Microeconomics+19


 * __ Question: __** Distinguish between private costs and benefits and social costs and benefits. Explain how an increase in the number of cars on the roads of a country might lead to a misallocation of resources. Evaluate the ways in which a government might remedy this misallocation.


 * __ Answer: __** Through the consumption of a good or service, costs and benefits to the individual and society must be differentiated. A situation in which the social cost that arise as a result of a good or service’s consumption exceeds private benefit obtained from the consumption itself is called market failure. A frequent example for a good bearing a negative externality of consumption is a car. A marginal private utility (MPB) curve in a microeconomic market diagram represents the private benefit for any given good or service consumed at any given time, in this case through the use of the car. A marginal social cost (MSC) curve represents the “cost” to society as a consequence of the good’s consumption. The private and societal benefits and costs can be represented through the following diagram:



The diagram presents the market for cars in given economy A. The demand for cars is represented by the curve MPB, which also presents the marginal private benefit, or the utility to the individual “consuming” the car. However, the benefit to society, represented by curve MSB (situated leftward of MPB) through the consumption of the vehicle is smaller, resulting in a loss of welfare, represented by the leftward pointing triangle “welfare loss”. The intersection of the MSB curve with the MSC curve, representing the marginal social cost occurring through the consumption of the car, is the point to which cars should be consumed in economy A to avoid a welfare loss. However, consumers ignore this welfare loss and so cars are “consumed” at a quantity of Q1 at price P1, suggesting economy A’s market for cars if failing (as it incurs a welfare loss). This market failure would be avoided if economy A’s consumption of cars were to be at Q* at price P*. An increase in the number of cars in the roads would further expand the gap between private and social benefits of consumption, resulting in a greater welfare loss. As a result, it can be assumed that resources are being misallocated, as the economy is not following a path of sustainable development.

However, the economy has various options to counter this misallocation of resources. These include educating the public about the negative externality incurred through car consumption, imposing an indirect tax upon car consumption, or banning the use of cars completely and improving possible substitutes to cars in the form of public transport.

A frequent method employed by governments to reduce the effects of negative externalities is through the broadcasting of negative publicity. Economy A’s government could start a campaign educating the public about the environmental and societal costs incurred through the use of cars. However, this type of negative advertising is likely to have only a small effect, as consumers are likely to value their own benefit more than the cost to society.

However, if the government’s intervention has a financial consequence for consumers, it is more likely to have an effect. Through the implementation of an indirect tax of car consumption, for example, a set tax on every kilometre driven or an increase in taxes on petrol, marginal private benefit of car consumption is likely to decrease, thus reducing or eliminating welfare loss completely and bringing the market out of its state of ‘failure’. The complete ban of car consumption is a step the government is unlikely to take, as cars still provide a benefit to society as represented by the curve MSB. Thus, consumption of cars would be optimal if the MPB curve (or demand curve) for cars would reduce to level MSB.

Lastly, the government could intervene by making public transport more efficient and interesting as a substitute to car consumers. This would have the result of decreasing demand (MPB-curve) for cars, bringing it closer to the MSB-curve. A balance of indirect tax implementation and improvement of public transport is the most frequent and likely measure the government of economy A would take to remedy the situation.