How is inefficiency related to both the negative externalities as well as positive externalities? Explain with the help of appropriate diagrams
To illustrate how inefficiency relates to both negative and positive externalities, let’s look at diagrams for each type.
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Negative Externalities
Diagram Explanation:
- Private Cost and Social Cost:
- Private Cost (PC): The cost incurred by the producer for producing a good.
- Social Cost (SC): The total cost to society, which includes both the private cost and the external cost imposed on others.
- Demand and Supply Curves:
- Demand Curve (D): Reflects the marginal benefit to consumers.
- Supply Curve (S): Reflects the private cost of production.
- Market Equilibrium Without Externalities:
- Equilibrium Price (P(_{E1})) and Equilibrium Quantity (Q(_{E1})) are determined by the intersection of the demand and supply curves.
- Market Equilibrium With Negative Externalities:
- Social Cost Curve (SC) lies above the Private Cost Curve because it includes the external costs.
- The socially optimal quantity (Q(_{E2})) is where the Demand Curve intersects the Social Cost Curve.
- Deadweight Loss (DWL) represents the loss in social welfare due to overproduction (Q(_{E1})) compared to the socially optimal level (Q(_{E2})).
Diagram:
In this diagram, the difference between the private cost and the social cost leads to overproduction, causing inefficiency.
Positive Externalities
Diagram Explanation:
- Private Benefit and Social Benefit:
- Private Benefit (PB): The benefit received by the consumer of a good.
- Social Benefit (SB): The total benefit to society, which includes both the private benefit and the external benefit received by others.
- Demand and Supply Curves:
- Demand Curve (D): Reflects the private benefit to consumers.
- Supply Curve (S): Reflects the private cost of production.
- Market Equilibrium Without Externalities:
- Equilibrium Price (P(_{E1})) and Equilibrium Quantity (Q(_{E1})) are determined by the intersection of the demand and supply curves.
- Market Equilibrium With Positive Externalities:
- Social Benefit Curve (SB) lies above the Private Benefit Curve because it includes the external benefits.
- The socially optimal quantity (Q(_{E2})) is where the Supply Curve intersects the Social Benefit Curve.
- Deadweight Loss (DWL) represents the loss in social welfare due to underproduction (Q(_{E1})) compared to the socially optimal level (Q(_{E2})).
Diagram:
In this diagram, the difference between the private benefit and the social benefit leads to underproduction, causing inefficiency.
In both cases, the presence of externalities leads to a divergence between private and social costs or benefits, resulting in market outcomes that do not maximize total societal welfare. Addressing these inefficiencies typically requires interventions such as taxes, subsidies, or regulations to realign private incentives with social welfare.