Difficulty: Intermediate | Prerequisites: supply and demand basics, consumer and producer surplus, understanding of tax incidence.
This material covers two areas that appear together on many intermediate micro exams: labour market interventions (EITC versus minimum wage) and externalities (pollution, marginal external cost, and market-based solutions like tradeable permits). Both topics deal with situations where the unregulated market outcome is not efficient, and both ask you to reason about who bears the cost of policy and how market outcomes shift. You should already understand supply-and-demand diagrams and the concept of surplus before working through these notes.
The EITC and minimum wage both aim to help low-income workers, but the EITC avoids creating unemployment and targets support more precisely; its main drawback is that benefits arrive only once a year. Externalities arise when a transaction imposes costs or benefits on third parties. Pollution is the classic negative externality, and the socially optimal fix is to internalise the external cost, either through taxes or tradeable permits.
Earned Income Tax Credit (EITC)
A refundable tax credit for low-to-moderate-income workers that supplements earned income. In simple terms, the government tops up your pay through the tax system rather than regulating your wage directly.
Minimum wage
A legally mandated price floor on the hourly wage rate. Think of it as a rule that says employers cannot pay less than a certain amount per hour.
Externality
A cost or benefit of a transaction that falls on someone who is not a party to that transaction. In simple terms, it is a side effect of economic activity that hits bystanders.
Negative externality
An externality that imposes a cost on third parties, such as pollution from a factory.
Positive externality
An externality that confers a benefit on third parties, such as a neighbour's beautiful garden you enjoy without paying for it.
Marginal external cost (MEC)
The additional cost imposed on third parties by producing one more unit of output. When MEC rises with output, the total external cost grows at an increasing rate.
Marginal social cost (MSC)
The sum of marginal private cost and marginal external cost: MSC = MPC + MEC. The socially optimal output is where MSC equals marginal benefit (the demand curve).
Transferable (tradeable) permits
Government-issued rights to emit a certain quantity of pollution, which firms can buy and sell. The market price of a permit reflects the cost of the last unit of pollution allowed.
Socially optimal output
The quantity at which marginal social cost equals marginal social benefit. At this point, the full cost of production, including external costs, is accounted for.
The EITC and minimum wage are both tools aimed at raising the income of low-wage workers, but they work through different mechanisms and have different side effects.
Advantages of the EITC over a minimum wage:
Does not create unemployment. A minimum wage is a price floor that can push the wage above the equilibrium, reducing the quantity of labour demanded.
Can be targeted to specific household types (families with children, for example).
Does not burden employers directly; it is funded through the tax system.
The key disadvantage of the EITC relative to a minimum wage: benefits arrive only once a year (at tax filing time), rather than in each pay packet. This is the answer to the exam question "which is NOT an advantage of the EITC."
Minimum wage effects on employers and workers:
Employers are always hurt by minimum wage laws (they face higher labour costs).
Workers do not always benefit, because some lose their jobs or have hours cut when the wage rises above the market-clearing level.
The correct pairing: Statement I (employers always hurt) is true; Statement II (workers always benefit) is false.
An externality exists whenever a transaction affects a third party who did not choose to be involved.
Whether something is a positive or negative externality can depend on the person affected.
Loud music from a neighbour's party: a positive externality if you enjoy the music, a negative externality if you do not. The same activity, two different externalities depending on the bystander.
When negative externalities are present, the market produces more than the socially optimal quantity because private costs understate the full social cost.
When positive externalities are present, the market produces less than the socially optimal quantity because private benefits understate the full social benefit.
Marginal external cost (MEC) often increases with output. If MEC(q) = 2q², the total external cost is the integral of MEC, which grows at an increasing rate as output rises.
This means each additional unit of output imposes a larger external cost than the one before it.
The socially optimal output is found where marginal social cost (MPC + MEC) equals marginal benefit (the demand curve).
If the marginal external cost curve shifts upward (pollution becomes more damaging per unit), the socially optimal price increases and the socially optimal quantity decreases.
Intuition: higher external costs mean the social cost curve pivots up, intersecting demand at a lower quantity and higher price.
Transferable (tradeable) permits:
The government caps total emissions and issues permits. Firms can trade them.
When new technologies make cleaner production possible, the demand for permits falls and the price of permits drops.
This is an elegant result: technological progress reduces the cost of pollution abatement, making permits less valuable.
Plastics factory example: constant marginal private cost, increasing marginal external cost, downward-sloping demand. If MEC shifts up, the MSC curve shifts up, optimal price rises, and optimal quantity falls.
