1.3.2 Externalities

Question 1

What are externalities?

Answer 1

Externalities are spill-over effects from production and/or consumption for which no appropriate
compensation is paid to one or more third parties affected.

Question 2

How can externalities cause market failure?

Answer 2

Externalities cause market failure if the price mechanism does not take account of the full social costs and
benefits of production and consumption. Externalities can be positive and/or negative i.e. the impacts on third
parties can be good or bad

Question 3

What are private costs?

Answer 3

Private costs are the costs faced by the producer or consumer directly involved in a transaction

Question 4

What are external costs?

Answer 4

External costs are the costs imposed on third parties as a result of a transaction that they are not
directly involved in (or just externalities)

Question 5

What are social costs?

Answer 5

• Social cost = private costs plus external costs
• Therefore, when negative (production) externalities exist, social costs exceed private cost

Question 6

Explain when external costs can occur and what effect it has on third parties.

Answer 6

• External costs occur when the activity of one agent has a negative effect on the wellbeing of a third
  party
• External costs damage third parties, but the consumer and producer don’t have to pay, meaning that
  output will be too high. In the case of production externalities, the market price will therefore be too
  low

Question 7

What is marginal private cost?

Answer 7

cost to the producing firm of producing an additional unit of output or
costs to an individual of any economic action

Question 8

What is marginal external cost?

Answer 8

cost to third parties from the production of an additional unit of output

Question 9

What is marginal social cost?

Answer 9

total cost to society of producing an extra unit of output. MSC = MPC + MEC

Question 10

What are examples of negative externalities from production?

Answer 10

Question 11

Show negative production externalities on a diagram:

Answer 11

Question 12

Explain negative production externalities

Answer 12

• If there are negative externalities, then we must add the external costs to the firm’s supply curve (i.e.
  it’s marginal private cost (MPC) curve) to find the marginal social cost curve (MSC)
• If the market fails to include these external costs, the private equilibrium output is Q1 and the price P1
  where marginal private cost = marginal private benefit.
• The socially efficient output would be Q2 with a higher price P2. At this price level, the external costs
  have been considered, and marginal social cost is equal to marginal social benefit
• We have not eliminated the pollution – but at least the market has recognised them and priced them
  into the price of the product.
• For economists, it is rarely the case that products generating external costs should have production
  levels of zero – we recognise that there are usually some benefits to these products being provided!

Question 13

Show the welfare loss from negative externalities

Answer 13

The (deadweight) welfare loss refers to the total value of the undesired impact of negative externalities, as a
result of the over-production occurring in this market.

Question 14

What are positive externalities?

Answer 14

Positive externalities exist when third parties benefit from the spill-over effects of production/consumption e.g.
the social returns from investment in training or the positive benefits from health care/medical research.

Question 15

What are private benefits?

Answer 15

Private benefits are the benefits faced by the producer or consumer directly involved in a transaction

Question 16

What are external benefits?

Answer 16

External benefits are the benefits enjoyed by third parties as a result of a transaction that they are not
directly involved in (positive externalities)

Question 17

What are social benefits?

Answer 17

• Social benefit = private benefits plus external benefits
• Therefore, when positive (consumption) externalities exist, social benefits exceed private benefits

Question 18

Explain when external benefits can occur and what effect it has on third parties.

Answer 18

• External benefits occur when the activity of one agent has a positive effect on the wellbeing of a third
  party
• External benefits are good for third parties, but the consumer and producer don’t take this into
  account, meaning that output will be too low. In the case of positive consumption externalities, the
  market price will therefore be too high

Question 19

What is marginal private benefit?

Answer 19

benefit to the consumer of consuming an additional unit of output

Question 20

Marginal external benefit (MEB

Answer 20

benefit to third parties from the consumption of an additional unit
of output

Question 21

Marginal social benefit (MSB)

Answer 21

total benefit to society of consuming an extra unit of output. MSB = MPB + MEB
MSB>MPB in positive consumption externalities

Question 22

Show positive externalities from consumption on a diagram

Answer 22

Question 23

Explain the graph of positive externalities from consumption

Answer 23

• If there are positive externalities, then we must add the external benefits to the demand curve (i.e. the
  marginal private benefit (MPB) curve) to find the marginal social benefit curve (MSB)
• If the market fails to include these external benefits, the private equilibrium output is Q1 and the price
  P1 where marginal private cost = marginal private benefit
• In a free market, there is under-consumption of this good or service
• The socially efficient output would be Q2 with a higher price P2. At this output level, the external
  benefits have been considered, and marginal social cost is equal to marginal social benefit

Question 24

What are examples of positive consumption externalities?

Answer 24