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[link] shows the supply and demand conditions for a firm that will play trumpets on the streets when requested. Output is measured as the number of songs played.
| Price | Quantity Demanded | Quantity Supplied without paying the costs of the externality | Quantity Supplied after paying the costs of the externality |
|---|---|---|---|
| $20 | 0 | 10 | 8 |
| $18 | 1 | 9 | 7 |
| $15 | 2.5 | 7.5 | 5.5 |
| $12 | 4 | 6 | 4 |
| $10 | 5 | 5 | 3 |
| $5 | 7.5 | 2.5 | 0.5 |
Step 1. Determine the negative externality in this situation. To do this, you must think about the situation described and consider all parties that might be impacted. A negative externality might be the increase in noise pollution in the area where the firm is playing.
Step 2. Identify the equilibrium price and quantity when only private costs are taken into account, and then when social costs are taken into account. Remember that equilibrium is where the quantity demanded is equal to the quantity supplied.
Step 3. Look down the columns to where the quantity demanded (the second column) is equal to the “quantity supplied without paying the costs of the externality” (the third column). Then refer to the first column of that row to determine the equilibrium price. In this case, the equilibrium price and quantity when only private costs are taken into account would be at a price of $10 and a quantity of five.
Step 4. Identify the equilibrium price and quantity when the additional external costs are taken into account. Look down the columns of quantity demanded (the second column) and the “quantity supplied after paying the costs of the externality” (the fourth column) then refer to the first column of that row to determine the equilibrium price. In this case, the equilibrium will be at a price of $12 and a quantity of four.
Step 5. Consider how taking the externality into account affects the equilibrium price and quantity. Do this by comparing the two equilibrium situations. If the firm is forced to pay its additional external costs, then production of trumpet songs becomes more costly, and the supply curve will shift up.
Remember that the supply curve is based on choices about production that firms make while looking at their marginal costs, while the demand curve is based on the benefits that individuals perceive while maximizing utility. If no externalities existed, private costs would be the same as the costs to society as a whole, and private benefits would be the same as the benefits to society as a whole. Thus, if no externalities existed, the interaction of demand and supply will coordinate social costs and benefits.
However, when the externality of pollution exists, the supply curve no longer represents all social costs. Because externalities represent a case where markets no longer consider all social costs, but only some of them, economists commonly refer to externalities as an example of market failure . When there is market failure, the private market fails to achieve efficient output, because either firms do not account for all costs incurred in the production of output and/or consumers do not account for all benefits obtained (a positive externality). In the case of pollution, at the market output, social costs of production exceed social benefits to consumers, and the market produces too much of the product.
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