1.3.2 Externalities

Question 1

Distinction between private costs, external costs and social costs and Distinction between private benefits, external benefits and social benefits

Answer 1

• Private costs/benefits ​are 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​ are the costs/benefits of the activity to society as a whole.
• External costs/benefits are 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.

Question 2

Use of a diagram to illustrate:
the external costs of production using marginal analysis

Answer 2

The marginal private cost (MPC) is the extra cost to the individual from producing one more of the good

The marginal social cost (MSC) is the extra cost to society from the production of one more good

Question 3

Use of a diagram to illustrate:
the distinction between market equilibrium and social optimum position

Answer 3

equilibrium is where MPC and MPB cross

social optimum is where MSC and MSB

Question 4

Use of a diagram to illustrate:
identification of welfare loss area

Answer 4

triangle between equilibrium price, social optimum price and the point on MSC where equilibrium quantity crosses it. the triangle always points towards the social optimum

Question 5

Use of a diagram to illustrate:
the external benefits of consumption using marginal analysis

Answer 5

The marginal private benefit (MPB) is the extra satisfaction gained by the individual from consuming one more of a good

The marginal social benefit (MSB) is the extra gain to society from the consumption of one more good

Question 6

Use of a diagram to illustrate:
the distinction between market equilibrium and social optimum position

Answer 6

equilibrium is where MPC and MPB cross

social optimum is where MSC and MSB

Question 7

Use of a diagram to illustrate:
identification of welfare gain area

Answer 7

triangle between equilibrium price, social optimum price and the point on MSB where equilibrium quantity crosses it

Question 8

The impact on economic agents of externalities and government intervention in various markets

Answer 8

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.

• Indirect taxes and subsidies
• Tradable pollution permits
• Provision of the good
• Provision of information
• Regulation