Ch. 5, Welfare Economics and Externalities

CHAPTER 5
WELFARE ECONOMICS, EXTERNALITIES AND

NON-CLASSICAL MARKETS
Microeconomics,
Curtis & Irvine, 2015
©Microeconomics, Curtis & Irvine, 2015
Learning Outcomes
By the end of this chapter you should understand:
• Consumer and producer surpluses
• Efficient market outcomes
• Taxation and efficiency
• Market failure and negative externalities
• Market failure and positive externalities
• Other types of market failure
• Climate change and the environment
• Equality, justice, and efficiency

Consumer and Supplier Surpluses

Analytical tools for determining economic efficiency
• Consumer surplus: related to the demand side of the market
• Producer surplus: related to supply side of the market
Illustrative example….
Consider the following illustration of the market for rental housing with
a demand schedule and a supply schedule
Consumer and Supplier Surpluses

$500 is the equilibrium
Demand price, and 5 apartments
Supply
are rented
Individual Valuation Individual Reservation
Alex 900 Gladys 300
Brian 800 Heward 350
Cathy 700 Ian 400
Don 600 Jeff 450
Evan 500 Kirin 500
Frank 400 Lynne 550
Consumer and Producer Surplus

• Consumer’s surplus
• Is the difference between the consumer’s willingness to pay and what is
actually paid, or..
• Is the difference between the market price and the individual’s valuation
• Producer’s surplus
• Is the difference between the producer’s willingness to supply and the
price that he/she receives, or..
• Is the difference between the market price and the individual’s
reservation price
Note: suppliers and demanders are willing to participate in the market

because they earn surplus
Let us look at this graphically…
Consumer and Supplier Surplus

Price
Demand Side:
900 Equilibrium price is in $
Alex
Brian
Cathy
Don Evan
500
CS = 400 CS = 300 CS = 200 CS = 100 CS = 0
300
Quantity
Consumer and Supplier Surplus

Price
Equilibrium price
900
Gladys Heward Ian Jeff Kirin

500 PS = 0
PS = 50
PS = 100
PS = 150
PS = 200
RP = 500
RP = 450
RP = 400
300 RP = 350
RP = 300
Quantity
Computing the Surplus Using Equations

• D: P = 1000 – 100Q
CS = 0.5 x 5 x 500 = 1250
• S: P = 250 + 50Q Price
PS = 0.5 x 5 x 250 = 625
1000
• Equilibrium:
S
• 1000 – 100Q = 250 +50Q
• Q = 5; P = 500 CS
500 PS
CS is given by the area of the triangle
below the D curve above the price
250
PS is given by the area of the triangle D
above the S curve below the price
5 Quantity
There is neither producer or consumer surplus for the last, marginal, unit
Efficient Market Outcomes

• Efficient Market
• Maximizes the sum of producer and consumer surpluses
• That particular quantity of output is therefore efficient
• Leaves no scope for additional agreements that would improve the

financial status of participants
• Any other quantity yields lower levels of welfare
• Marginal benefit (demand) equals marginal cost (supply)

Efficient Market Outcomes
The free market equilibrium may be efficient
• At that equilibrium, the marginal benefit (on the D side) from

consuming one more unit equals the marginal cost (on the S
side) from producing one more unit provided the demand
curve measures benefits correctly and the supply curve
measures costs correctly
Taxation and Efficiency

• The efficiency criterion can be applied to a tax that is
imposed in the S and D framework
• Consider an ad valorem tax that is collected from

suppliers
• It creates a tax wedge as there is now a gap between the

price that the consumer must pay and the price that the
supplier receives
Illustration..

• Original Equilibrium {P0, Q0}
St
• 15% tax, shift S to St {Pt, Qt}
Et
• Post-tax supply price Pts
Pt S
P0 E0
Pts
• Revenue burden
• Excess burden and deadweight

Loss
D
Elasticities are important in
determining the deadweight loss of
of a
tax
Qt Q0

• Deadweight losses occur because the tax results in a lower
equilibrium level of output
• At the margin, demanders and suppliers would both benefit if more

units were traded, but the tax reduces quantity by raising the price
• Deadweight losses imply an efficiency loss
• The magnitude of deadweight losses depends on the elasticities of

demand and supply: elastic demands and supplies imply larger
quantity adjustments, and these give rise to larger deadweight
losses
Taxation and Efficiency: Summary

• The government gains through the revenue collected
• The equilibrium market price increases, and the equilibrium quantity

decreases
• The price that consumers pay increases and the price that suppliers
receive net of the tax decreases
• This causes both consumer surplus and producer surplus to fall
Wage tax illustration..

