Impact Of External Costs And Benefits On Resource Allocation

Explain and Illustrate the imapact of external costs and external benefits on resource allocation

External Cost

External cost is the cost generated from an activity but is not accounted in the market price. External costs also termed as negative externality indicates the cost inflicted on the third party of any transaction in the production or consumption side. In the transaction process, the producer and consumers are the first and second parties while the third part can be an individual, organization or in a broader sense the society. Such external costs have a spillover effect on the third party resulting in a socially inefficient allocation of resources. The market supply curve here represents only the private marginal cost and not the social marginal cost. Presence of external cost causes social cost to exceed private cost (Stiglitz and Rosengard 2015). The lower private costs induce the producer to produce an output which is higher than socially efficient quantity. This is shown in figure 1. The socially efficient quantity is at Qs. With external cost, private market however overproduces the good at Qp reflecting inefficiency. 

External benefits points to the benefits derived from an economic activity but are not realized by the direct consumer or producer of such activity. External benefits economically termed as positive externality are enjoyed by a third party. As the benefits are not recognized by direct parties of transaction market produces the good at a lesser quantity that actually desired. Benefit to society or third party here is higher than that of individual participants. Resources are thus not allocated in sufficient quantity resulting in an underproduction (Weimer and Vining 2017). The figure below portraits the market condition with a positive externality. Qopt denotes the socially efficient outcome. Private market however produces Q_1. 

Goods and services having some special characteristics are identified as public goods. The distinguishing features of public goods separate it from that of a private good. Two exclusive quality of public goods are non-rivalry and non-excludability. A good is called non-rival in consumption when one user of the good does not reduce utility to other users. For a non-excludable good, the good once offered is offered to everyone. More precisely, the users cannot be segregated depending upon the ability to pay (Acs et al. 2016).  This ultimately leads to the problem named as free rider problem. The free rider problem makes it difficult to assess the true cost or benefit of such good. Private agents therefore do not engage in supplying such goods. Instead, government provides these goods publicly to ensure well-being of the entire society. As such goods are offered for the benefits of common people, these are known as public goods. 

1. Private good

External Benefits

Excludable:  Supply weapons to only those who pay for it

Rivalry: Weapons supplied to single cannot be utilized by other.

1. Public good

Non-excludable: The service aids everybody in a particular locality

Non-rivalry: Utilization of the service by one person does not reduce satisfaction to others (Fike and Gwartney 2015).

iii.  Private good

Excludable: Toll road is used only by the people willing to pay the toll tax.

Rivalry:  As number of cars increases in the road satisfaction to others get reduced due to congestion.

1. Private good

Excludable: Students paying the fees only do the course.

Rivalry: Seat occupied by one student cannot be used by other.

1. Private good

Excludable: Use of Contact lenses depends on the monetary payment for lenses.

Rivalry: Pair of lenses is exclusive to one individual and the same cannot be used by other. 

Elasticity of demand is a popular concept of microeconomics indicating certain percentage change in demand for an associated change in own price, income or price of the related goods (Johnson 2015). The measure of income elasticity is a measure that predicts changes in demand given a change in income.

For pre-recorded music compact disc, income elasticity is obtained as +6.0. As the computed elasticity is greater than 1, this means that demand changes more than the corresponding change in income. The outbreak of recession likely to cause a decline in income by 10 percent. From the income elasticity measure, 10 percent change in income likely to cause a decline in demand by (+6.0 *10) = 60 percentage point.

The income elasticity for cabinet maker is relatively inelastic in nature as obtained from the elasticity measure of 0.6. The implication of an elasticity measure less than one is that demand changes by a relatively less proportion compared to income. As income falls by 10 percent, using the given elasticity measure demand would record an estimated fall by (0.6*10) = 6 percent.

The higher elasticity measure thus makes demand for pre-recorded compact disc more responsive in comparison to cabinet maker (Gostkowski 2018). The pre-recorded compact disc is thus more vulnerable to recession. 

