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Chapter 18

ECON 200 Chapter Notes - Chapter 18: Economic Surplus, Social Cost, Demand Curve

Course Code
ECON 200
Cindy Clements

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Chapter 18: Externalities
What Are Externalities?
External costs and benefits
Private costs- a cost that falls directly on an economic decision maker
External cost- a cost imposed without compensation on someone other
than the person who caused it
Social cost- the entire cost of a decision, including both private costs and
any external costs
Private benefit- a benefit that accrues directly to the decision maker
External benefit- a benefit that accrues without compensation to
someone other than the person who caused it
Social benefit- the entire benefits of a decision, including both private
benefits and external benefits
■ Externality- a cost or benefit imposed without compensation on someone
other than the person who caused it
Network externality- the effect that an additional user of a good or
participant in an activity has on the value of that good or activity for others
Examples of external effects- (Positive or Negative?)
Automobile exhaust- Negative
Vaccinations- positive
Acid rain
Well-kept buildings- Positive
Body odor
Honeybees and orchards
■ Education-positive

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Negative externalities and the problem of “too much”/ Gas, automobile exhaust
Drivers don’t take external cost into account, they will decide to drive
more than they would if they themselves had to bear the full cost of
driving (cost of pollution)
People drive “too much” - more than they would if they faced the
social costs of their actions
Where there are externalities, the free market no longer allocates
resources in a way that maximizes total surplus for society as a whole
If gas sales in California were completely unregulated (no gas taxes, no
emission standards, etc)
At any given price, as in any other market, a certain number of
drivers decide that the private benefits of buying a gallon of gas
outweigh the private cost
Without any regulation, the gasoline market reaches equilibrium
based on private costs and benefits
How do we quantify the external costs of a gallon of gas? (What is the
size of the effect? Is it easy to ascertain?)
It is not easy to put a dollar figure on all of the diffuse effects of air
pollution around the world
How much would people who are affected by pollution be
willing to pay to avoid it?
How much would you have to pay the people who are
affected by pollution to persuade them to accept it?
Market with social cost
Suppose that we estimate the cost of pollution at about $1 per
The social cost = the market price + $1 external cost of
If drivers are forced to take the external costs of pollution into account,
the new demand curve for gasoline would be below the demand curve
based on private costs alone (Does the effect impact demand?)
The market will reach equilibrium at a lower price and quantity,
based on social costs and benefits

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How can drivers be forced to consider external costs, and thus operate on
the social demand curve?
Implement a gasoline tax
With a $1 tax, drivers are paying the market price +
external cost, represented by the social demand curve
W/ a gas tax, the equilibrium point moves down along the
supply curve to its intersection with the social demand
curve, resulting in a lower price-quantity combination
The market price is lower in this new equilibrium
The cost per gallon that is actually paid by drivers is
higher, once the tax is included
Lower quantity of gas is purchased
If drivers had to pay the full cost of gas, including the external cost of
pollution, they would choose to buy less of it.
When there are external costs, a tax can increase surplus, making the
market more efficient
A tax does reduce the surplus enjoyed by buyers and sellers of
Increases surplus by those outside of the market
Markets fail to maximize total surplus in the presence of externalities
Under a negative externality, the surplus lost to those outside the
market due to the external cost is subtracted from consumer and
producer surplus
External cost per gallon ($1) times the number of gallons
If the externality is internalized, consumer and producer surplus in
the gasoline market are both lower, but the external cost imposed
on people who suffer from pollution has disappeared
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