A Wage Tax
The employer must pay the government aa percentage tax
tax on each unit
unit of labour employed
With infinitely elastic D

Wage S
there is no surplus on
the demand side
W0
Government
DWL Wage D
Revenue Tax The tax reduces the
Wt
Dt equilibrium quantity and
generates tax revenue.
The tax revenue is less
than the loss of supplier
surplus by the amount of
Lt L0 Labour the DWL
A Wage Tax – Another Perspective

The worker must pay the government a tax on each unit of labour supplied
St
The tax shifts the
Wage Wage tax
supply curve upward
S
W0
Government
DWL
D The outcome is the
Revenue same as in the case
Wt
where the employer
deducted the tax.
Hence the legal incidence

of the tax does not impact
Lt L0 Labour the economic outcome
Market Failures – Negative Externalities
• Externality refers to a cost affecting parties other than

those involved in the activity’s market
• It is a side effect that impacts outside parties e.g. pollution
• These side effects may be external to the decision making process

of the producer
Market Failures – Negative Externalities

Example: Pollutants adversely affect the health of the population or damage
the environment
• The polluting firm faces only private costs as it decides how much output
to produce
• Society faces the social costs, which include the private costs as well as
the adverse effects
• Social costs > private costs
• Graphically the full or total supply costs are reflected in St, lying above S,
which reflects only private costs
• Left to its own devices, the firm will produce an output that reflects only
private costs
• The social optimum differs from the private optimum because it reflects
all of the costs of production (denote it by Q*)
• The firm is thus over-producing from a social point of view
Negative Externalities and Inefficiency
A tax that increases the price and reduces the output is one solution to the externality
Price
Stt (Total Social
Social Supply Cost)
S
S (Private
(Private Supply Cost)
P
D
Excessive production is inefficient:
true MC > M benefit beyond Q*
Q* Q0 Quantity of Coal-
Generated Electricity
Negative Externalities - Solutions

A possible policy remedy is to impose a corrective tax on each unit
produced such that the producer faces higher costs of producing and
hence of polluting
• This causes the supply curve for the firm shifts upward, resulting in
a lower market output
• This makes the costs of the pollution internal to the firm’s

decisions; the equilibrium becomes more efficient without direct
controls from the government
• In the previous graphic the tax should reflect the difference

between the private and total cost at the optimal output: the tax,
whether ad valorem or specific should result in the output Q*
Market Failures – Positive Externalities

• Externalities of the positive kind enable individuals or producers to
get a type of “free ride” on the efforts of others
• Government intervention may be equally beneficial in the case of

positive externalities
• The private benefits received by the producer differ from the social
benefits received by society
Examples
• Research and development expenditures
• Immunizations
Market Failures – Positive Externalities

Example: Vaccinations benefit not only the patient, but the entire community
• The patient receiving the shot considers just the private benefits in deciding
whether to be vaccinated
• Society receives social benefits, which include the private benefits as well
as the positive effects on others
• Social benefits > private benefits
• Graphically, the full social value is reflected in Dt, lying above D, which
reflects only private benefits
• Left to their own devices, individuals obtain Q0 units of output
• The social optimum, which reflects all of the benefits, is Q*
• The market thus under-produces from a social point of view

Positive Externalities – Market for Flu Shots

The government may choose to subsidize production in
order to increase the output to the social optimum
Price S
A policy solution is to
S’ subsidize vaccinations to
P* induce the market to Q*
P0
Dff (Full Social
Social Value)
Value)
D (Private Value)
Q0 Q* Quantity of vaccinations
The private market outcome is suboptimal:
at Q0 the true MB > MC
Positive Externalities (cont.)