In order to find out whether pre-recorded compact disc and MP3 music player compete with each other or not, cross price elasticity measure needs to calculated between MP3 music player and pre-recorded music disc.  The cross price elasticity measure indicates how pre-recorded compact disc is related with MP3 music players. Goods are said to be substitute if cross price elasticity measure is found to be positive. In this case, decline in prices of one good has an adverse effect on demand of the related good. Sellers of substitute goods engage in extensive competition to reduce market share of other. For complementary goods, price decrease in one market has a positive influence on the demand for related good (Baumol and Blinder 2015). Hence, there is no competition between two goods. The cross price elasticity measure thus can be used to determine competition between pre-recorded music compact and MP3 music player. 

Public Goods and Free Rider Problem

A good is classified as normal or inferior depending on the relation of demand with income. If demand increases with increase in income, the good is said to be a normal good. If demand tends to go down with income, then the good is an inferior good (Chan and Gillingham 2015).

YED = +0.8. From the elasticity measure, it can be inferred that a 10 percent increase in income cause demand to increase by 8 percent. The positive influence of income on demand implies that the good is a normal good.

YED = -3.8. From the elasticity measure, it can be inferred that a 10 percent increase in income cause demand to decrease by 30.8 percent. The negative influence of income on demand implies that the good is an inferior good. 

Measure of cross price elasticity indicates how two goods are related to each other. If increase in price of one good increase demand of the related good, then the two goods are substitute to each other (Mohajeryami et al. 2016). On the other hand, if increase in price of one good decreases the demand for the related good, then the two goods are complementary to each other.

XED = +0.79. The given estimate of cross price elasticity points towards a positive relation between the two goods. More precisely, 10 percent increase in price of one good increase demand for other by 7.9 percent. Such a relation holds for substitute goods.

XED = - 3.5. The given estimate of cross price elasticity points towards an inverse relation between the two goods. More precisely, 10 percent increase in price of one good reduces demand for other by 30.5 percent. Such a relation holds for complementary goods.    

Firm A: Producing equilibrium level of output, firm A makes a loss of $30

Firm B: Producing equilibrium level of output, firm B makes a profit of $184 

i.Variable cost. Cost depends on the making of jewellery.

1. Fixed cost. Minimum wage has to be paid irrespective of level of production

iii. Fixed cost. Does not depend on the making of Jewellery.

1. Variable cost. Overtime payment is subject to production of Jewellery.
2. Fixed cost. Electricity bills have to paid irrespective of production level.
3. Fixed cost. Interest payment has to be made irrespective of level of production

vii. Fixed cost. Machine depreciates with passes of time without varying with output level.

viii. Fixed cost. Tax has to be paid irrespective of output level.

1. Fixed cost. Electricity bills have to paid irrespective of production level
2. Fixed cost. Machine wears out with passes of time without varying with output level. 

The law of diminishing return states that with increase in amount of variable input keeping constant the fixed input increases output initially, then reaches to the maximum level and then falls. The law has implication for produced output and associated cost (Shepherd 2015). 

Private Good

The first stage of production is characterized as a stage of increasing return as total product and average product increases throughout this stage. The second stage begins after average product reaches to the maximum. In the second stage with increase in variable input both average and marginal product fall and hence, the stage is known as stage of diminishing return. 

In the phase of diminishing return, marginal product falls. The average product though continues to increase but starts to fall as marginal product become negative. 

In the phase of increasing return, marginal product increases along with a fall in marginal cost. As the diminishing return begins, marginal cost starts to increase and marginal product falls.  

