Short on time? This page is the recap. For explanations, graphs and worked examples, use the full study guide.
Recap
- An externality is a cost or benefit that falls on a third party and is not paid for through the market.
- Rational agents respond only to private costs and benefits, so the market finds MPB = MPC, not MSB = MSC.
- Causes: poorly defined property rights and high transaction costs. Non-excludable benefits lead to free riding.
- The deadweight loss is the triangle between MSB and MSC from Qm to Qs, pointing to where MSB = MSC.
Key relationships
| Type | Curves | Market vs optimum |
|---|---|---|
| Negative, production | MSC = MPC + MEC lies above MPC (supply) | Qm > Qs; price too low |
| Negative, consumption | MSB = MPB − MEC lies below MPB (demand) | Qm > Qs |
| Positive, production | MSC lies below MPC | Qm < Qs |
| Positive, consumption | MSB = MPB + MEB lies above MPB | Qm < Qs |
| Calculation | Rule |
|---|---|
| Market quantity | MPB = MPC |
| Optimal quantity | MSB = MSC |
| DWL (straight lines) | ½ × (Qm − Qs, as a size) × (gap between MSB and MSC at Qm) |
| Corrective tax or subsidy | MEC or MEB at Qs |
| Tax revenue / subsidy cost | per-unit amount × new quantity |
| Policy | Use |
|---|---|
| Per-unit tax | negative externalities; raises revenue |
| Per-unit subsidy | positive externalities; costs the government |
| Regulation | output or emission limits, required methods |
| Public provision | government supplies the good (e.g. free vaccinations) |
| Property rights | assign a right, or let rights be traded or bargained over when transaction costs are low |
Assumptions
- Competitive markets, so supply = MPC and demand = MPB.
- With low transaction costs and clear rights, bargaining reaches the efficient outcome whoever holds the right.
Mistakes to avoid
- Saying a negative externality makes the market price too high (it is too low).
- Shading the whole band between MPC and MSC as DWL.
- Setting the tax equal to the MEC at the market quantity when MEC changes with output.
- Drawing a consumption externality by moving the cost curve (move the benefit curve).
- Claiming the optimal pollution level is zero.
- Missing labels: name every curve (D = MPB, S = MPC, MSB, MSC), Qm, Qs and the DWL.
Quick self-check
- Demand is P = 40 − Q, MPC = 4 + Q and MEC = $6. Find Qm and Qs. (40 − Q = 4 + Q gives Qm = 18; 40 − Q = 10 + Q gives Qs = 15.)
- What is the DWL in question 1? (At 18: MSC = 28, MSB = 22. DWL = ½ × 3 × 6 = 9.)
- What per-unit tax corrects it? ($6, the MEC. Buyers then pay $25 and sellers keep $19.)
Next: practice questions.