1.3.2 Externalities Flashcards
Private costs/benefits
The costs/benefits to the individual participating in the economic activity. The demand curve represents private benefits and the supply curve represents private costs.
Social costs/benefits
The costs/benefits of the activity to society as a whole.
External costs/benefits
The costs/benefits to a third party not involved in the economic activity. They are the difference between private costs/benefits and social costs/benefits.
Merit and demerit goods
- A good with external benefits, where the benefit to society is greater than the benefit to the individual. These goods tend to be underprovided by the free market e.g. education, healthcare, public transport, renewable energy.
- A demerit good is a good with external costs, where the cost to society is greater than the cost to the individual. They tend to be over-provided by the free market e.g. smoking, alcohol, gambling, junk food.
Marginal cost/benefit
The extra cost/benefit of producing/consuming one extra unit of the good.
Marginal Private vs Social cost
Marginal Private Cost (MPC): the extra cost to the individual from producing one more of the good
Marginal Social Cost (MSC): the extra cost to society from the production of one more good
Marginal private/social benefit
Marginal Private Benefit (MPB): the extra satisfaction gained by the individual from consuming one more of a good
Marginal Social Benefit (MSB): the extra gain to society from the consumption of one more good
Negative production externalities
Negative externalities of production occur when social costs are greater than private costs.
- The market left to operate freely will ignore the external costs involved in producing a good.
- It will produce where MPB=MPC, the market equilibrium, at Q1P1.
Negative production externalities examples
The difference between marginal social cost and the marginal private cost increases as output grows, because external costs grow the more that people do something.
- If one person drove their car, then the external costs of pollution would be very small. The more people that drive cars, the larger the external cost of pollution.
- The noise pollution from airplanes and industrial waste are two examples of negative production externalities.
Positive consumption externalities
Positive externalities of consumption occur when social benefits are greater than social costs. In the diagram, the market left to its own devices will produce where MPB=MPC, it will not consider the benefits to society so will produce Q1P1.
Positive CONSUMPTION externalities examples
Walking/cycling to work
Electric car
Significance of an externality
It is difficult to work out the size of the externality as it tends to be placed on value judgements, since it is difficult to monetise external costs.
- Many externalities are involved with information gaps, as people are unaware of the full implications of their decisions.
Government interventions for externalities
There are a number of ways that the government can intervene to ensure the market considers the external costs and benefits:
- Indirect taxes and subsidies
- Tradable pollution permits
- Provision of the good
- Provision of information
- Regulation
Indirect taxes and subsisdies
Taxes can be put on goods with negative externalities and subsidies on goods with positive externalities. These help to internalise the externalities, moving production closer to the social optimum position.
Tradable pollution permits
These allow firms to produce up to a certain amount of pollution, and can be traded amongst firms so give them choice whilst reducing the total level of pollution