An alternative policy would be to grant an income tax credit
to buyers
• This would cause the demand curve to shift outward,
resulting in a higher, socially superior quantity
Other Market Failures

• Besides externalities, there are many other cases of
market failure, which mean that the equilibrium quantity
generated by the market is not efficient
• Monopolies
• Public goods
• International externalities
• Insufficient information concerning the product

Climate Change: Environmental Policy

• Greenhouse gases (GHG) cause global warming and can be viewed
as a negative externality
• The Kyoto protocol stipulated that Canada would reduce its

emissions of GHG to 6 % below 1990 levels
• Policies to reduce GHG emissions

• Direct controls
• Corrective taxes (a ‘carbon’ tax)
• Tradable permits to pollute
• The latter two rely on the market

Climate change, the Environment and Policy

• Marginal damage curve reflects
the cost to society of one
$ additional unit of pollution. Here it
Marginal
Marginal damage
damage curve
curve is assumed to increase at the
margin
• Marginal abatement curve reflects

the cost to society of reducing
pollution by one unit. Convex
shape implies it becomes
progressively more costly to
reduce pollution when pollution
Marginal abatement
levels are low
cost curve
• Optimal pollution level is where
marginal damage = marginal
abatement cost. This level is not
zero
Q* Q0 – pollution with no abatement

Economic policies work on the margin
Policies to Reduce GHGs - Taxes

• In the previous diagram, the optimal amount of pollution, Q*, can be
attained by several different policies
• Taxes on pollution increase the supply cost to producers

• Higher supply costs increase the price of the product in the
marketplace
• In turn the quantity traded in the market declines and therefore the
amount of pollution that is generated in production declines
• Question: What is the appropriate value of the tax on pollution?

• Answer: The value that results in the quantity Q*
Taxes on GHGs – the Mechanics

• The cost of abatement curve reflects how much producers of GHGs
are willing to pay for the right to emit a certain quantity of pollutants. It
is linear in this example
• If the government taxes each unit of GHG emitted, then the emitter
should be willing to cut back on those emissions where the cost of
reduction is less than the tax imposed on him by the government
With a price or tax of t imposed on each unit,

emitters would chose the quantity Gt to emit.
$
It is less costly to reduce emissions from G0
MCA
to Gt than pay the tax on those units.
t
GHG
Gt G0
GHG Taxes with Multiple Firms

Price of pollution The MCA of A & B is the ‘demand’
for GHG rights in the economy
MCAA Suppose the government imposes

a limit on emissions = Q*
MCAB Q*
P*
QB* QA* Quantity of emissions
Government could impose a price of P* per unit of emissions. At this

price firm A emits QA* and firm B emits QB* for a total of Q*. Since firms
have different abatement costs they emit different amounts of pollution.
GHG Taxes with Many Different Emitters

Not every firm faces the same cost of reducing their emissions. This
has important consequences for policy.
Example…
• At a point where each firm is emitting the same amount of GHGs,
Firm A incurs a cost of $20 to reduce carbon emission by one ton
and Firm B incurs a cost of $30.
• Thus, from an economy-wide perspective, it is less costly for A to

reduce
• In fact, by permitting B to pollute more, and A less, society could

save $10/ton
• These differences inspire the concept of tradable permits

Reducing GHGs through Tradable Permits

• Tradable permits
• Exist under a ‘cap and trade’ control system

• A limit or ‘cap’ is set for emissions
• Firms trade certificates for the ‘right to pollute’
• Gives incentive for the firms with the highest abatement costs to
pollute more, and for firms with the lowest abatement costs to pollute
less
• In our example above, A could sell B the right to pollute for $25/ton
and both would gain
Let’s look at a graphic……

GHG Control via Cap and Trade

Price of pollution
Suppose each firm is permitted to produce Q0.
Then they have an incentive to trade pollution
Q0 rights because of their differing abatement costs
If A produces one unit more and

MCA of A & B B one unit less the cost saving is
(Ca- Cb). Thus they have an
Ca incentive to bargain: B sells to A
the right to more pollution.
Cb
MCAB MCAA
Quantity
If emitters have different abatement costs then the economy

can reduce the cost of controlling emissions by permitting
emitters to trade permits: emitters with the lowest abatement
costs thereby have an incentive to reduce GHGs,
Equity, Justice, and Efficiency

Horizontal equity
• People who have the same income should pay the same tax
• Rules out discrimination
• By varying the distribution of earnings through tax policy, we can
influence demand and therefore change the ‘efficient’ outcomes in
many markets
Vertical equity
• Unequal treatment of individuals whose innate abilities, capacities

and incomes are different
• Implies that high income people should pay higher tax
• A more normative concept
Equity, Justice, and Efficiency

