A UK electricity company burns coal to generate energy. It sells electricity in a competitive market. The company considers its fuel, workers and machinery ...
Question 1 Report
A UK electricity company burns coal to generate energy. It sells electricity in a competitive market. The company considers its fuel, workers and machinery costs, but local residents also face health costs from air pollution. The market demand curve is D = MPB and the firm's supply curve is S = MPC. At the market equilibrium, 80 million kWh are produced at £30 per 1,000 kWh. At this output, the marginal social cost is £45 per 1,000 kWh. Assume that the marginal external cost is constant at £15 per 1,000 kWh and that the socially efficient output is 60 million kWh. The UK government wants to reduce pollution without creating excessive inflation in household energy bills.
(a) What is meant by a negative production externality? [1]
(b) Which curve shows the private costs faced by the electricity company? [1]
(c) Which costs should be added to MPC to obtain marginal social cost? [2]
(d) Draw an MSC curve on the diagram. [2]
(e) Which output, 60 million kWh or 80 million kWh, is socially efficient? [2]
(f) Calculate the total external cost at an output of 80 million kWh. Show your working. [2]
(g) Which per-unit tax could the government use to internalise the external cost, and why? [3]
(h) Draw the likely supply curve after this tax is imposed. [2]
(i) Which two groups are likely to benefit from the tax? [3]
(j) Which limitation could make this tax less effective in practice? [2]
Answer Details
(a) A negative production externality is a harmful effect of production imposed on third parties and not included in the producer’s costs. [1]
(b) S = MPC shows the firm’s private costs. [1]
(c) Add external health costs from pollution and other third-party environmental costs, such as damage to buildings or ecosystems, to MPC. [2]
(d) Since marginal external cost is constant, MSC is above and parallel to MPC.
[2]
(e) 60 million kWh is socially efficient. At 80 million kWh, MSC exceeds MSB, so electricity is overproduced. [2]
(f) \[£15\times80\text{ million}=£1,200\text{ million}=£1.2\text{ billion}\] [2]
(g) A Pigouvian tax of £15 per 1,000 kWh internalises the external cost. It raises marginal private cost by MEC, shifts supply towards MSC and gives the firm an incentive to reduce output and emissions. [3]
(h) Supply shifts vertically upward/left by £15 per 1,000 kWh, coinciding with MSC. [2]
(i) Local residents gain cleaner air and lower health risks. The government or taxpayers may gain tax revenue, and cleaner-energy producers may become relatively more competitive. Any two developed groups gain. [3]
(j) The true external cost may be difficult to measure, so the tax could be too high or too low. Inelastic demand may also limit the fall in output. [2]
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