5 Steps to a 5 AP Microeconomics, 2014-2015 Edition

Public Goods, Externalities, and the Role of Government ‹ 157

produces most electricity. The private cost of electricity production includes the coal, the

labor, and capital at the plant. But the burning of coal imposes environmental costs in the

form of air, water, and land pollution. These societal costs are not found in the market price

(Pmkt) of charging your cellphone or running the dishwasher. The difference between the

private cost and the societal cost of producing electricity is seen in Figure 11.4. The private

supply curve, which does not include the spillover costs, lies below the societal supply

curve. The market produces Qmktunits of electricity, but the optimal amount is less at

Qsocial. Because the market produces more than the socially optimal amount, it is said that

there is an overallocation of resources to electricity production. In other words, society

wants less than the market provides.

• The existence of spillover costs in a market results in an overallocation of resources in
  that market. In other words, there is too much of a bad thing.

So how could cigarette smokers alleviate the discomfort that they impose upon their

nonsmoking citizens? The aim of any such policy is to try to move the spillover costs away

from the third-party victims and back upon those who produce the externality.

“I was always
told to make big
graphs to keep
things clear. It
ended up saving
me from many
careless errors.”
—Ross,
AP Student

Ssocial

D

Quantity

Pmkt

$P

spillover

cost

Qsocial Qmkt

Sprivate

Figure 11.4

Pollution Taxes

Rather than allow the spillover costs to fall externally on members of society, the goal of

pollution taxes is to internalize these costs by imposing a tax on the production or con-

sumption of goods that create negative externalities. Our goal is to move the market equi-

librium quantity closer to the socially optimal quantity of electricity. Suppose government

imposes a tax, equal to the spillover cost, on every unit of coal that our power plant uses to

produce electricity. This pollution tax results in an inward shift of the private supply curve

so that it equals the social supply curve. See Figure 11.5. The price of running the dish-

washer has increased, but now that price incorporates all of the costs of electricity, includ-

ing the effects of pollution on the environment and human health.

In some cases, a tax may be imposed on consumers, if they are responsible for the neg-

ative externality. For example, in major metropolitan areas, traffic is a serious problem and

millions of commuters create significant amounts of pollution. We might increase the auto-

mobile registration tax or create a system of toll highways so that the users of automobiles

and the commuters themselves must pay an additional price for that behavior. We have seen

that any time the price increases, quantity demanded (driving) must fall.

Be carefulwhen designing a tax to remedy a negative externality. We must tax those who

are imposing the spillover costs on society. Would you tax the nonsmoker to fix the prob-

lem of secondhand smoke? Hardly.

TIP

KEY IDEA