Inter-generational equity
• Involves a balancing of interests and well-being of different

generations
Example…
Canada/Quebec Pension Plan.
Will today’s aged population benefit at the expense of
today’s youth?
Equity, Justice and Efficiency

• By imposing suitable taxes we could implement more equity
However…
• There may exist a tradeoff between equity and efficiency because
high taxes create larger deadweight losses – see following graphic
• In other cases the impact of the expenditures made possible by the

efficiency reducing taxes may have efficiency benefits themselves
Example: expenditures that improve productivity and skills enable

the economy to produce more, and reduce the costs of social
assistance
Equity versus Efficiency
Labour Market Example
Wage S
The imposition of t1
W0 gives rise to a DWL
DWL D
DWL Wage tax
Wt
Dt1 A higher tax gives rise
to a much greater DWL
Dt2
Increases in tax rates

L2 L1 L0 Labour increase the DWL
disproportionately
Chapter Summary
• Welfare economics deals with both normative and positive
aspects of economics
• Efficiency and equity are major elements
• Consumer surplus and producer surplus are the primary tools for
measuring economic welfare
• An efficient market outcome is the one where the sum of CS and

PS is maximized
• Taxes drive a wedge between marginal value and marginal cost,

and create deadweight losses because the resulting output level
is inefficient
• Externalities occur when the market demand or supply does not

reflect the social valuations
Chapter Summary
• A corrective tax can be employed to remedy an externality
• Greenhouse gases are associated with global warming are a type of

negative externality
• Policies to mitigate global warming include carbon taxes, cap and

trade permit systems, and direct controls
• Equity is a goal of government that may involve re-distributing income

• Horizontal, vertical, and inter-generational
• Governments may face a degree of conflict between the goals of

equity and efficiency: equity and efficiency sometimes compete,
sometimes reinforce each other

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CHAPTER 5

WELFARE ECONOMICS, EXTERNALITIES AND

• Efficient market outcomes

• Taxation and efficiency

• Market failure and negative externalities

• Market failure and positive externalities

• Other types of market failure

• Climate change and the environment

• Equality, justice, and efficiency

Consumer and Supplier Surpluses

• Consumer surplus: related to the demand side of the market

• Producer surplus: related to supply side of the market

Consumer and Supplier Surpluses

Consumer and Producer Surplus

Note: suppliers and demanders are willing to participate in the market

Consumer and Supplier Surplus

Consumer and Supplier Surplus

Gladys Heward Ian Jeff Kirin

Computing the Surplus Using Equations

Efficient Market Outcomes

• Leaves no scope for additional agreements that would improve the

• Marginal benefit (demand) equals marginal cost (supply)

Efficient Market Outcomes

The free market equilibrium may be efficient

• At that equilibrium, the marginal benefit (on the D side) from

Taxation and Efficiency

• Consider an ad valorem tax that is collected from

• It creates a tax wedge as there is now a gap between the

Taxation and Efficiency

• Excess burden and deadweight

Taxation and Efficiency

• At the margin, demanders and suppliers would both benefit if more

• Deadweight losses imply an efficiency loss

• The magnitude of deadweight losses depends on the elasticities of

Taxation and Efficiency: Summary

• The equilibrium market price increases, and the equilibrium quantity

• This causes both consumer surplus and producer surplus to fall

Wage tax illustration..

With infinitely elastic D

A Wage Tax – Another Perspective

Hence the legal incidence

Market Failures – Negative Externalities

• Externality refers to a cost affecting parties other than

• It is a side effect that impacts outside parties e.g. pollution

• These side effects may be external to the decision making process

Market Failures – Negative Externalities

Negative Externalities and Inefficiency

Negative Externalities - Solutions

• This makes the costs of the pollution internal to the firm’s

• In the previous graphic the tax should reflect the difference

Market Failures – Positive Externalities

• Government intervention may be equally beneficial in the case of

Market Failures – Positive Externalities

• Social benefits > private benefits

• Left to their own devices, individuals obtain Q0 units of output

• The social optimum, which reflects all of the benefits, is Q*

• The market thus under-produces from a social point of view

Positive Externalities – Market for Flu Shots

Positive Externalities (cont.)

Other Market Failures

• Insufficient information concerning the product

Climate Change: Environmental Policy

• The Kyoto protocol stipulated that Canada would reduce its

• Policies to reduce GHG emissions