect on the market it is fixed at or below the market equilibrium
price
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TAXES AND SUBSIDIES:
Taxes fall into two main groups, direct and indirect
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On the other hand, indirect taxes are those which
are levied on expenditure, that is, on goods and services
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On the other hand, specific tax is levied per unit of the commodity, irrespective of its
price, for example, excise duty
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Hence, when indirect taxes are imposed,
the producers face a higher cost of production
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However, the shift is different for ad valorem tax and specific tax
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The formal incidence of a tax is upon the
person who is legally responsible for paying it
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The incidence and burden of direct tax fall on one and the same person
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In other words, the incidence of
indirect tax can be shifted so that burden of the tax is wholly or partly upon the consumers
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In other words, the producers also
pay part of the tax
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AB is the total tax per unit imposed by the government
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AC is the tax per unit paid by consumers, while CB is paid by producers
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This follows that when
demand is perfectly inelastic, all the tax would be passed on to the consumers

AB is the total tax per unit imposed by the government
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AC is the tax per unit paid by consumers, while CB is paid by producers
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This follows that when
demand is perfectly elastic, all the tax is paid by producers only
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This tax is borne both by the producer
and by the consumer
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Hence, it
can be noted that producers pay more tax than consumers if supply is inelastic
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AB is the total tax per unit imposed by the government
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AC is the tax per unit paid by consumers, while CB is paid by producers
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This follows that when
supply is perfectly elastic, all the tax is paid by consumers only
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SUBSIDIES:
The government sometimes subsidises a product by giving an amount of money to the producers
for each unit they sell
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The
division will again depend upon the price elasticity of demand
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This subsidy is benefited both by the
producer and by the consumer
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