Economics Investigation Notes

Michael Adams

General Notes

 Causes-refer to MPC, MPB, and MEC

o Over/Under allocation of resources
o Inefficiency – Highlighted by DWL (Explain) – What it means in the scenario.
 Measures – Market-based (Internalisation) diagram.
o Regulation/legislation
o MAKE SURE to reference the diagram.
 To reduce MEC – quantity falls – DWL lessens, MPC CONVERGES WITH MSC
 Free market outcome occurs when MPB and MPC meet.
 Socially outcome occurs where MSB and MSC meet.
 When there is an externality, there is a welfare(deadweight) loss involving a
reduction in social benefits due to the misallocation of resources.

Part (a) – Explain the existence of externalities in the market for oil and gas in Australia.
Note – This part is intended to specifically address the NPE of oil and gas.
Negative Production Externalities
 To extract our oil and gas in Australia, facilities and resources must be built on land,
which must be cleared first. Commonly, this land comes at the expense of Australian
wildlife as they are forced out of their natural habitats. More than 200,000 hectares
of threatened species habitat were approved to be leveled to produce oil and gas in
2021.

 Oil and gas production is a vital component of the global energy mix, but it is also
reliant on finite and non-renewable resources. These resources are the remnants of
ancient organic matter that took millions of years to form, and as firms continue to
consume them to meet the world's energy demands, they not only affect the present
but also deprive future generations of their access to these valuable natural
resources. Approximately 4.2 billion metric tons of oil are extracted globally each
year, further depleting these non-renewable resources, and depriving future
generations of access to these resources.

 The production of oil and gas in Australia has caused significant air and water
pollution, leading to negative impacts on both the environment and society. Oil spills
during transportation have contaminated marine habitats and caused damage to
marine life, resulting in compensation costs of up to $1.2 billion. Fuel combustion,
such as petroleum and LNG combustion for production and extraction, also
contributes to air pollution, with Carbon Monoxide being a major pollutant that
reduces oxygen transportation in the bloodstream. In 2022, the emission of Carbon
 Monoxide in Australia was 710 million kilograms, posing a severe threat to the
breathability of our air thus resulting in health issues for the population.

 The greenhouse gas emissions produced during the production process of oil and gas
contribute to climate change, are highly detrimental to the environment and society.
In Australia, the total greenhouse gas emissions in 2021 were 391.19 million metric
tons of CO2, equivalent to 22.85 metric tons per capita. This data only represents
production-based emissions, excluding land use and focusing on fossil fuels and
industrial usage. Australia has emitted a total of 18 billion metric tons of CO2 to date,
with energy production from burning fossil fuels contributing 33.6% of these
emissions. Climate change effects can be observed in Victoria, where temperatures
have risen from 2.8°C to 4.3°C, leading to shifts in natural weather patterns and
increased frequency of extreme heat and droughts.

 These externalities are considered negative production externalities of oil and gas
because they entail negative side effects toward third-party entities. This means that
it would be in society’s best interest to produce less oil and gas. Since there are
negative production externalities, the market is considered to overproduce and does
not achieve allocative efficiency, so the market fails. This results in a deadweight loss
that is usually in the form of damage to health, welfare, or loss of benefits.

Part(b) – Discuss 2 measures that could address the market failure in the oil and gas
industry.
 The market failure in the oil and gas industry is caused by the divergence between
private costs and social costs and the market fails because it overproduces causing a
deadweight loss.

 The aim of a measure is to internalize a firm’s marginal private cost within the
marginal social cost by raising the firm’s private cost be a value equal to the external
cost. Here, the optimal quantity is produced, and the optimal price is set. This
eliminates the main problem of resource over-allocation, thus correcting market
inefficiency.
Measure One - Government Regulations
 To deal with negative production externalities, Governments may use their
authority over firms to enact legislation and regulations to correct market
inefficiencies by reducing or eliminating negative production externalities.

 Regulations can forbid the dumping of toxic substances into the environment,
eliminating overproduction and removing the DWL.

 More commonly, regulations do not totally ban the production of pollutants, but
rather attempt to restrict their emissions by doing one of the following:
 o limit the emission of pollutants by setting a maximum level of pollutants
permitted.
o limit the quantity of output produced by the polluting firm.
o require polluting firms to install technologies to reduce emissions

 These reduce or eliminate production externalities by increasing private cost to a

value equal to or like external cost, resulting in an eliminated or lessened
deadweight loss.

Measure Two – Market-Based Regulations (Taxes)

 When externalities exist, the market outcome will not be efficient so the
optimal quantity will not be produced, and the price charged may not reflect
the true value of the resources used in production.
 AIM IS TO INTERNALISE THE EXTERNALITY BY FORCING THE MARKET TO
RECOGNISE AND INCLUDE THE EXTERNAL COST IN THEIR MARKET PRICE
 A tax is put in place on firms to raise prices – reduce output.
 For example, a government could place a pollution tax on a firm equal to the
marginal external cost.
 The tax will then increase a firm’s private costs which increases the marginal
private costs to coincide with the marginal social costs.
 The tax corrects market failure – firms are being forced to pay for their
external costs.
 Thus, the market corrects itself by eliminating the divergence between the
MPC and MSC and tends toward the socially optimum price and quantity.
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