1.3.2 Externalities Flashcards
Externalities
> The cost or benefit to a third party from an economic transaction. A spill-over effect of production or consumption.
The extent to which a market fails involves a value judgement, so the monetary value of an externality is difficult to determine. This makes determining government policies different too.
Private, Social and External Costs and Benefits
> Private - the costs/benefits to the economic agents participating in the economic activity.
Social - the costs/benefits of the activity to society as a whole.
External - the costs/benefits to a third party not involved in an economic activity. They are the difference between social costs/benefits and private costs/benefits.
External cost - net social cost is greater than net private cost.
External benefit - net social benefit is greater than net private benefit.
Where is the socially optimum position?
> Where MSC = MSB
It is the point of maximum welfare. The social cost of producing the last unit of output is equal to the social benefit derived from consuming it.
Merit and Demerit goods:
> A merit good is one with external benefits, where the benefit to society is greater than the benefit to the individual. They tend to be under provided.
A demerit good is one with external costs, where the cost to society is greater than the cost to the individual. They tend to be over provided.
Marginal costs and benefits
> A marginal cost is the extra cost of producing an extra unit of the good.
A marginal benefit is the extra benefit of consuming an extra unit of the good.
Therefore:
MPB is the extra satisfaction gained by the individual from consuming one more of a good.
MSB is the extra gain to society from the consumption of one more good.
MPC is the extra cost to the individual from producing one more of the good.
MSC is the extra cost to society of the production of one more good.
The difference between MSC and MPC increases as output grows, because the more production there is, the greater the external cost.
Same goes for the difference between MSB and MPB.
Negative Production externality diagram:
(Diagram Sheet 2)
> Social costs are greater than private costs. A free market will ignore the external costs involved in producing a good. It will produce where MPC = MPB, the market equilibrium, at Q1 and P1.
> The economy should produce at the socially optimum postion where MSB = MSC, Q2P2.
> At Q1 the costs to society are higher than the benefits to society. The external cost of production at Q1 is equal to the line AB, resulting in a welfare loss equal to the shaded area, ABC.
> ANALYSIS: Firms act out of self interest and ignore the social cost and only consider their private cost, causing the market to allocate resources where MPB = MPC.There is therefore overproduction and consumption of this good in the economy. The price is too low which encourages over consumption. There is therefore a misallocation of resources, causing market failure.
Positive Consumption Externality
(Diagram sheet 2)
> Occur when social benefits are greater than social costs.
> The free market will produce at the market equilibrium, where MPC = MPB. It will not consider the benefits to society and produce q1 at a price of p1.
> The socially optimum level of output is Q2 where MSB = MSC.
> The line AB represents the external benefit of consumption, and there is therefore a misallocation of resources with an underproduction of Q1-Q2, leading to a welfare loss of the shaded area.
> ANALYSIS - Individual consumers are only considering their private benefits due to self interest. As a result the market allocates resources at Q1 meaning there is an under consumption/production compared to the socially optimum level. There is a misallocation of resources and the welfare loss.
Government intervention (more detail later)
> Indirect taxes and subsidies - move production closer to optimum position.
Tradable pollution permits - allow firms to produce up to a certain level of pollution.
Provision of the good - when the social benefits are high the government may provide the good through taxation (revenue).
Provision of information - the gov can provide information to help people make informed decisions for products with information gaps.
Regulation - could limit the consumption of goods with negative externalities.