In the monopolistically competitive market, large number of firms engage in selling an almost similar but differentiated product. Sellers of each differentiated items enjoy some market power and face a downward sloping market demand curve. Resource allocation said to be efficient if both productive and allocative efficiencies are achieved. Neither of these two forms of efficiencies are attained by monopolistically competitive market. Market attains allocative efficiency if price in the market set equals to the marginal cost of production. Firms in this form of market however charges a price above the marginal cost. For productive efficiency firms should product output equivalent to the minimum average cost (Moulin 2014). Monopolistic firm in contrast stop production before the minimum point of average cost and thus operate with excess capacity. Resource allocation is thus inefficient in the monopolistically competitive market. 

The situation however is completely different under perfect competition. Here, no firm has any market power. Price in the market is set equivalent to marginal cost Firms can freely enter or exit the market. Entry or exit continues to occur unless the market is left with only normal profit. Competitive firms in the long run produce output corresponding to the minimum point of long run average cost (Nguyen and Wait 2015). Resources are thus allocated efficiently in the market resulting in socially efficient outcome. 

Resource allocation under perfect competition and monopoly market

Allocative efficiency refers to an allocation of resources where marginal cost matched with marginal benefit. Taking price as a measure of marginal benefit, the condition thus reduces to equality between price and marginal cost. Market price in a competitive firm is equivalent to marginal cost. Presence of numerous firms in the market implies that no firm has no amount of market power, Hence, firms charge a price determined from market forces of demand and supply and therefore, is socially efficient. Monopolist on the other hand is the single seller in the market and hence, devices maximum market power. Monopolist thus charge a price which is far above the marginal cost. Market thus fails to attain allocative efficiency under monopoly.  

Income Elasticity

Resource allocation for individual firm and the industry

Individual firms under shirt run allocate resources following the short run equilibrium condition. The two condition for short run equilibrium is given as price equals marginal cost and MC cuts MR from below (Cowen and Tabarrok 2015). Short run equilibrium thus might yield a supernormal profit or loss for the firm depending on the position of average cost curve.  

For the industry as a whole, equilibrium occurs only at a point where demand equals supply. The industry thus always produces a socially efficient outcome.  

Long run equilibrium for a firm operating in a perfectly competitive market is given by the condition that price equals minimum point of average cost which in turn equals to long run marginal cost. In the short run, if firms enjoy supernormal profit, then new firm starts to enter the industry. This reduces profit by reducing price resulted from the increased supply. In contrast, if firms incur loss then loss making firms exits the industry (Carlton and Perloff 2015). This reduces loss by raising price resulted from supply shortage. Entry or exit continues unless the long run equilibrium condition is fulfilled producing normal profit for firms. 

References 

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Chan, N.W. and Gillingham, K., 2015. The microeconomic theory of the rebound effect and its welfare implications. Journal of the Association of Environmental and Resource Economists, 2(1), pp.133-159.

Cowen, T. and Tabarrok, A., 2015. Modern principles of microeconomics. Macmillan International Higher Education.

Ebers, M. and Oerlemans, L., 2016. The variety of governance structures beyond market and hierarchy. Journal of Management, 42(6), pp.1491-1529.

Fike, R. and Gwartney, J., 2015. Public choice, market failure, and government failure in principles textbooks. The Journal of Economic Education, 46(2), pp.207-218.

Gostkowski, M., 2018. Elasticity of Consumer Demand: Estimation Using a Quadratic Almost Ideal Demand System. Econometrics, 22(1), pp.68-78.

Johnson, M., 2015. Public goods, market failure, and voluntary exchange. History of political economy, 47(suppl_1), pp.174-198.

Mohajeryami, S., Moghaddam, I.N., Doostan, M., Vatani, B. and Schwarz, P., 2016. A novel economic model for price-based demand response. Electric Power Systems Research, 135, pp.1-9.

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

Nguyen, B. and Wait, A., 2015. Essentials of Microeconomics. Routledge.

Shepherd, R.W., 2015. Theory of cost and production functions (Vol. 2951). Princeton University Press.

Stiglitz, J.E. and Rosengard, J.K., 2015. Economics of the public sector: Fourth international student edition. WW Norton & Company.

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