External Costs and Inefficient Resource Allocation

External benefits or external cost either in consumption or in production process interrupts efficient resource allocation. These are benefits or costs that though present in economic transaction but are not accounted by the direct parties involve in the transaction. Such benefits and costs are thus not reflected in the market price. External cost refers to the additional cost present in the production process affecting the third party.

This is also termed as negative externality. With negative externality, private marginal cost is smaller than social marginal cost (Baumol & Blinder, 2015). If the market is left unregulated, then goods are overproduced in the market implying over allocation of resources.  Figure 1 explains how external cost leads to inefficiency in the market.

                                                  External cost and inefficient resource allocation

With external cost, social marginal cost lies above the private marginal cost. Socially efficient output is at Q_S. The private market however produces a larger output at Q_P.

In contrast to external cost, external benefits refers to the additional benefits enjoys by the third party from production or consumtion of certain good. The external benefit is termed as positive externality (Mahanty, 2014). Here, marginal social benefit is larger than private benefit and thus free market produces insufficient quantity of the good. This is shown in figure 2

                                                  External benefit and inefficient resource allocation

Private markets are unable to supply some goods and services having specific characteristics. Two such features of goods preventing private market to supply a good efficiently are non-rivalry and non-excludability. A good is non-rival when individual consumption of the good does not reduce benefits of the goods to others. A good is non-excludable when it is not possible to exclude anyone to consume the good and enjoy associated benefits. When a good is non-rival and non-excludable then people do not reveal their true preference for the good (Moulin, 2014). Private market thus fails to produce and allocate these goods efficiently. Government intervention is then needed in the market to produce and allocate these goods for social benefits.

i.Private goods

Rival: Laboratory owned privately and others cannot use the weapons

Excludable: Only specific contractor can use weapons

1. Public goods

Non-rival: The service given to others do not reduce the benefit to others

Non-excludable: It is not possible to exclude anyone from the service

iii. Private good

Rival: Increase in number of cars increases congestion and thus reduces benefit to other

Excludable: The road is used only by those agree to pay the toll

1. Private good

Rival: Additional student reduces available seat to others

Excludable: Only those paying fees of the courses can be enrolled in the course

1. Private goods

Rival: others cannot purchase the same Lenses as purchased by one

Excludable: Use is limited only those purchase the lenses

External Benefits and Inefficient Resource Allocation

When firm increases price of the product, the change in total revenue depends on the nature of elasticity. Demand is relatively elastic when demand changes more than price. The value of demand elasticity is greater than one.  In this situation, total revenue falls with increase in price. Demand is said to be relatively inelastic when proportionate change in demand is less than the proportionate change in price (Sloman & Jones, 2017). The value of elasticity is less than one. Under this, revenue increases with increase in price.

When price is $4 the quantity sold of Apple is 220.

Therefore,

At price $5, the quantity sold falls to 200

Therefore, Following the inelastic demand, increase in price results in an increase in revenue.

i.Variable cost: Cost of solder is subject to number of jewellery made.

1. Fixed cost: Store has to pay minimum wage to its workers irrespective of production level.

iii. Fixed cost: Expenditure on advertisement campaign is independent of number of jewellery made

1. Variable cost: Overtime pay is related with level of production.
2. Variable cost: Electricity bill depends on the production level of jewellery (Nicholson & Snyder, 2014).
3. Fixed cost: store has to make interest payment independent of its production

vii. Fixed cost: Machines depreciates overtime irrespective of jewellery prepared

viii. Fixed cost: Business rates do not depend on level of production

1. Variable cost:  The quarterly cost of electricity for running machines and drills is subject to level of production
2. Fixed cost: Machines wear and tear overtime and is independent of level of production.

Number of jewellery piece prepared every day = 100

Total Fixed Cost (TFC) = $4,000

Total Variable Cost (TVC) = $13,000

The average total cost is given as $46.71. The marginal cost is also equivalent to $46.71. The average total cost of the firm equals the marginal cost. This happens when firm is operating at the minimum point of average total cost (Friedman, 2017). At this point, firm achieves the minimum efficient scale of production and marginal cost equals the average cost.