Marginal social cost: MSC = MPC + MEC
Socially optimal output: where MSC = marginal benefit (demand)
If MEC(q) = 2q², total external cost = integral of 2q² = (2/3)q³, which grows at an increasing rate
Pigouvian tax = MEC at the socially optimal output (sets the tax equal to the external cost of the last unit produced at the optimal quantity)
The EITC is one of the largest anti-poverty programmes in the United States. Its design reflects the trade-off between targeting accuracy and the timing of benefit delivery.
Cap-and-trade systems for pollution (such as the EU Emissions Trading System) are direct applications of the transferable-permits framework. As renewable energy technology improves, permit prices tend to fall, which is exactly what the theory predicts.
Students often think workers always benefit from a minimum wage. They do not: some workers lose jobs or hours when the wage floor exceeds the equilibrium.
A common mistake is classifying an externality as strictly positive or negative without considering who is affected. The same activity (loud music) can be both.
Students sometimes think that if MEC is rising, the total external cost is rising at a constant rate. If MEC rises with output, total external cost grows at an increasing rate (the curve gets steeper).
Some students assume tradeable permits become more expensive as technology improves. The opposite is true: cleaner technology reduces demand for permits and their price falls.
⚠️ The "not an advantage of the EITC" question is a recurring exam item. The answer is that benefits arrive once a year.
⚠️ Know the correct pairing for minimum wage statements: employers are always hurt (true), workers always benefit (false).
⚠️ Be ready to determine whether total external cost is growing at an increasing, constant, or decreasing rate from the functional form of MEC.
⚠️ Understand the direction of change in permit prices when technology improves: prices fall.
⚠️ When the MEC curve shifts upward, the socially optimal price rises and quantity falls. This is a common graph-interpretation question.
True or false: The EITC creates unemployment in the same way a minimum wage can. (False)
Fill in the blank: Benefits arriving only ________ is a disadvantage of the EITC compared to a minimum wage. (once a year)
True or false: Loud music from a party is always a negative externality. (False, it depends on whether the listener enjoys it)
True or false: When cleaner technology becomes available, the price of tradeable pollution permits rises. (False, it falls)
Fill in the blank: The socially optimal output is where marginal ________ cost equals marginal benefit. (social)
Q: Which of the following is NOT an advantage of the EITC over a minimum wage: (a) does not create unemployment, (b) can be targeted to specific households, (c) benefits arrive once a year, (d) does not burden employers directly?
A: (c). Benefits arriving once a year is a disadvantage of the EITC, not an advantage.
Q: Consider: I. Employers are always hurt by minimum wage laws. II. Workers always benefit from minimum wage laws. Which is correct?
A: I is true and II is false. Employers face higher costs, but some workers lose jobs or hours, so workers do not always benefit.
Q: Loud music from a neighbour's party is what kind of externality?
A: A positive externality if you like the music, and a negative externality if you do not. The classification depends on the effect on the specific third party.
Q: Given MEC(q) = 2q², what can be inferred about total pollution cost as output increases?
A: The total cost of pollution is growing at an increasing rate. MEC itself is rising with q, so each additional unit adds more external cost than the last.
Q: What happens to the price of transferable permits when new technologies make cleaner production possible?
A: The price of permits falls. Cleaner technology reduces firms' need for permits, shifting demand for permits leftward.
Q: A plastics factory has constant MPC, increasing MEC, and downward-sloping demand. If the MEC curve shifts upward, what happens to the socially optimal output and price?
A: Optimal price increases and optimal quantity decreases. The upward shift in MEC raises the MSC curve, moving the intersection with demand to a lower quantity and higher price.
The EITC discussion connects to labour market analysis (supply and demand for labour, wage floors, elasticity of labour demand) and to public finance (how tax credits are funded and administered). Externalities link directly to welfare economics and the first and second theorems of welfare economics: when externalities are present, the first welfare theorem breaks down and the market does not produce an efficient outcome. Tradeable permits connect to Coase's theorem and to the broader debate about market-based versus command-and-control environmental regulation.
EITC, earned income tax credit, minimum wage, price floor, labour market, wage floor, unemployment, externality, positive externality, negative externality, marginal external cost, MEC, marginal social cost, MSC, marginal private cost, MPC, Pigouvian tax, tradeable permits, cap and trade, transferable permits, pollution, socially optimal output, welfare economics, market failure, intermediate microeconomics, FIU econ