Allocative efficiency under perfect completion and monopoly

In a perfectly competitive market, long run equilibrium satisfies following two conditions –

a)Price equals marginal cost

1. b) Long run minimum cost is minimized

The condition that price equals marginal cost implies allocative efficiency. This occurs when sum of surplus to consumers and producers is maximized. This in turn is achieve where demand equals supply and demand is same as average revenue. When price equals marginal cost, then this is smaller than the price consumers are willing to pay and hence, desired surplus is received (Cowen & Tabarrok, 2015). The price is also greater than minimum supply price and therefore maximizes producers’ surplus. Resources are thus efficiently allocated in the society where price equals marginal cost.

In contrast, price charged under monopoly is higher than marginal cost making the market allocative inefficient.  Following the significant market power, monopolist can raises price above marginal cost and reduces consumer surplus. There is a resulted dead weight loss from inefficient allocation of resources.

                          Comparison of allocative efficiency in competitive and monopoly market

Figure 4 shows equilibrium in a perfectly competitive market in the long run.  The long run equilibrium point is at E satisfying the two conditions – P = MC and minimum of LAC.  Competitive firms in the long run cannot charge a price above P*. If price exceeds P* then price line would be above the minimum point of average total cost yielding supernormal profits. With supernormal profits, new firms enter and drive away profits. For a price lower than P*, price is less than minimum average cost and firms incur loss. Then firms exit the industry reducing loss (McKenzie & Lee, 2016). Firms thus attain long run equilibrium where demand curve is tangent to minimum of average cost curve.

a)

A rise in price of margarine reduces margarine demand and increases supply. At the high price, there is thus an excess supply of margarine.

1. b) As yogurt demand increases, there is an increase in milk demand, which increases price of milk. As milk is one main component used in making margarine, there is a decline in supply moving the supply curve to the left (Stoneman, Bartoloni & Baussola, 2018). Consequently, market price increases while equilibrium quantity falls.

A rise in price of bread reduces bread demand. As bread is a complementary good of margarine, lower bread demand reduces demand for margarine as well shifting the demand curve inward. At the new equilibrium, both price and quantity of margarine reduces.

Rise in bread demand rises margarine demand as well. Demand curve for margarine shifts outward increasing both price and quantity at the new equilibrium.The expected rise in butter in future increases butter demand at present. An increase in utter demand reduces demand for margarine. Accordingly, the demand curve shifts inward reducing both equilibrium price and quantity.

Imposition of tax on butter production discourage butter production by reducing profit of suppliers. The resulted increase in price of butter after tax induces people to substitute butter with margarine. An increase in margarine demand shifts the demand curve to the right causing an increase in equilibrium price and quantity.

The new process that removes all cholesterol from butter increases demand. As the process in expensive employment of this technology increases production cost of butter. Therefore, law stating all producers of butter to use this cause some suppliers to exit the industry. Rise in butter demand lower demand for margarine causing leftward shift of the demand curve. Suppliers leaving butter industry might start to produce margarine, as this is a close substitute. The supply curve thus shifts rightward (Hill & Schiller, 2015). Following a shift in both supply and demand curve equilibrium quantity might increase, fall or remain same while equilibrium price declines certainly.

References 

Baumol, W. J., & Blinder, A. S. (2015). Microeconomics: Principles and policy. Nelson Education.

Cowen, T., & Tabarrok, A. (2015). Modern principles of microeconomics. Macmillan International Higher Education.

Friedman, L. S. (2017). The microeconomics of public policy analysis. Princeton University Press.

Hill, C., & Schiller, B. (2015). The Micro Economy Today. McGraw-Hill Higher Education.

Mahanty, A. K. (2014). Intermediate microeconomics with applications. Academic Press.

McKenzie, R. B., & Lee, D. R. (2016). Microeconomics for MBAs: The economic way of thinking for managers. Cambridge University Press.

Moulin, H. (2014). Cooperative microeconomics: a game-theoretic introduction (Vol. 313). Princeton University Press.

Nicholson, W., & Snyder, C. (2014). Intermediate microeconomics and its application. Nelson Education.

Sloman, J., & Jones, E. (2017). Essential Economics for Business. Pearson.

Stoneman, P., Bartoloni, E., & Baussola, M. (2018). The Microeconomics of Product Innovation. Oxford University Press.